Corporate Finance I: Measuring and Promoting Value Creation

Professors Heitor Almeida and Stefan Zeume

Module 3: Making Investment Decisions

Table of Contents
Module 3: Making Investment Decisions ................................................................................. 1
Lesson 3-1: Objectives and Overview ............................................................................................... 2
Lesson 3-1.1: Objectives and Overview ............................................................................................................... 2

Lesson 3-2: NPV Example – Speeding Up the Collection of Receivables ............................................. 9

Lesson 3-2.1: NPV Example – Speeding Up the Collection of Receivables .......................................................... 9

Lesson 3-3: Net Present Value (NPV) .............................................................................................. 17

Lesson 3-3.1: The Concept of Net Present Value (NPV) .................................................................................... 17

Lesson 3-3: Net Present Value (NPV) .............................................................................................. 29

Lesson 3-3.2: Calculating NPV in Excel............................................................................................................... 29

Lesson 3-4: The Relationship Between NPV and Shareholder Value ................................................ 32
Lesson 3-4.1: The Relationship Between NPV and Shareholder Value .............................................................. 32

Lesson 3-5: Internal Rate of Return (IRR) ........................................................................................ 39

Lesson 3-5.1: The Internal Rate of Return (IRR)................................................................................................. 39

Lesson 3-6: Using the IRR to Evaluate Investments ......................................................................... 47

Lesson 3-6.1: Using the IRR to Evaluate Investments ........................................................................................ 47

Lesson 3-7: Problems With the IRR ................................................................................................. 53

Lesson 3-7.1: Problems with the IRR ................................................................................................................. 53

Lesson 3-8: Free Cash Flow Formulas .............................................................................................. 63

Lesson 3-8.1: Free Cash Flow Formulas ............................................................................................................. 63

Lesson 3-9: Real Options – Valuing R&D ......................................................................................... 81

Lesson 3-9.1: Real Options – Valuing R&D......................................................................................................... 81

Lesson 3-10: The Option to Wait – Gold Mine Example................................................................... 95

Lesson 3-10.1: The Option to Wait – Gold Mine Example ................................................................................. 95

Lesson 3-11: The Option to Abandon ............................................................................................ 109

Lesson 3-11.1: The Option to Abandon a Project ............................................................................................ 109

Lesson 3-12: Review ..................................................................................................................... 117

Lesson 3-12.1: Module 3 Review ..................................................................................................................... 117

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 Corporate Finance I: Measuring and Promoting Value Creation
Professors Heitor Almeida and Stefan Zeume

Lesson 3-1: Objectives and Overview

Lesson 3-1.1: Objectives and Overview

How do companies create value for shareholders? Right? That is a fundamental

question, it's the question that drives a lot of corporate finance teaching, research, and
real-world practice, right. There are two main sources of value creation. The first one is
creating new products, right. If a company creates a product that people love that
people want to pay a high price for, right. That is going to generate profits. That is going
to create shareholder value, okay.

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 Corporate Finance I: Measuring and Promoting Value Creation
Professors Heitor Almeida and Stefan Zeume

The other main way in which companies can create value is by buying other companies
that have created valuable projects, right? So, you either create it yourself, or you find a
way of buying other companies that have done it for you. Okay? Unfortunately, a
finance professor like me is not going to be able to tell you how to create something like
an iPhone, okay? That's not what finance is about, we are not inventors, maybe we wish
we were, but we are not, okay? What we can do, what we know how to do, and what
you will learn in this module, is to figure out how a new investment was going to
contribute to shareholder value, okay. We have tools, we have techniques, we have
formulas, we have calculations that we can use to try to figure out whether a new idea,
whether a new investment, and also an acquisition is going to contribute to shareholder
value or not. Are you increasing shareholder value by creating a new product, or are
you destroying shareholder value? Okay?

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 Corporate Finance I: Measuring and Promoting Value Creation
Professors Heitor Almeida and Stefan Zeume

And in some cases, we may even be able to stop a new product from being made.
Okay? One of our roles is to, in some cases, figure out that an idea, no matter how cool
it sounds, no matter how important may be, is going to destroy shareholder value. And if
a company is maximizing shareholder value, perhaps that product should not be made.
That acquisition should not be made, this idea should not be developed. Okay? So, that
is what the finance professor can help with.

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 Corporate Finance I: Measuring and Promoting Value Creation
Professors Heitor Almeida and Stefan Zeume

In the next two modules, we're going to develop these techniques. Okay? To be able to
estimate the contribution of a new project or a new acquisition to shareholder value.
We're going to start on module three by thinking about investment. Okay? So, we're
going to be learning tools that are going to allow companies to make decisions about
projects. And then in Module Four we're going to talk about mergers and acquisitions.
So that is the game plan in terms of our next two modules.

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 Corporate Finance I: Measuring and Promoting Value Creation
Professors Heitor Almeida and Stefan Zeume

For this module specifically, what you will learn is the first time we're going to talk about
this essential concept in finance, which is the notion of net present value. This is a very
important idea and we're going to spend a lot of time talking about NPV to really make
sure that you understand how to calculate and how to use NPV. Okay? We're going to
learn how to use NPV and why NPV equivalent to maximizing shareholder value, right?
One thing we're going to learn is that NPV, if you use NPV to make investment
decisions, you are essentially maximizing the company's stock price, okay? And then of
course, if you're taking a corporate finance course, you have to learn how to build NPV
calculations. How to build cash flows, how to computer NPV, how to use NPV to make
decisions. So, we're going to learn this is this module, okay? We are also going to talk
about the concept of internal rate of return.

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 Corporate Finance I: Measuring and Promoting Value Creation
Professors Heitor Almeida and Stefan Zeume

We're going to learn how to compute rates of return on projects, and then we're going to
talk about the relationship between NPV and IRR, okay? It turns out that there are some
cases in which you can compute a rate of return on a project, and there are some cases
in which you should not compute the rate of return on a project. And you should be
using only NPV to make investment decisions. So, we're going to talk about that. Okay?
And then, finally, we're going to incorporate a very important idea, as well, which is the
idea of real options. Okay? Many investment decisions are going to come embedded
with real options. Options to wait, options to abandon, options to change, options to
expand, okay? And we're going to try to think about how to model these options and
how to incorporate them into investment decision, okay? It turns out that we're going to
use this very useful tool called a decision tree. To make this, to incorporate real options
into evaluation.

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 Corporate Finance I: Measuring and Promoting Value Creation
Professors Heitor Almeida and Stefan Zeume

We're going to talk about a few specific examples. In particular, we are going to learn
how to value R&D. That is a very important part of the economy. It's of growing
importance in economies around the world, and it turns out that to value R&D, you have
to use real option techniques. Okay, so we're going to discuss our R&D evlauation. In
addition to that, we're going to discuss two additional options which are the option to
wait and the option to abandon a project. Again, what you're going to see is that we can
incorporate these options into investment decisions by using decision trees.

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 Corporate Finance I: Measuring and Promoting Value Creation
Professors Heitor Almeida and Stefan Zeume

Lesson 3-2: NPV Example – Speeding Up the Collection of Receivables

Lesson 3-2.1: NPV Example – Speeding Up the Collection of Receivables

Let us start from exactly where we ended at Module Two. Okay? So, this is the problem
that you're working with in the final assignment of Module Two. It's a problem that
describes the situation that many real-world companies may face. The specific situation
here is that the company has to decide whether to speed up the collection of accounts
receivable or not. Okay? So, you have the data on annual sales. Currently the company
receives 80% immediately. Okay? And 20% after one year and the firm has the choice
to move to 90% immediate collections. So, you get 90% of the cash immediately. Right?
But then the cost is that, if the firm does that, sales are going to go down by 2%. Okay?
So that was the nature of the problem.

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 Corporate Finance I: Measuring and Promoting Value Creation
Professors Heitor Almeida and Stefan Zeume

And in the final assignment of Module Two you worked with these numbers to derive
these cash flows, the cash flows for both collection systems. So those are the values of
cash flows that are coming in the firm in both cases. Okay? So, in the existing system
you get 800 today. Right? It's 80% of sales and then you get the full amount next year
and the year after, which is 1 billion. Okay? If you move to the new system, you're going
to get 882 today but the cost is that sales are going to go down. Right? So, your sales
go down to 980. Right? If you need to recap this calculation, please go to the final
assignment of Module Two. You can find a video where I explain that. You can look up
your work as well. Okay? But this is the situation. Right? And you can see it in the
numbers the tradeoff that the firm faces. Right? If you move into a quicker collection,
you're going to get cash earlier. Right? The amount of cash that you get today
increases. Okay? But your sales go down. Right? This is the fundamental tradeoff that
we talked about when we were talking about working capital investments like
receivables and inventory. Right? Increasing receivables, is likely to increase sales
because customers like, they will appreciate having time to pay for the goods, but it
costs the company terms of time to receive cash. So, it ties up cash, cash takes longer
to come in. Okay, so now we have these numbers. Our job is going to be to develop
tools that are going to allow the company to really make a decision on whether they
should change the collection system or not. Okay.

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 Corporate Finance I: Measuring and Promoting Value Creation
Professors Heitor Almeida and Stefan Zeume

To do that, we have to introduce this very important idea which is the idea of
incremental cash flow. Okay. The way that I like to think about incremental cash flow is
extremely simple. Okay. It really is the idea of new minus old. Any time a company has
to make a decision on an investment the relevant cash flows that we're going to
consider are new minus old. So, whatever the new system is minus the old system. The
new product minus the old product if there is one. Okay? So, these ideas you're going to
see as we progress, it's a very, very general idea. So, remember this concept, new
minus old. Okay?

