Let's spend some time on understanding the intuition. We have cashflows, we have very simple cashflows. What were the cashflow? Minus 1,000 today signifying our effort, the cost of what it took to start the project. What will the cash flow next year, 1,320. Where do these cash flows come from? I'll later use the following language. Who do they belong to? Please recognize one thing extremely important, and I will keep emphasizing this, but it's very important. Cashflows belong to the project. To your idea. You are responsible as the person generating this idea to come up with the costs and benefits. Because if you can't do it, then the idea is not very obvious to anybody. This is the first step in recognizing what are the costs and benefits of your own idea. Now, it's not easy to do. It involves accounting, it involves finance and so on. I'll spend an entire session next time on how do you come up with these. But I must warn you, that's the one part of this class that I cannot spend a lot of time on because it will require you to do a class at accounting. Remember the language that we use as accounting. If you don't understand accounting, we cannot take business plans and convert them into cashflows. But don't worry, it's not that difficult. I'll introduce you to enough thought so that you can do some basic stuff yourself. What are cashflows income from? The most important point is think of them as profits, not revenues, not costs of doing something. Profits. What is left in the end? Those we call cashflows and they occur at various points in time, in this case, 1,320, in the future and the cash outflow today is minus 1,000. The key point, however is, it's your ideas signature. It's unique to your idea. The idea and cashflows to me are the same thing. Idea and benefit and costs are the same thing. Because if you can't combine the two, an idea is meaningless. Now, here's the important point. What is R in our problem? The interest rate? It's 10 percent. This is something that's really critical to understand. If the cashflows come from what your sense of the idea is, your ability to figure out the cashflows. It obviously ultimately the cashflow is also dependent on the customer whether they buy a product or not. But what I'm saying is, it's your responsibility to do all the hard work to show what the cashflows in benefits of your idea. Where does R come from? R is an extremely critical aspect of finance. R captures the opportunity cost of investing in this idea. Opportunity cost is easily said, everybody nods their head when it's said, but it's very tough to understand. PhD's take tests on our opportunity cost. People have been working in the real world for years and they screw up. The reason is, it's a very easy concept to say, yes, I understand it, but it's very tough to actually figure out. Let me tell you why R is tough. You would imagine as most of the world does, is that R comes from thin air. In fact, most of the time I'm really frustrated where people pull R out of thin air and say, R is 20 percent. Why? Here's something very important to understand. R comes from the next best use of even your own investment, leave alone other people's on a similar project. Think of R as not belonging to your project. R is that return that is coming from investing in, say, a competitor. Imagine you're going on, you have a great idea, but similar ideas usually exist. It was the Internet boom that threw us off because we had never seen things like that, but typically, your idea is not brand new, something similar is going on. Imagine if you have the money to start your own idea. I think it would be good of you to look at existing people doing the same thing. If they are getting a better return than you are, it doesn't make sense for you to do it. It helps society to use R as the return or the possibility of making money in a similar venture with a competitor. That becomes your R. Because when you go to R, you should be thinking like the investor in you or in other people. What will an investor do? If you show me your cash flows, cost, and benefits, what's the first thing that will strike me? How could I do better? But in the same type of business. Because I can't compare businesses that are making rocket engines with selling bananas. You'll see why not. Because they are not the same thing. One is much riskier than the other. We'll get to that. What does the final number mean? What was our NPV? Our NPV was what? Two hundred dollars. What is the unit of measurement? Dollars. It is the measurement of value. I'm not saying dollars can measure all value, what I'm saying is the unit of measurement is the unit used by everybody. Here's the cool thing: you will add $200 or 200 million if you may, if you want to put everything in million, in net value to you and hopefully to society by this idea. The final number has a very cool meaning as well. It says, how much value have you created? You've created 200 million worth of value. Why? Because you invested 1,000 and you got 1,200, you got 1,320 but when you discounted it back today by what the competitor could have done, you're making 200. Should you pursue this idea? What do you think? Answer is yes. The reason is very straightforward; you are creating positive value. One caution: if you do not have the resources to do so, should you not do it? Why am I raising this caution? Is because there could be situations in the world where you have a great idea but don't have the resources. What comes in to your rescue? Markets. Competitive, fair, not moneylenders dressed as banks, whatever, it's fair resources available to you. Why will that happen? Because most of us don't have great ideas. It's okay not to. I don't come up with great ideas all the time, it's very tough to come up with great ideas. So what do we do? We have mostly savers in society if you have the resources of course, and we want them to go to the people with the ideas. The people with the ideas don't have great ideas all the time. So at some point, they will also want their resources to go elsewhere. If the resources are not there, then ideas are not implemented. Therefore, the importance of markets. I'm going to assume if you have a good idea, resources will come, regardless of whether you have the resources or not. That clearly depends on the availability of a market. Net Present Value: the essence. Value is always incremental. I'm going to emphasize this because this is extremely important, it puts everything together. To what? Let's get started. Let me ask you the following cool thing. Suppose you have $1,000 and you're going to invest it at time zero, what is the option? The option is clearly very simple. Your idea has been practiced elsewhere. The R of 10 percent as I said, is