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 Corporate Finance I: Measuring and Promoting Value Creation
Professors Heitor Almeida and Stefan Zeume

Let's apply it here to our receivables example. Right? So, you have the old system that
cash flows in the existing system, that's the old. Okay? And then you have the cash
flows in the new systems, that's the new. Right? So, the idea of incremental is just to do
new minus old. Right? It's pretty simple here. Right? So, the incremental cash flows are
going to be $82 million today. Right? It's 882 minus 800. And then starting tomorrow,
next year, and the year after. Right? You're going to lose $20 million. Right? So, look at
these numbers, think about them for a while. Right? It seems, just by looking at these
numbers, it seems the new system looks quite attractive. Right? You're getting $82
million, and you're just losing 20 million. Right? So, it seems good. The problem, as
we're going to see next, is that something is missing. Okay? Remember what we've
been talking about. We talked about this idea in Module One for example. Every time a
company makes a decision, you have to think about all the consequences. It's not just
today. It's not just current profit. It's not just current cash flows, you have to think about
every consequence, every cash flow. Right? To value a form for example, to find the
stock price, you have to think about all the future cash flows. So really, what is missing
here is the future. Okay?

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 Corporate Finance I: Measuring and Promoting Value Creation
Professors Heitor Almeida and Stefan Zeume

Future cash flows, what is going to happen in the future. Right? And if you think about
this problem, if you look at your assignment solution, it's very easy to see that what will
happen is that the same situation is going to repeat itself. Every year the same situation
is going to happen over and over again in the existing system. Right? What happens is
you sell a 1000 or a billion here. Right? Collect $800 million immediately and then you
collect the receivables from last period. Which are equal to 200 million, so your total
collection is 1 billion every year. With the new system you sell 980, collect 882
immediately and then you collect the receivables from last period. Okay, which are
equal to 98, so you're going to get $980 million every year. And this is going to go on.
Right?

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 Corporate Finance I: Measuring and Promoting Value Creation
Professors Heitor Almeida and Stefan Zeume

The way we're going to write this down is as a timeline. Okay? I like to think of this
sequence of cash flows as a timeline. And let me go over here to show you something
important. Okay? Notice that here we have three dots. Okay, these three dots here at
the end. Okay? What these three dots are going to mean in this timeline is that these
cash flows are going to go on into the future. Okay? So, these go on and on. Okay?
This is what these three dots mean, and then these three dots are going to show up in
other problems as well. Okay? When we write the timeline, we may not write today, next
year, year after. A simpler way of writing this is with numbers. You can represent today
by writing a zero, next year you write a one, year after you write two, year after you write
three, and then it goes on. Okay? The advantage of doing this with numbers is that you
can work with timelines even if the length of the period here is not a year, you can still
work with timelines. Right? So, for example if this is a month, if cash flows happen every
month, you can still represent cash flows using a timeline. Okay? Except that in that
case the length of the period is going to be one month. If you recall Module Two when
we worked on our inventory management problem, we already had a timeline in that
case the timeline was represented in quarters. Right? Because the problems there is
that the company had to have the inventory in place a quarter before the goods were
sold. Okay? So, this is the idea of a timeline. Every time we work with these corporate
decision problems, we're going to try to calculate incremental cash flows and then
express, and then write them down in a timeline. Okay?

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 Corporate Finance I: Measuring and Promoting Value Creation
Professors Heitor Almeida and Stefan Zeume

So, here's the timeline that we just talked about. Okay? Zero, one, two, three, and then
the little, the three dots. Okay? And now we have the numbers, we have all the numbers
here. Right? You can see, you can express the tradeoff we're thinking about in
numbers. So, to speed up the collection payment, the collection of receivables, you're
going to get $82 million today, and then you're going to lose $20 millions every year
starting next year. Okay? So, what should the company do? Just by looking at these
numbers now it's not obvious. Right? Now it's not obvious because this $20 million is
going to go on and on. So, is that good or bad for the company? Right? Is that going to
be better? Is it better to receive the $82 million today and then lose $20 million every
year, or is it better not to do anything and keep the old collection system?

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 Corporate Finance I: Measuring and Promoting Value Creation
Professors Heitor Almeida and Stefan Zeume

To answer this question, we're going to have to develop the concept of net present
value. The reason I love this example is that it really shows you why we need to define,
to think about net present value to answer questions about corporate decisions. Okay?
We are missing this concept. That's where we are going next. We are going to develop
the concept of net present value and then we are going to use the concept of net
present value to answer this question. Should the company do it or not?

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 Corporate Finance I: Measuring and Promoting Value Creation
Professors Heitor Almeida and Stefan Zeume

Lesson 3-3: Net Present Value (NPV)

Lesson 3-3.1: The Concept of Net Present Value (NPV)

So now, let's develop the concept of net present value. This is a fundamental concept in
corporate finance because that's what's going to allow us to make decisions about
projects, about collection systems, about acquisitions and pretty much everything else
we're going to talk about in this course. What is the net present value? The net present
value is the sum of all the incremental cash flows. Remember, we already defined
incremental cash flows, new minus old. All the incremental cash flows discounted from
the future to the current period. The important thing here is that to get your NPV right,
you have to take all the incremental cash flows into account. Everything. You take all
the consequences, any decision you're thinking about, you have to model all the
consequences of taking that decision and then discount to the current period. That is
NPV.

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 Corporate Finance I: Measuring and Promoting Value Creation
Professors Heitor Almeida and Stefan Zeume

Notice that there is the word discounting here. So, we have to discount. And so we are
going to need to use a couple formulas. That I'm pretty sure you've seen those already
at some point. If you didn't, it really is very easy to learn and to apply these formulas. All
you need really are these two formulas, the computer, and a calculator. And in some
cases, pencil and paper really works. It might be even the best way to solve a problem.

So, these are the two formulas that we need. So, there is this term r, which is the

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 Corporate Finance I: Measuring and Promoting Value Creation
Professors Heitor Almeida and Stefan Zeume
discount rate. So that's the rate that we're going to use to discount the cash flows. So
here you have a situation where you have a cash flow, Ct, that is happening t periods
ahead. Remember this is a timeline, so t, here could be anything. t could be anything, it
could be a year, it could be a month whatever you want. And to discount that cash flow,
what you do is you divide it by 1 plus r to the power t. So, if the cash flow happens two
periods ahead, you do 1 plus r to the power of 2. Very simple stuff. I hope. This is a little
bit more complicated, but it’s very important that we learn that. We cannot work, we
cannot do corporate finance without a growing perpetuity formula. That this is what it is.
Now, we have a cash flow that happens every period. So here, there is a cash flow C
with period one, there is a cash flow C another cash flow in period two. And notice that
now the cash flow is going to grow at a certain rate. g here is the growth rate of cash
flow. So, if you look at this. If g is 5%, then the cash flow in period two, remember it's
not necessarily a year. The period two is going to be 5% larger than the cashflow in
period one. If you go to period three again, you're growing cash flow at 5%. If you have
this pattern which as we're going to see is going to be a very common pattern. If you
have this pattern, the present value is just going to deceit the cash flow divided by r
minus g. So, I know this is math, it's a formula. Many people get scared with math, but it
really is very simple. All you need to do is to remember these two formulas or even look
them up if you forgot. And apply them to solve some different problems and you're going
to get this very quickly, I think. All calculations can be done with these two formulas. All
of them. So, I like to really narrow down and just tell you about those two formulas,
because they are sufficient.

To allow you to practice this, I want you to try to answer these two questions on your

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 Corporate Finance I: Measuring and Promoting Value Creation
Professors Heitor Almeida and Stefan Zeume
own. So very simple present value problems. So first one, we have $1 million in one
year, the discount rate is 6% a year, the second one is a perpetuity. So, it's a payment
of 1 million every year that's going to last forever and the discount rate is 6%. So please
work on these two questions.

Answer should be really simple. The first problem, all you need to do is to discount the
cash flow of 1 million by 6%, so you divide 1 million by 1 plus 6%. And then you should
get a present value of 943,396. If you're dealing with a stream of payments, $1 million
every year lasting forever, then you have to use the perpetuity form. Like I said, that's
going to come over and over again. Perpetuity formula. Now, we have the discount rate
is 6%, what is the growth rate? The growth rate in this case is 0. Because the payment
is not growing, so all you have to do is to divide 1 million by 6%. And you should get a
present value of 16.666 million this is one of those numbers that are annoying us. You'll
get six forever. So, 16,666,000. It's a tongue twister. So, it's really, really, very easy to
use this form.

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 Corporate Finance I: Measuring and Promoting Value Creation
Professors Heitor Almeida and Stefan Zeume

Let's go back to the accounts receivable example. Remember, we have the incremental
cash flows. $82 million today, and then a loss, a negative cash flow of minus 20 million
every year, starting next year. And now the time period here is years. So we're
expressing this in years. This is the tradeoff that we've already derived. Now, we have
to think about, how many years into the future are we going to consider? Are we going
to consider 10, 20 years, what's the timeline?

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 Corporate Finance I: Measuring and Promoting Value Creation
Professors Heitor Almeida and Stefan Zeume

What you are going to see and once you think about this, it might sound like a not very
natural idea but for most corporate finance problems like acquisitions, valuation, project
analysis, we have to end up considering an infinite horizon. This sounds strange, so I
really want to talk about this now, but the issue is that there is no natural date for a
company to end. So, suppose that we're thinking about a company and we think that in
the future the company's going to be sold to another buyer. That's an example you
might think about. So if you're going to value this company today, what you need to do
is you need to think about what's the sale price. The sale price if it's not zero, is going to
be part of the value. And now what? The sale price, how are you going to determine
that sale price? Again, it's the same idea, net present value. The sale price is going to
depend on the future cash flows after the sale, that are going to go to the buyer. So, it
doesn't stop. Even if you sell the company it doesn't stop. The cash flows are always
going to go on. So really this is the infinite, the sign, the mathematical sign for infinity
which is something that is going to show up in corporate finance over and over again.
There's no way to get around that.

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 Corporate Finance I: Measuring and Promoting Value Creation
Professors Heitor Almeida and Stefan Zeume

And you might be saying yeah, infinity, no one lives forever. And a cash flow that
happen, let's say a thousand years in the future shouldn't matter. This intuition is right.
And it is actually taken into account in our formula. This is what the present value
formula is doing for us. Think about this, you don't have to do this calculation, I've done
it here for you. But if you want to check it, do it so you believe me. Supposed you're
going to get a billion dollars sounds a lot. If I had a billion dollars, I would be I would be
a billionaire. Yeah, of course. But today, okay, what if I get a billion dollars in a thousand
years? How much is that worth? Do the math. You can discount a billion by 1
plus 6% to the thousandth power. Guess what. What answer you get, here's the
number. I can't even count the number of zeros. Really, let me just go here to
emphasize this. The answer is zero. A billion dollars in a thousand years is worth
nothing. Unless the discount rate is zero, which it's not. As we're going to see in
corporate finance discount rates are not going to be zero. So yeah, a thousand years
ahead, it’s really not going to affect our calculation. But this is taken into account. All
you have to do is to use the present value formula. And you're going to get that.

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 Corporate Finance I: Measuring and Promoting Value Creation
Professors Heitor Almeida and Stefan Zeume

So, let's solve this problem. So finally, we've been working on this for a long time. But
like I said, I really like this Because every concept builds on another concept and now,
we can finally get a solution. Suppose that the companies we're going to need a
discount rate. We just learned we have to discount. We're going to need a discount rate.
Let's say it's 10%. In this model we're really not going to talk about where discount rates
come from that's something we're going to talk about in Module Four. So, if the discount
rate is 10%, what is the NPV of the new system? Let's go back here. And do this. So,
what is NPV? You have to take all cash flows into account and discount them. The $82
million comes today, do we have to discount it? No. And then what we have, we have
these infinite cash flows of $20 million. It goes on forever, so all you need to do is to
apply the perpetuity formula. It's a magic formula. All you need to do is to divide 20 by
10%, and if you're not mathematically inclined, you might need a calculator to do this,
but you'll find that the answer is 200. Actually it's 82 here, not 80. So, the present value
of a $20 million stream of payments happening every year is 200, if the discount rate is
10%. So, this means that the NVP is minus 118. The NVP is minus 118. So now, we
have the number that is the net present value of this particular decision.

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 Corporate Finance I: Measuring and Promoting Value Creation
Professors Heitor Almeida and Stefan Zeume

So, before we talk about, what are we going to do with the NPV, let's talk a little bit
about Excel. So, I want to show you how to compute net present values in Excel and do
a little exercise for you to talk about the perpetuity formula. So, we could set the horizon
to 30 years, instead if you had never seen the perpetuity formula, one way you might
want to solve this problem is by setting the horizon to a large number of years. So here,
very boring to write this down but I wrote all the 30 years here. To compute the NPV in
Excel, all you need to do is to use this Excel function. There is an Excel function in
Excel that is literally called NPV. So, the NPV function you write the discount rate, in this
case it's 10% of the first point and then all you do here is you refer to the cells. Cell 1 to
cell 30. And then you should be able to computer NPV in Excel.

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 Corporate Finance I: Measuring and Promoting Value Creation
Professors Heitor Almeida and Stefan Zeume

The problem is that what I end up getting is that answer here. Instead of getting minus
118, I just get a blank. So, what's going on? Actually, the reason why Excel does that is
because the amount of numbers that Excel reports are too large. That's what Excel is
reporting, minus 10,653%. It seems to make no sense.

So, here's a little letter to Microsoft. NPV is not a percentage. The problem is, in some
versions of Excel, the NPV function is programmed to give you an answer in the

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 Corporate Finance I: Measuring and Promoting Value Creation
Professors Heitor Almeida and Stefan Zeume
percentage. Come on, it's the wrong answer. It's a currency. It's either a number or a
currency please. And by the way, we do not need to have decimal points.

Anyway, so you may need to reformat the answer. I showed you; this is I'm just showing
you a tab from Excel. You can figure this out on your own, I'm sure but here is the
formatting.

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 Corporate Finance I: Measuring and Promoting Value Creation
Professors Heitor Almeida and Stefan Zeume

And then what happens is you're going to get an answer of minus 106.54. Our answer
of course is minus 118. What's going on? So, what's going on is that we considered 30
years. We are considering 30 years. We're not considering the entire future. 30 years is
not that far, if somebody tells you you're going to get $20 million in 30 years, you're
going to be happy. That matters, that has value. $20 million in 30 years is a lot. So,
what you need to do if you really want to get an answer that is closer to the perpetuity
value is to increase the horizon. If you have the patience to do this, I recommend you do
it once. So do it with 50 years. You're going to get minus 116.3. Do it with 100 years.
You're going to get 117.99, which is mathematically it's the same. It's really very close to
minus 118. So, a cash flow of $20 million in 100 years is worth nothing or very close to
nothing. So, if somebody tells you you're going to get $20 million in 100 years, you
should really think about whether this is a lot of money or not, probably not. The pattern
of course, is the more years we put in the formula, in the calculation in Excel, the closer
we're going to get to the perpetuity form.

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 Corporate Finance I: Measuring and Promoting Value Creation
Professors Heitor Almeida and Stefan Zeume

Lesson 3-3: Net Present Value (NPV)

Lesson 3-3.2: Calculating NPV in Excel

Hi there, I received many questions about how to calculate NPV in Excel, and I realized
that several of the students are having trouble with this calculation. It is actually very
simple, but there is a specific procedure that you have to follow to get the right NPV. So
what I'm doing here is, I'm showing how to calculate the NPV using one of the examples
that we used in Module Three, and we're also using in Module Four. It's the example
that we used to do sensitivity analysis using Module Four. And we first introduced this
example on slide 63 of Module Three. So here you have the Excel spreadsheet, I have
already calculated the cash flows for you. So, you have a cash flow of -40,000 in day
zero, and then you have the positive cash flows later on. So here I'm going to show you
how to calculate the NPV. The key thing is so you can see what I'm doing here. The key
thing is that the first cash flow that you put in the NPV formula, is the cash flow at day
one. So, you go from day one until the end. And of course, you also have to add the
discount rate. Okay? So, you do NPV of the discount rate. Okay? And then the cash
flows from day one to day ten. Okay? And then, what you need to do is you need to add
the day zero cash flow separately, okay? You cannot have the day zero cash flow inside
the NPV formula. I'll show you why in a second. So, if you this you'll see that you will get
the right NPV, which in those lights is $13,153.

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So, here's the problem, so this is the right way of doing it. But what many students are
doing, is to include the first cash flow in the NPV formulas. So, the day zero including
the day zero cash flow as well, okay. And then you see that you're not going to get the
same answer, right? So, look at this, is, you have in this case now you have all the cash
flows. Right? And the discount rate and you get a lower NPV. What's going on? The
problem is that Excel assumes that the first cash flow happens one year from now. So,
Excel is discounting all the cash flows, including the cash flow at day zero. But since the
cash flow at day zero, happens today, it should not be discounted. Okay. So that's why
you need to compute the right NPV, you have to start from day 1, and then add the day
zero cash flow separately, okay. If you do that, you'll get the right NPV. With the IRR it
really doesn't matter, because Excel is in fact assuming that, so, to do the IRR, let me
show you.

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You just put all the cash flows in the IRR formula, and you get the right answer, which is
15.25%. Excel is actually assuming that the first cash flow is happening one year from
now, but the thing is that the IRR actually does not depend on when the cash flows
start. So even if cash flow at day zero is actually at day one, if you move all cash flows
one year from. From now, so if you have one, two, three, four, five, six, seven, instead
of zero, one, two, three, four, five right. You would still get the same IRR. The IRR does
not depend on when the project starts. So that's why to calculate the IRR, you actually
have to include all the cash flows in the formula. So, I hope this clarifies this point, since
I was getting several questions on the discussion board, I decided to record this short
video. Please let me know if you still have questions, but I think this calculation, this
example here is going to be useful for you. Thank you.

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Lesson 3-4: The Relationship Between NPV and Shareholder Value

Lesson 3-4.1: The Relationship Between NPV and Shareholder Value

Okay, we got an NPV of minus 118, right? That's what we just did, we did all those
calculations, and we figure out the net present value is minus $118 million, okay? What
are we going to do with that? Now we have to think about what does net present value
mean, okay? How are we going to use net present value to make decisions? In order to
understand this, this is really a fundamental point in corporate finance. Let's think about
the relationship between NPV and shareholder value, right?

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If you go back to Module One, we talked about the stock price, right, which is the
measure of shareholder value that we focus on in corporate finance. The stock price is
just the sum of all the future cash profits, discounted to the current period, right? So,
you take all future profits into account, discounts to the current period, that is how we
figured out the stock price as we talked about in Module One. Now think about NPV.
NPV is the sum of all cash flows that are a direct consequence of making a decision, or
taking a decision, right? Discounted to the current period. So, we are taking all cash
flows into account, discounting to the current period, right? Think about this, these two
definitions are the same. They are virtually the same, there is no difference.
Mathematically, they are the same, okay. Conceptually, they are the same, right. So
really what this means is that NPV and stock prices are equivalent, right.

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So, let's think about that, okay. Let's take this idea, okay, and consider the following
question, right. And I think you should be able to answer this even before I do it, okay.
We figured out here that if the discount rate is 10%, the NPV is minus 118 million, okay.
So ask yourself the following question. Suppose the company decides to change the
system, okay. So you want to change the system, you're going to change the system,
you change the system, okay. What is going to happen to shareholder wealth if the
company does that, okay. And then let's try to think about what the company should do,
given this.