what is gotten on, say, a similar or a competitive idea that exists. Your investors or even your dad says, ''Look, I have $1,000 or a million, whatever, and I can't figure out how much can I make in the marketplace.'' The important thing is apples to apples. If you set up a banana stall, your dad should be comparing it to a banana stall. If he's set up a rocket engine machinery factory, he should compare it to something similar because risk, apples versus apples, oranges versus oranges. Suppose he took this money and put it in an existing business that was similar. How much would he make? Very simple. You've got to calculate the future value of $1,000 one year from now. Don't tell me you can't do it. You can. It is 1,100. Do you get it? Take 1000, you'll get the 1,000 back plus the 10 percent return. What is this? This is equal to P of 1 plus r. This is the first thing we did. What is P? $1,000. Why is it negative and this positive? Because paying comes and then you get a gain. The $1,000 grows into 1,100. This is with the existing idea. Somebody is already doing this kind of business. Obviously, sometimes you have a brand-new idea and it's tough to evaluate, and that's why we screw up when new things come. Because, after all, we are human. Now, what is your idea saying? Your idea saying is, give me the 1,000, this is your alternative, and I'll give you how much? Well, somehow you are so cool that you are able to generate 1,320 instead of 1,100. Why am I emphasizing this? The reason is, value is not created in absolute amounts. This is extremely important, value is always created in a relative amount. Look at this. This is the same investment, so I'm not having an investment of 500,000 versus 1,000. But look at what's happening. That's why a one-period problem is so simple. How much am I creating? Yes, I'm creating 1,320. But that's not the right way of figuring out value. The right way of figuring out value is how much have I created additional to what already would have existed? Take 1,320 and subtract 1,100, how much are you left with? 220. Everybody gets this? I have been, with my ingenuity in a very similar business with the similar risk, able to create value of 220. By the way, this is happening all the time. Let me give you a very simple example that we'll come back to. Walmart. Is Walmart doing something that was never done before? Heck, no. I mean, not to take anything away from their efforts, they don't sell something that we've never seen before. Walmart is not like Apple, which has created something new that we like. It is selling stuff that we already wanted to buy, but in a different way, and created value to that process. You have 220, but when is the 220, which year? Now, look at the beauty of this. If I bring this back today, how much is it? Very simple. 220 divided by 1.1. Why? Because the interest rate is 10 percent, and I'm discounting for one year. How much am I left with? 200, which is also what? NPV. This is something that is so important to recognize, that the process of discounting that we did takes care of the opportunity cost of capital. Another way to think about it is, everybody else was making zero, then everything is green. But everybody else in this example is not making zero, they're making 10 percent. I hope this was useful to you, and I hope you remember that net present value is always incremental, and value creation is always incremental because that's how life is. There's no such thing as absolute value. It's always relative value. Let's do another example, and then I promise we'll take a little bit of a break after we do the NPV. What's the NPV of this? Let's go a little bit faster. Why? Because we can. What's the value of this? Minus 1,000. What's the value of the next guy? We already know this. 1,320 divided by 1.1. Remember, 10 percent of the discount rate. Note, now that you know how to do present values, I'm going a little bit faster. We just did this. What is the NPV? Now, this is a little bit tricky and I'll do Excel in a second. This one, how did I get? I took 1,320 and divide it by 1 plus r, which was 1,320 divided by 1.1 and I got 1,200. Now, look, if this is apples, this is oranges, what is this? Bananas because its one year has passed that's [inaudible]. However, the interest rate is very high. What do I have to do? I have to take this amount, take 1,452 divided by 1.1 squared, which turns out to be, I'm going to go sideways here now, 1.21. If you do this, I believe you get 1,200 again. Set up the problem so that I can get round numbers and so on. What is the NPV? 2,400 minus 1,000. So 200 was the first periods value creation and so it's 1,400. Let me just make sure I've got this number right. I believe I have, but I want to do one last thing before we talk about NPV overall. What I'm going to do is I'm going to use Excel to generate these numbers. There's a trick and unfortunately, there's a little bit of a hassle in doing NPV, which I wanted to introduce also. Let's do this problem. In cell 1, I'm going to put minus 1,000. Please remember it's an A cell, A1, and I'm putting all these numbers in there because eventually when you're doing a more complicated problem, the beauty of Excel is you can put all the numbers in and then you can modify and so on, so forth. What is the next number? The next number is 1,320. Remember I'm doing exactly the same problem that we just did. What is the last number? Fourteen fifty-two. These are the cash flows. You have negative 1,000, 1,320, 1,452. Now what I want you to recognize about NPV is there's a little bit of an issue with it. I'm going to do NPV and open parenthesis. The first number that jumps out at you is always right, so 0.10. Now, here's the thing that already is on the website, a resource saying how to use Excel, which Nate, my great TA, has created for you. He has highlighted this issue, but I wanted to do it in real-time too. You do not want to put the investment there. It is set up to do PV. The first payment is starting in cell B1. The first payment in the future is one year from now. You'll do B1:C1, but then you recognize that this is just the PV. What do you have to do? You have to take account of the NPV part of it, so what I'll do is I'll add A1. Why did I add A1? Because I know if I add A1 and A1 is already negative, which it should be because it's an investment, what do I get? I get 1,400. This allows you to use Excel. The only thing that I would encourage you to remember is Excel NPV is really doing PV of future cash flows, so don't give time zeros information or the first cell information in your cash flows. Of course, please remember how do you get cash flows we'll do next time, but think of these as profits. The first period times zero is an investment.