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The answer is very simple, right? Since NPV and shareholder wealth are the same
concept, since they are mathematically equivalent, what will happen is that shareholder
wealth is going to go down by exactly $118 million, okay? If the company makes that
decision, then they're going to destroy shareholder value, right? Shareholders are going
to lose $118 million. So what should the company do? Obviously, keep the old system,
okay? 0 is better than -118, so just do what you're doing right now, okay, no change. No
change is the right answer in this case, okay. So finally, we know what to do after many,
many slides and assignments regarding the answer to this problem, okay. And I think it
really illustrates all the concepts that you have to remember very well, okay.

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So, this is the result, we call this the equivalent result in corporate finance because it is
a fundamental notion in corporate finance which is the notion that maximizing at present
value is equivalent to maximizing shareholder wealth, okay. So, if you want to make
decisions that increase shareholder wealth, what you do is you take all investments that
have positive net present value, right. As long as an investment has positive net present
value, net present value greater than zero, it's going to increase shareholder wealth,
okay. So, that is the equivalent result.

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And as we've many things in corporate finance, this result does not always hold exactly,
right? In the real world, the equivalence between net present value in corporate and
stock prices not going to be perfect, right. For example, the market, the stock market is
computing the stock price, the stock market may not have all the information that is
required to compute net present value, right? Maybe the project is a secret project, so
the market is going to learn about it slowly, right? Managers may have more information
than the market, right? Of course, the result, just as in Module One, we talked about the
fact that maximizing a stock price relies on market efficiency, here we have the same
concept, okay. If markets are inefficient, then all [inaudible] lose. The stock price may no
longer reflect future cash flows and then of course, NPV and stock price are not going to
be the same thing. So, we are relying on the assumption that markets are reasonably
efficient to do this calculation, okay? And finally, this is something that we are not going
to cover as much in this course. We did talk about leverage, right? We talked about how
to measure leverage for real-world companies in Module One, right? So when leverage
gets very high, there could be problems as well. What happens is that the decisions that
maximize firms value may not be the same decisions that maximize the stock price
because many of the proceeds may end up going to debtholders, okay? So, this sounds
a little bit complicated. It is, actually, and it's something that we're not going to talk about
in this course, but I just wanted to highlight that leverage may also matter. If you want to
learn more about this, you may consider taking the additional corporate finance course
that we're going to provide, okay? So, this result that NPV, and shareholder wealth are
equivalent relies on these assumptions but even if they don't hold exactly, it's still a very
useful guideline for financial management, okay. Similar to what we discussed in
Module One, there are no good alternatives to net present value, right? So even if

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market is not perfectly efficient, for example, computing net present value is still a very
important step to make sure that managers make the correct financial decisions.

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Lesson 3-5: Internal Rate of Return (IRR)

Lesson 3-5.1: The Internal Rate of Return (IRR)

We just talked about net present value, which is the concept, the calculation we're going
to use to make corporate decisions, right? The net present value is a number. In our
accounts receivable example, we computed $118,000,000. And we also talked about
the fact that there is a direct equivalence between net present value and shareholder
wealth so shareholder wealth would go down by $118,000,000, if the management
decided to speed up the collection of accounts receivable. The problem is that when
we think about investments, we like to think of investment returns in percentages. So,
when we think of the stock market return, we're not measuring that in dollars. Usually,
we're measuring it in percentages. What's the return on your portfolio? What's the return
on PepsiCo stock. We are always thinking of percentages.

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So, that is why we need this additional concept, which is the rate of the return on an
investment. It's very important for us to be able to compute the rate of return on any
investment that we are given. And the idea is that's going to give you a percentage
measure of how much you're getting out of that investment, okay? And here is the
definition and I know that the first-time people see this definition it sounds a little bit
confusing, okay? The rate of return of any investment can be defined as the discount
rate that makes the net present value of the investment equal to zero, okay? That is the
most general definition of a rate of return that we can come up with, okay? And by the
way we have this alternative name, just like NPV, we have this alternative name for the
rate of return, which is the IRR, okay? That stands for Internal Rate of Return, okay?

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So let us see why, let us try to understand why the rate of return is the discount rate that
sets the NPV to zero. Okay, so let me give you an example. A very simple one and my
experience teaching this is that most people that have done some math, you know basic
algebra can figure this out, okay? So, suppose that you have an investment that
requires $10,000 today. And that's going to pay back $11,000 in a year’s time. And ask
yourself, what is the rate of return on this investment? Let me go over here. So, you
invest $10,000 today, let's do this in a timeline. Okay? And we're going to use later. And
then you'll get $11,000 a year from now. Each should be obvious to most people that
their rate of return is 10%. Okay? So, I'm pretty sure that the moment I gave you this
problem, you'll say yeah, the answer is 10%. What kind of problem is that? Right? Too
easy. Okay? But I want to use that problem to show you that this concept works. Okay?
So, think about, let's go inside your brain, okay? So, this is fun, we're actually going to
try to think about, what is the equation that you're solving in your brain when you got
that 10%.

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And I'm pretty sure that this is the equation you're solving the first one here. What you
did is you deducted 10 from 11, so I'm making $1,000. And then you divided 1,000 by
10,000. Okay. So that's how you get the return of 10%. Okay. So, if you've done basic
algebra you can try to manipulate this equation a little bit. Just change the numbers
around. Okay. So, our equation what you can do here is you can divide the 10,000 by
10,000. So, you'd have 11,000 divided by 10,000 minus 1. We know that that's equal to
10%. And then you can start rewriting this. So, you can send 1 to the other side, you get
1 plus 10%. And now you can divide everything, first actually you send the 10,000 to the
other side, multiplying the 1 plus 10%. And then you divide the 11,000 by 1 plus 10%,
okay? So, this can be written as follows, right? If you deduct 10,000 from the right-hand
side here, this can be written as 0 = 11,000 / (1 + 10% )-10,000. So, think about this, we
did the timeline. So, you have 10,000, 11,000. So, this term here that we just derived,
let me highlight this. This term here that we just derived is nothing more than the net
present value of an investment. That pays off $11,000 in a year and requires an
investment of $10,000. Right? When the discount rate is 10%, we are discounting by
10%. Highlighted here for you, okay. What is this NPV? The NPV is equal to zero.
Okay? So, the equation you're solving here in your brain is mathematically equivalent to
writing down the NPV and setting the NPV to zero. Finding the discount rate that sets
the NPV to zero, okay.

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If you don't believe me we can do it in another way, right. Write down the NPV of that
problem. It's very simple, right. We learned NPV already. So the NPV = -10,000 +
11,000 / (1 + Discounted rate). And then do step number two. Find the discount rate that
makes the NPV equal to zero. So set this equation to zero, you will see, it's very easy to
see that the value that you have to plug in here to set the NPV to zero is 10%. Okay?
So, if the discount rate is equal to 10% the NPV is going to be exactly equal to zero.
Okay? So, this is why the definition of rate of return is the discount of NPV rate to zero,
okay? Of course, you could have solved this problem another way. You could have
used Excel, for example. Excel also has an IRR function. And this one actually works
fine as opposed to the NPV function that we just talked about. All you have to do is to
input the cells. Okay. So is the IRR of cell one and cell two. Right. And then Excel would
tell you that the IRR is 10%. Okay. Of course, for this problem you probably don't need
Excel. For another problem you may want to use Excel. So, I wanted to talk about this
as well.

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Okay. Let us now see if we can apply what we just learn. Okay. Let me give you this
problem to work on. We have an investment that requires 10,000 today, and now it
produces a cash flow in perpetuity. So, the cash flow is expected to grow at 4% a year.
And the question I have for you is, what is the rate of return of this investment?

So, every time we solve a problem like this, what I want you to try to do is to use what
we learned. Set the NPV to zero, okay? This turns out to be a very powerful idea that

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Professors Heitor Almeida and Stefan Zeume
helps us solve many problems in finance. Okay? So, what is the NPV? Right? We
learned the growing perpetuity formula, right? It's minus 10,000 the investment today,
then the present value of the cash flow is going to be 500 divided by the discount rate
minus 4%. Right? And I didn't give you the discount rate? Right? You might be like well,
but how am I going to solve this problem? What is the discount rate? Remember, that's
not what we are trying to do here. In this problem, what we are looking for is the rate of
return. We are looking for the IRR. And step number two here is the definition of the
IRR. What the IRR is, is the discount rate that makes the NPV equal to zero. The
discount rate that makes the NPV equal to zero. And if you solve this equation,
mathematically what you're going to see is that the IRR is 9%. If you put 9% here,
you're going to get 500 divided by 5%, which is going to be equal to 10,000. So, you get
an IRR of 9%. So, this is really cool. I gave you the schedules. It was probably not
obvious what the rate of return is. But I can tell you, with certainty, that the IRR, the rate
of return on this investment, is 9%. Okay?

Let us try to use Excel in this case. Okay? And here you are going to see that there is
going to be a problem, right? You can do it, but it's going to take a lot of boring work.
Okay, let me show you this. Suppose we were doing this with 30 years. Right. So, we
have an investment of 10,000 and then we have the cash flows. 500 in year one, 520 in
year two and it's growing, right, the cash flow continues to grow. When you get to year
30 the cash flow is 1,559, okay, I just did this manually. And then you can ask Excel to
compute the IRR for me, Excel will tell you in this case that the IRR is just 6.65%. The
problem is that here we have growth. The cash flow is growing, so if even if you do it for
30 years, the value is still too high, this is still 1,559. You know, it still matters, right. So,

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the rate of return of this investment really is higher because this cash flow is going to
continue to grow, right. So, if you just ask Excel to do it for 30 years, you'd get an
answer that is a considerable underestimate of the true rate of return on the investment,
okay? So, in this case, you actually do have to use the little trick that we learned, right?
Instead of using Excel, you have to write down the NPV and then set the NPV equal to
zero.

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Lesson 3-6: Using the IRR to Evaluate Investments

Lesson 3-6.1: Using the IRR to Evaluate Investments

We just learned the concept of IRR, the rate of return of an investment. Right? Now we
know how to calculate it, and we just did it for this specific example, the investment
that requires 10,000 today, and then produces a yearly cash flow of $500 in perpetuity,
okay? So, with a growth rate of 4%. In that case, we calculated an IRR of 9%. The
question now is should we invest in this project or not, right? We know it has a rate of
return of 9%. How do we know if we should make this investment or not, right?

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The answer is that you don't have enough information. Okay, to figure out whether a
project is good or not we are also going to need a discount rate. All right, when we
computed net present value for example, we needed the discount rate to discount the
cash flows, right. And so now we also to make a decision using IRR, we're also going to
need a discount rate, okay. An idea that it really is very intuitive it should make sense to
you, is that in our case, we would invest in the project if the discount rate turned out to
be lower than 9%, right? So, you should think of the discount rate as the required return
on a project, right? The discount rate is the minimal return that the project would need to
have for the project to be a good project. On the other hand, the IRR is the actual return
on the project. Okay? So, if the IRR is bigger than the required return, if the IRR is
bigger than the discount rate, that means this is a good project. Okay? We think of
these as the IRR rule. The IRR rule says that you invest in a project if the rate of return
is greater than the discount rate. That's what we think of as the IRR rule.

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Let's do an example here. Let's go back to our simple investment, which has an IRR of
9%. And now let's assume that the discount rate is 8%. Okay? Let me actually go over
here. The discount rate is 8%. Okay? So, the IRR is 9%, the discount rate is 8%. Okay?
So that means this is a good project. Okay? That means this is a good project. Right?
The IRR is bigger than the discount rate. Ask yourself what should be the net present
value then? We just learned about NPV, and we learned that when a project is good,
the NPV should be positive. So, in this case we know that even though we didn't
compute NPV yet, we know that the NPV should be positive.

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Consider now a different case where the discount rate is 10%, okay? So now let's have
a discount rate of 10%. You should be able to do this very easily, right? Since the IRR is
lower than the discount rate, right? What should you do? You should not invest in that
project. Right. So, the answer is that this is a bad project, okay. This is a bad project
because the discount rate is bigger the IRR. What should be the NPV, the NPV should
be negative in this case. Okay?

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If we want to check that, of course what we could do is just to go ahead and compute
the NPV. Right? Which is what I've done here. Okay? And I recommend that you go out
and really try to do this calculation on your own. Compute the NPV, okay? And you will
find out that this the discount rate is 8%. The NPV is 2,500, okay? If the discount rate is
10% the NPV is minus 1,667, okay? So, this shows that if the discount rate 8% the NPV
is positive. If the discount rate is 10% the NPV is negative. So here comes the question
for you. There is a very important lesson here, there is a pattern, there is a general
result that lies hidden in these number here. Not that hidden but I want you to think
about this question and try to generalize, you know, what we learned by doing this
calculation.

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This is what we learned, okay? Another very important set of rules, okay? If the NPV is
positive, right? So if a project is good, if it increases shareholder value, if the NPV is
positive, these are all the same things as we've just learned. Then the IRR should be
bigger than the discount rate. These statements are equivalent. Okay. Positive NPV,
IRR bigger than the discount rate, good project, project that increases shareholder
value, all of these are equivalent. Same thing for a negative NPV. Right? If an NPV is
negative, then what this means is that the IRR is lower than the discount rate. And this
result is great, because what this means is that you can use either NPV or IRR. So if
you compute IRR of a project and you know the discount rate, you're going to get it
right. You're going to make the right decision. So maybe we don't even need to compute
NPV, we can just compute IRR and compare the IRR with the discount rate. As we're
going to learn next, this is actually not true. There are some cases where we're going
to have problem to compute an IRR. That's our next lesson.

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Lesson 3-7: Problems With the IRR

Lesson 3-7.1: Problems with the IRR

We just learned that IRR and NPV can be equivalent, right? You make the same
decision using either IRR or NPV, okay? But before we start moving too fast and say
yeah, we don't need NPV we can just compute IRR, we have to talk about a few
problems with IRR, okay? There are some issues that you have to know about that
actually limit your ability to use IRR to evaluate projects, okay?

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The first notion is that there are some investments that are not going to have a well-
defined rate of return, okay? Sounds a bit strange but consider this example. Suppose
we have this timeline and we already learned about timelines, okay? So, we have an
investment that requires $20 million today, right? So, this is like the accounts receivable
problem. You get $20 million today, and then you have to pay $22 million tomorrow.
Okay, so you lose $2 million, right? Using the same intuition that we used when we first
talked about IRR, it sounds like the rate of return on this project should be minus 10%,
right? You're losing 10%, okay? But try to use Excel, write down this problem in Excel, I
mean it, it'll really do it. If you have Excel, try this, okay. Write down the timeline in
Excel, okay. And then write down 20 minus 22, and ask Excel to give you the IRR.
Excel will tell you the IRR is 10%, okay. And now this is not a Microsoft problem, okay?
This really is a mathematical problem. What Excel is doing is, Excel is doing those two
steps that I told you about. Compute the NPV, and then set the NPV to zero by trial and
error. Computers can do trial and error algorithms very quickly, right? So, I have Excel
just trying a bunch of possible discount rates, and it turns out that if you discount minus
22 by 10%, you're going to get minus 20. So, 20 minus 20 is zero the NPV is zero.
Okay, the IRR is 10%. Excel gets a solution. The problem though is we know the
solution is wrong, this is the, you know, this investment is a, this is an investment that is
losing money, right? You're not making 10%, you are losing 10%. Something is wrong.
Okay, right? And here you might think okay, I'm clever, I can figure this out. If I have an
investment like that, all I need to do is reverse the sign. I do this in Excel instead of
getting positive ten I take minus ten. That's the rate of return, okay? That could be, the
problem is that it gets more complicated.

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Suppose you have this case, again another timeline. Minus 4, 25, minus 25, okay. So,
you invest minus four today then you get the payoff of 25, let's say million dollars,
tomorrow or in a year. But then you have to pay again. You have to pay minus 25
million in two periods, okay? Let's try to use Excel. So, write down the cash flows, use
the IRR function, okay. Excel will tell you that the IRR is 25%, okay. I write the answer
here. Is that reasonable? I mean, who know I mean now it doesn't sound crazy that you
have a 25% rate of return here, right? The 25 minimum payoff comes before the -25,
maybe, okay? But this is the problem, write down this equation, okay. If you have the
time, the patience to do that, just write it down in a calculator or in pen, you know just do
this calculation. Minus 4 + 25/ (1+400%)- 25/ (1+400%)2, so, what does this, let me
actually write this down here for you. This is the NPV of the investment. This is the NPV
of this cashflow. Of these cash flows, okay. The NPV is equal to zero, okay. If the
discount rate is 400%, right? What does this mean? Is 400% also an IRR? Okay, so do
we have two possible IRR that doesn't make any sense right? An investment should
have one rate of return, not two rates of return. So, there's something wrong with this
problem as well. The other thing you can do, by the way, just do it in Excel, is you don't
want to do this equation. Write down the NPV in Excel to convince yourself that if the
discount rate is 400%, you should also get the zero NPV, okay?

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There is a problem. Think about the following thing. What is the common feature of
these two examples, okay? The common feature is that you have a negative cash flow
that is coming after a positive one, okay? You have positive and then negative, so, 20
minus 22, 25 minus 25. Here's my advice, okay. If you see this pattern, positive,
negative, do not use IRR, okay. It is tricky, it is complicated. And it might lead you to
make the wrong decision, okay. So, if there's positive and then negative, unfortunately,
you should not use IRR, okay. That is the lesson, and there is really no reliable
mathematical way to solve this problem, okay?

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The second problem that you have to know is an issue of magnitude, okay? So the NPV
as we talked about is in the same unit as cash flows. So, if the cash flow is in dollars,
the NPV will be in dollars. The cash flows is in pounds, the NPV is going to be in
pounds, okay? The higher the NPV the greater the impact of a project on value that
concept we learned when we're talking about NPV, okay? The IRR in other hand is a
percentage return. If you recall our lesson, that is the reason why we're using IRR is
because we want to measure investments in percentage, but this can create problems.
Okay, think about the following.

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Suppose we have two investments. We have an investment that requires one cent
today and pays off two cents next year, okay? So, you make one cent in a year, he's
asking one cent today. And then you have an investment that requires one hundred
dollars today and pays off two hundred dollars next year, okay? If you compute the
rates of return of these two investments, you're going to find what? You're going to find
100% for both, okay. The first investment, you invest one, get two, right? The second
one you invest 100, you get 200. It's in a different unit, right? The first one you're
investing cents, the other one you're investing dollars, so invest two requires a bigger
investment. It gives you a bigger payoff. Both have the same rate of return, okay.

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But try to answer the following question. Now comes the question for you based on this
simple example. Suppose the discount rate is 10%, which investments would you take,
okay? And then think about which one the better investment and which investment is
has the greater NPV? So, you can either calculate NPV, but I think it will actually be
obvious which investment has the greater NPV, okay? But you can do the calculation if
you want.

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So, let’s do the answer here, okay. Which investments would you take? Remember the
rule, we take all investments that create shareholder value, right? So, we would actually
take both okay. Investment one, you know, it's something, you know, one cent we don't
care about, right? But it is a good investment, it is creating value. So you would actually
take both, right? That's what we should do. But, obviously, Investment 2 is the better
one, right? You are making a hundred dollars instead of one cent, right? So it is
obviously the better investment to take, okay. Which investment has the better NPV?
Investment 2, right? You can do the calculation if you want but it's obvious that
investment 2 is going to have the higher NPV, okay. So think about that the IRR is
telling you correctly that both investments are good, but the IRR cannot tell you which
investment is better, okay. The IRR will tell you that both investments have the same
rate of return, right? Whereas, if we use NPV, we'll be able to figure out that Investment
2 is going to create more shareholder value, okay.

So this is the other problem, and there are really only three rules to remember. The
bottom line of all of this discussion we are having about IRR and NPVs that there are
three rules that you have to remember, okay. The first one is that IRR and NPV are
going to lead to identical decisions in most cases. So, if the IRR is bigger than the
discount rate, the NPV is going to be positive, okay. That is a really important idea, and
you should remember that, okay. However, there are the qualifications, right? There are
cases where you should not try to compute an IRR, okay.

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If you see a negative cash flow coming up after a positive one, don't compute IRR. For
example, recall that we worked on our accounts receivable problem, but I never
computed an IRR in that problem. We solved that problem only by using NPV, okay,
right? Why? Because that was a case where the positive cash flow came first and then
the negative cash flows came later. Okay, so don't compute IRR in that case.

And third rule which is simple beware of magnitudes. Okay, so you cannot reliably use

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IRR to compare investments of different sizes. So, our cents versus dollars example
showed that very clearly. So, if you want to compare investments, the safest way to do
it, is to use net present value.

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Lesson 3-8: Free Cash Flow Formulas

Lesson 3-8.1: Free Cash Flow Formulas

In this lesson, we're going to talk about free cash flow, how to calculate cash flows to
value a project and to use these cash flows in our net present value and IRR analysis.
Let's start with an example. This is a project that has the following characteristics. You
can think of it as a machine for example that the company is buying for let's say it's 40
million dollars. You're buying a machine for 40 million dollars, and what this machine
does, it increases profits by 9 million dollars. It increases your revenues, it also
increases your cash expenses, but the increasing revenues is higher, so your profits are
going up by 9 million. The investment, it's going to last 10 years. That is a tax rate. At
the end of the project life you can sell this machine. You can think of this as the value of
the machine at the end for 4 million dollars before tax. You also have a discount rate, as
we learned, you need the discount rate to calculate net present value. The question is,
should you invest in this project? To compute the NPV and IRR, you're going to need to
compute the cash flow. We already talked about this notion of incremental cash flows.
There is a similar [inaudible] corporate finance, which really means the same thing,
which is this notion of free cash flow that you might find this alternative definition in
financial websites exactly, but it really has the same idea of incremental cash flows
that'll be already talked about.

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Which cash flows are going to look at? This is a machine, you have an initial
investment, the machine is going to change as sales and costs, as we talked about,
there's going to be taxes and the other is going to be a salvage value. Let's start
building our analysis.

As we already talked about, it's good to have a timeline. Date zero is the period of time
when you're paying the cost for the machine and you're putting it in operation. At this

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date, zero, you have a required investment of 40 million dollars. The company is
spending cash, so you have a negative sign here. Then in date one and in other dates,
this project is going to generate a profit of 9 million dollars. These are the basics. But to
calculate cash flows, we also need to figure out the taxes. A lot of the discussion we're
going to have in this lesson is actually about how to calculate taxes.

The best approaches, it seems funny, but I always like to tell students that calculating
taxes in the real-world can be quite complex. It's not trivial to estimate the incremental
effect of a project on a company's tax. It's always good to check with accountancy if
we're doing the right thing. But of course, I want it to be able to at least get to the basics
and understand the basics of how you would do this in the real-world.

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The idea is that the capital expenditure is going to create tax breaks. We're not just
going to apply the 2% tax to the profit of 9 million dollars because the investment
creates tax breaks for the company. The trick here is that this tax break is going to
depend on the specifics of the tax code.

For example, in the U.S, prior to 2018, companies could deduct depreciation expenses
from taxable income. What we would do is we would estimate depreciation to the extent

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that is allowed by the IRS, and then you use the depreciation to reduce taxes. Since
2018, capital expenditures have become effectively have become tax deductible. Now
the company can fully deduct capital expenditures. What we're going to do here is we're
going to see how this change in the tax code affects our cash flow calculation for this
project.

To recap, our project costs 40 million dollars and it's still worth 4 million dollars in 10
years. If you think about reasonable notion of depreciation, the depreciation schedule,
you can start from the initial value and depreciated linearly or according to some
scheduled from 40 million to 4 million dollars.

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If you do economic depreciation, the amount that the asset is depreciating over time, it
would be approximately 3.6 million dollars a year. Then you have the calculation here. If
you're doing 3.6 million dollars depreciation every year, your taxable income is net of
depreciation so the company will pay tax on 5.4 million instead of 3.6.

But the trick is that even before 2018, the IRS typically allowed companies to accelerate
depreciation for tax purposes. Instead of spreading out the depreciation equally over the

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lifetime of the project, the company could bring depreciation earlier. To give an example
of accelerated depreciation, what I'm doing here is I'm assuming that the company is
fully depreciating the asset in five years. For tax purposes, you can think of this as tax
depreciation, is the depreciation that the Internal Revenue Service, allows the company
to do. The advantages that if you depreciate faster, then your taxable income from
years 1-5 is going to be lower. It's going to be only 1 million dollars because you almost
get the full deduction of your profits, through the depreciation tax shield. Your taxes are
going down a lot.

In terms of the salvage value, the depreciation schedule is also going to affect the taxes
on the salvage value. The project is worth 4 million dollars, but that's before tax. If the
asset is fully depreciated for tax purposes, then the cost basis is zero, so the entire 4
million is taxable. If the depreciation was lower than the asset, there would still be a cost
basis that you could deduct, that solve the residual value of the asset, and they would
reduce the taxes that you pay at the end. But in this case, since the asset has been fully
depreciated since Year 5, then the after-tax value is 3.16.

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Here you have the entire free cash flows before 2018. Notice that when you go from
Year 5 to 6, your tax increases, because the depreciation goes from 8 million to zero.
Because of the accelerated depreciation that the Internal Revenue Service allows, your
taxes are going to be lower upfront and then a company pays more and more taxes
towards the end of the project. Now you can calculate cash flows. You have sales
minus costs, minus taxes minus investments, you'll see the free cash flow here at the
bottom. I'm actually going to give you a formula to calculate cash flows in a second.

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Now we can compute NPV and IRR. Using the formulas that we already learned in the
course, you will conclude that this project creates almost 60 million dollars in value for
the company should invest in it.

What happens after 2018? As I mentioned before, the difference is that the U.S
government is now allowing fully accelerated depreciation. Companies can deduct
100 % in Year 0. It's as if the asset is put in place and that is immediately worth nothing,

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which doesn't make any economic sense. But the advantage for the company is, it can
now accelerate all the tax deduction to Year 0. Essentially, capital expenditures have
become tax deductible.

Here's the analysis. Now you have zero depreciation after Year 1, because you have
depreciated everything in Year 0. But the advantage is that in Year 0, you have
generated the negative taxable income because your asset is fully depreciated. The
company is essentially getting a tax break from the government, you have negative
taxable income of the same magnitude of the investment. If you multiply that by 21%,
you get a negative tax. It looks as if the company is getting a check back from the
government.

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The first question you might be asking is, how can taxes be negative? Are you getting a
cash? Are you getting a check back from the government? The easy case is, you can
think of a situation in which our company has profits that are greater than 40 million.
This machine that we're talking about, that's not the entire company. It's one project that
the company is investing in, and if you assume that the company is profitable, it has
profits greater than 40 million, then what you can do is, it can use the new investment to
offset this profits. You would get a deduction, not because you're getting a check back
from the government, but because you are paying fewer taxes to the government on
your other projects. There is a harder case, which is a situation in which the company is
not profitable. The reason why this is harder, because now we're going to get into tax
carry forward. The company may be able to carry these laws into the future. But now we
really have to call the accountant because it's going to get complicated. But the idea is
that, since 2018, companies can accelerate depreciation and this will create tax benefits
for the company.

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And you can see here that if we calculate the NPV and IRR using the cash flows after
2018, we're going to get a higher value. The NPV went up, the IRR went up, the project
is more valuable because of these additional tax break that the U.S government is given
to companies.

Now you might be worried. We did a calculation one way before 2018 and then the
calculation change and come on. Everyday every time the tax code changes, you have

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to pay corporate finance again, for me, it would be good because I always like to have
students taking my course again. But it's not great. It turns out that I can actually give
you a formula that you can always use to compute cash flows irrespective of the tax
code, you don't have to change the formula if the U.S government or decides to change
taxes again, or maybe if you live in another country that has a different tax code.

Here's the formula. I like to think of this as the magic formula because this formula will
always allow you to calculate free or incremental cash flows for our project. It's very
simple, is essentially sales minus costs minus taxes minus investments. Sales minus
cost is roughly equal to EBITDA. That's if you think about income statement, this is what
it would correspond to. Required investments here include both Capex and working
capital, which we have already talked about the module two. Working capital are also
investments in the business. If the project requires an increase in inventory, for example
or if the project requires you to increase accounts receivable to give your costumers
more time to pay, then you have to include these effects elsewhere in your cash flow.

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To compute taxes, call the accountant. I mean, the formula always works. The only
thing that changed a bit before 2018 and after 2018 is taxes. If you're worried about
taxes, you can always get help and that's really what you're going to be doing in the real
world if you're analyzing a project in the real world. Of course, not if you're writing an
example for this class, but in the real world, you would probably get helped to estimate
taxes because it's complicated. But what we can do is we can approximate taxes using
your best understanding of the tax code. That's what we're going to, we did that. What
we did in the formula is we use the our understanding of the tax code in order to for
example figured out that we could do the Capex after 2018.

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Not on working capital, I mentioned before. Projects will typically require short-term
investments in our example, we did not have working capital, but if working capital
investments are present, our cash flow formula must take those cash flows into account
as well.

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For example, if you assume that 50% of COGS must be in place one period before the
sale takes place, then you're going to have an inventory requirement. In our case, the
COGS is 3 million, so there's going to be 1.5 million inventory requirements.

What's going to happen is your inventory is going to go up by 1.5 million at date zero,
and then you're going to have, it’s like an investment the company is going to have an
additional investment at date zero of 1.5 million dollars. Notice that this investment is
not tax deductible. The inventory is only going to count towards taxes when the cost is
actually recognized, not when the inventory investment is made. This is a non-tax
deductible investment that you have to take into account in your analysis.

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Here you have the, our spreadsheet with the increase in working capital. By the way,
you can see that I'm using the magic formula here. If you look at the Excel spreadsheet
as well, you will see that I'm using that magic formula, sales minus costs, minus taxes
minus investments. That gives you the free cash flow for every period. What I've added
here is this increase in working capital at date zero. When you get to the end of the
project, the working capital is going to be recaptured. What is that? You have inventory.
The company is generating inventory when you get to the end of the project, you're not
going to throw the inventory through the window. You're not going to throw in a lake,
you're going to sell it so you're going to get the money back. You have -1.5 at the
beginning and then you get 1.5 at the end, assuming that the value is the same, caution
or there may be a change in black.

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Then you can recalculate the NPV. The NPV is going to be slightly lower because of the
working capital in debt.

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Lesson 3-9: Real Options – Valuing R&D

Lesson 3-9.1: Real Options – Valuing R&D

Our topic now is real options. Okay? We're still talking about investments, so real
options is still going to be about how to make right investment decisions. So, in a sense
is a follow up of the discussion we just had about net present value and IIR, okay? The
difference is that we are going to incorporate options into our calculations, okay? So far
what we've done, essentially, is we've been assuming that the decision is all or nothing.
You either take a project or you don't. You either replace a machine or you don't. Okay?
But in real life, investment projects are going to come attached with what we call a real
option. Okay? So, this could be an option to cancel the project, to abandon it. It could be
an option to modify. And the very important option that's actually going to be our starting
point, is that some investments actually create future opportunities. Okay. Rather than
creating current cash flow, they create future opportunities to invest. So specifically,
we're thinking about research and development, R&D.

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So, let's start with that, actually. It's one of the most important applications of real option
analysis. How to value R&D, how to make a decision about R&D expenses, okay? If
you think about R&D, the very purpose of R&D is to create an option to invest in the
future. When a company is spending dollars to do research to develop new drugs, for
example, the goal of the company is to discover something that can become a product.
Right? So, the value of R&D is going to come from this creation process. Okay. Rather
than creating future cash flows, you're creating an option to invest, right.

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So, let's work with a specific example, and try to put some numbers and try to think
about how we would value R&D. Right? So suppose a drug company has estimated the
cost of researching a new drug that you're trying to develop and this drug is going to
cost $30,000,000. Okay? It's a new diabetes drug just to be concrete. Okay? Question
is, how do we compute the NPV of the R&D investment? Right? Every time a company
spends money, and $30,000,000 is nothing in this, right? Every time a company spends
money, we have to think about shareholder value. Right? So, are these investments in
R&D indeed going to increase shareholder value? Right? And we cannot just guess. We
have to go on to go ahead, try to do the calculations to come up with this NPV. Okay?

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So how would we model this? The first thing to notice is that the R&D is not necessarily
going to generate a useful drug. Okay? So, the R&D may generate, it's research, right?
It's research like what I do for a living as well. Sometimes our projects work, and
sometimes our projects don't work, and we end up with nothing. So, the first thing we
have to think about is the R&D only produces a useful drug with a certain probability.
The way we're going to think about this is by using a decision tree. So, what you have
here in the slide is a decision tree, we're modelling the investment. So today you decide
if you take this investment, if you spend $30,000,000 in research. There is a chance that
you're going to develop a new drug, but there is also a chance that there's going to be
failure, your research is going to produce nothing, and no drug is going to be developed.
Okay. So, the first thing that the drug company has to estimate is this probability. What
is the probability that we are going to end up in the right side of the tree here? Right?
We want to be on the right side of the success side. How can we do that?

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This is obviously going to be hard. It's especially hard for novel projects, think about
this. Research is going on. It's probably something new. Something that is going to
create value. Something novel. Okay? So, it's not easy to estimate this probability.
Okay? But it doesn't mean that we shouldn't do it. We have to do it if we're going to
figure out the NPV of the R&D investment, we are going to have to do this somehow.
Right? The way that drug companies do it is by using experience. They've done related
research in all the drugs or educated guesswork.

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Here is some data that is useful. There are typically four phases to prove the safety and
the efficacy of a new drug. You start small, testing a few healthy volunteers, okay. And
then do you know; some drugs already fail at this stage. Right. 70% manage to go to
phase two. Then on phase two, you increase the number of volunteers. Right. Again, a
certain percentage goes to phase three. Right. Phase three then is going to take a
number of years. Right? That's when you really start spending the dollars to research
this new drug. You go global, increase the test to thousands of patients, and then at
phase 4 you have to get approval from a regulator. Here in the U.S., the regulator is the
FDA. The Food and Drug Administration that is responsible to approve whether a new
drug should be used in real life patients or not.

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So, just by looking at these numbers you see that the probability is small, right? Only
70% go through phase one, 33% go through phase 2, then there are two more phases,
all right? So, the probability is quite small. For any individual drug, it's going to be on
the, less than 10%. Here let's say that our probability's 5%. So, there is a 5%, the drug
company estimates a 5% probability that this new drug is going to produce, that this
research is going to produce a successful drug. And then there is a 95% probability that
the drug will not be developed. There's going to be failure. Okay?

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It's small probability. That doesn't mean that the R&D shouldn't be done. We have to do
more calculations. Okay, the first thing we need to figure out is, how much is the
company going to have to spend if the R&D is successful? Right, remember what we
talked about in the beginning, the R&D is not generating cash flows immediately, the
R&D is actually generating an option to invest. If you're R&D, what you're creating is the
rights to spend money, if you want. So just going to spend more money to begin with.
Okay? Recently I read a very interesting interview with the Chief Financial Officer of a
drug company here in the U.S. called Parexel International and the CFO is precisely
describing this process. And one of the points that he made is that each phase requires
an increasing investment. And that once you get to the late phases, once the drug gets
close to being a success, the investments become very large. Okay? So, it could cost
$500,000,000 for a single drug to be developed.

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So, let's say for our example that the required investment is $1 billion. So here we have
the 5% chance that you're going to spend $1,000,000,000. So far this is not looking very
good right? All we've done is estimating the chance that we're going to spend more
money, right?

Of course, what we need to get at now is to figure out the cash flows that this
investment is going to produce. So, if the drug is successful, you spend $1,000,000,000

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and then you're going to generate profit. It turns out that the regulators, I understand
that developing a drug is very costly process. It takes many years of research; it takes
these large investments. So in many countries in the world we have this concept of a
patent. So, the FDA will typically grant a patent for a certain number of years, so our
example here let's say it's 10 years, okay? The patent creates the monopoly for the
company during that period. So, the company will probably have higher profits because
it's the only one that can produce exactly that drug. After that, competitors are going to
be able to copy this drug, okay? So how would we model that? There's going to be a
two-stage cash flow process, right? Initially, the drug is going to generate high profits.
Let’s say here it's $200,000,000 a year, okay for these ten years. Then the cash flow is
going to drop to $20,000,000 a year in perpetuity. Again, the right horizon to consider is
typically an infinite horizon, as we discussed already in this module. Suppose then also
that the discount rate is 6%. What we need to do now is to figure out the present value
of these cash flows. Okay, at the point that the drug is developed, what is the present
value of this cash flows? Okay and yes, this is one more present value example, right.
Practicing is always great. Practicing is what makes perfect, both for guitar playing and
for finance.

Okay, so let's go on and do that, okay. So here what you have are the cash flow of the
timeline, right. So, 1, 2, 3, 4 right. $200,000,000 cash flow for the first 10 years and then
the cash flow drops to $20,000,000, right. I have the calculation here for you. Notice one
thing, right. Because we have the infinite horizon at the end, we're going to have to use
the perpetuity formula. Right. We have this $20,000,000 cash flow that keeps going on
forever. The discount rate is 6%, so we know we're going to have to use the perpetuity

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formula to divide 20 by 6% to get the value of that perpetuity at the end. And then notice
that if you apply the present value formula, the first cash flow is happening in year 11.
This value is going to go here in year 10. Okay? The value of this perpetuity is going to
accrue to the firm 10 years from now, when the patent expires. It's as if the company
were like selling the drug at that time and the value of the drug is plainly divided by 6%.
So, you have that here, 10 years from now in addition to the cash flow of $200,000,000
that the company's still producing in that time. Okay, and then you have the other cash
flows that we are discounting back. Again, at this point you can do Excel. You can use
Excel, right. You're going to have to apply the perpetuity formula at the end, but after
you have figured out the perpetuity, you can definitely use Excel the calculate the
present value of the cash flows. Which here we got to be $1.658 billion. Okay? You are
investing $1,000,000,000. So, what this means is if the R&D is successful, if the drug is
developed, we are forecasting, we are estimating, we are guessing. Right? We are not
sure, but we are guessing there's going to be an NPV of $658,000,000. Okay?

So, we can go back here and add that to our decision tree. So now we have all the
numbers. If you invest $30,000,000 you have a 5% chance of generating a net present
value of $658,000,000. And then there is a 95% chance that you get nothing, right?

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We still have to think about one more issue before we do the final evaluation, which is,
how long does it take? Research takes time. Like I said, this is one of the things I do for
a living is do research, write papers. I can tell you that each paper that I work on can
take two, three, even four or five years, to between the time you start and the time you
complete. Research should develop a drug is similar, there's lots of people working, but
it usually takes a few years to decide if the drug is going to be successful or not. So, for
our example here, let's say it's three years. What I'm saying is that lets say the length of
this period between the $30,000,000 investment and the development of the drug is
three years. Okay?

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And now the question for you try to with this data, we've figure everything out except the
NPV of the R&D try to do the calculation yourself.

And here it is for you, okay. So that's how you would do it. You have the minus 30 in the
beginning of course. Right? And notice that since there is only a 5% chance that you get
a positive NPV, we have to multiply the 658 million by 5%. Right? There's only a 5%
chance you get that, and then we have to do it through discount by three periods. Which

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is was by our assumption it's going to take three years. Okay. If those numbers are
correct, we are getting an NPV of minus $2.37 million. Okay.

So we got the negative NPV for the R&D investment. Right? What this means is that
despite the large potential benefit of the drug, right? You could generate really a ton of
money, but the R&D's just not making sense for shareholders, okay? The risk of failure
is too high. It takes too long to generate profits, okay? At this point what the company
could do is to try to change the parameter somehow, right? In a real way, not playing
with parameters, not making optimistic assumptions. But what I would recommend is
that the company should try to lower the cost of research. Is there a way of doing this
research in a way that's maybe going to cost less than $30,000,000. Is that a way of
getting results sooner? Any of these changes might cause the drug to become positive
NPV and will definitely help the company.

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Lesson 3-10: The Option to Wait – Gold Mine Example

Lesson 3-10.1: The Option to Wait – Gold Mine Example

The next real option we're going to talk about is the option to wait. The option to wait
comes from the idea that companies in some cases will have the option, the benefit of
waiting for more information before you commit cash to a project. So, it might make
sense in some cases, rather than investing in a positive NPV project today, waiting a bit
longer, getting more information to make sure that the project truly is positive NPV, or
whether there is a better alternative. So, we will illustrate this option with a specific
example of a gold mine, which is a classic example of an option to wait. And we're going
to get numbers and all that, okay?

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These are the numbers that we're going to use. So, you own the rights, so there is a
monopoly, which is something I'm going to talk about later. You own the rights to
operate a gold mine for three years, okay? And there is a certain cost to open the mine,
and if you open the mine, you can extract a number of ounces of gold. Here we have
1,000 ounces, okay? And let's assume, this is something I'm going to talk about at the
end, let's assume that this investment is irreversible to begin with, okay? So once the
mine is open you have to keep it open until the end of the three years, okay? Let's say
that the current gold price is 500 an ounce, and each year there is a chance that the
gold price is going to go up or down. This is where the value to wait is going to come
from. In some cases, it may make some sense for us to wait and to get more
information on what the price of gold is, okay?

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There is an extraction cost of 460. No fixed cost of opening the mine, so all costs are
variable. So other assumptions about discount rates, okay? We are going to assume for
simplicity that cash flows happen at the beginning of the year. So, the moment you open
the mine, you can already extract the gold and sell it. This is not realistic, but we really
don't have to deal with this issue here, it's simpler to do the problem this way, okay? So,
for example, if you open the mine today, you're going to get the 1,000 ounces
immediately, and then sell it in the market, okay? So, you get your profit immediately,
okay? The question we're going to try to answer is should you open the mine today or
should you wait one year to get more information on the price of gold?

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And again, the way we're going to do this is by building a decision tree. Like as we did
with the R&D, we're going to go here and think about a decision tree. In this case the
decision tree is going to be based on the price of gold. Okay, so gold starts today at
$500 an ounce, and we have an expectation that the price could move up or down with
an equal probability, okay? And we are thinking of I know we're thinking of a two-year
horizon for this problem, right? The mine keeps open for 3 years but remember our
assumption that we extract the gold today. So, 2 years ahead, the price of the gold 2
years ahead is going to determine the profit that you're making in year 3. Okay, so that's
why we have it like that. So, the price could go up to 600 or it could go down to 400.
And naturally, the profitability of the mine is going to depend on the price of gold, okay.
This is what's going to make this problem interesting, okay.

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Before we do the calculations, it's very important to understand, that we understand the
problem. Okay, what is the trade-off, right? As with other net present value problems, it
is essential for us to understand the nature of the problem. Before we get into
calculations, and start throwing out numbers, let's try to understand what's going on. So
here is what happens, right? So, if you open now, okay? Gold price is currently 500, so
you're going to be profitable, okay? Remember that the cost of extraction is 460. If the
gold price goes down, right? And you have decided to open the mine now, you're going
to make a loss, okay? On the other hand, right, if you wait, if you don't open the mine
today you are essentially giving up the current profit. So, you say, okay, I'm going to
wait. I know that by doing that I am giving up on the current profit. The benefit here is
the main benefit. The main benefit is that if you decide to wait, you can avoid this state
of the world where the gold price is low, and the mine becomes unprofitable. So, you're
essentially opening the mine only if you know that the mine is going to be profitable,
okay? So that is the tradeoff that we have to think about, and try to put numbers on,
okay?

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In terms of calculations, this is what we're going to do to try to solve this problem, okay?
What I want us to do, is to build a profit tree from the tree with the gold prices. So today,
if we open the mine, we're going to make a profit. The profit's going to turn out to be 40.
I will show you the calculations in a second. And then, of course, the profit's going to go
up or down depending on where we are, right? If the gold price goes down, then there's
going to be a loss next year. If you're going to be making an annual loss of a 10,000,
okay? And then I also here, right, you're going to be making a loss of 60,000 if you
decide to open the mine today and keep it open, right? Then you're going to be making
a large loss in year 3 by operating your mine. And remember, the investment is
irreversible, so you cannot close the mine. We'll talk about that later.

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Just to give a couple examples here where we got those numbers. I know that's always
a question that I get when I teach this, okay? So right, if you open the mine today, the
profit is 40,000 because you extract 1,000 ounces and you make a profit of $40 per
ounce, okay. If the gold price goes down to 450, then you're making a loss of 10,000
because your margin goes down to minus 10, okay. So very simple calculation really,
okay?

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So, what is the NPV of opening today, right? if you go back to the profit 3 and look at
the numbers this is what's going to happen, okay. If you open today, you pay the
opening cost which is -70 and then you get the profit of 40. Okay, and then we have to
take the probability into account, right? A year from now, you could either be making a
large profit of 90, or you could be making a loss of -10. So, this calculation is taking the
probabilities into account in the same way that we included the probability of the drug
being successful, when we did the R&D calculation. So, there is a 50% chance of 90,
50% chance of 10 and then we discount using the 5% discount rate. And here we have
the year 2, there is a 25% chance of a very high profit, that's what you want, right? But
then there is also 25% chance of a negative profit of -60, okay? So, we discounted by 2
periods, right, because you're two years ahead. And if you do all of these calculations,
you're going to get an NPV of 44,367, okay? Make sure you understand this calculation.
This is the standard NPV calculation, but it has these probabilities, right? So, for
example, you can ask yourself, do I really understand this probability? Right, so why is
the probability of the 140K profit equal to 25%, right? The reason, of course, is because
to get to 140, you need two up moves, right? You need the gold price to go up next year
and then to go up again two years from now. Each move has a 50% chance, okay? So,
make sure you understand this calculation.

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And here's a question for you. It's very useful that you try to build a decision tree
yourself rather than just looking at mine. Now I want you to think about the waiting
option, okay? Let us think about what happens if we decide to wait. What does the profit
tree look like in that case?

Here's the answer, okay? Remember, if you don't open today, right, you're essentially
giving up today's profit, okay. So, you're going to get 0 instead of 40, right? The benefit

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is that, remember, this state of the world here in the bottom was a loss state. The gold
price went down. The company was losing money, okay. If you decide to wait until
tomorrow, then you are essentially avoiding this loss. And going forward to period 2, to
the third year of extraction, again you are getting 0, okay? Here this state was very bad
because the gold price is too low. But you can avoid that by waiting a year. You only
open the mine if the mine is profitable. So, essentially you are guaranteeing that the
mine is going to be profitable by waiting a year, okay. That's how the profit tree should
like, and I hope you are able to get these numbers correctly. If not, try to think about
what you've done wrong, okay because that's an important skill to be able to view this
profit tree yourself, okay. Given these three, computing the NPV should be easy, right?
We can even think about it here. So, you're going to open the mine tomorrow, right? So,
you're going to pay the 70K here, and get a profit of 90, okay? And then you get these
additional profits 2 years from now. If the gold price goes down, you'll essentially get 0,
okay?

So, this is what the NPV of waiting looks like. There is a 50% chance of opening the
mine, okay? That happens one year from now and you get a profit of 20, okay?
Because it's 90- 70, and then we take into account the probabilities that you're going to
end up in the high gold price state, right? 25% chance of being 140, 25% chance of the
profit being 40. You discount that 2 years and you get an NPV. The NPV in this case is
50,340, okay.

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So, let's think about the decision, right. So, we computed the NPV of opening now is
44,367, right. So, the way I like to explain this is if you force the manager to make a
decision today, if you tell the manager rule. You either open today or never, then yes,
you should do it because the NPV is positive, right? But if you wait an extra year, then
the NPV is even higher, okay? The NPV of waiting is 50,340, okay? So, the right
decision here is to wait. Opening the mine is a great investment, it's not bad. But waiting
would be even better, okay? Nobody likes waiting, but in this case, it turns out to be the
optimal decision for this company, all right? Before we end, let's talk about a couple of
ideas that are very important.

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The first one is that the value of the option to wait is going to depend on the amount of
uncertainty that you have in the economy. In this case it's going to depend on the
uncertainty on the price of gold, okay? So, suppose if volatility is high, suppose we are
in a case where gold prices are extremely volatile, right? What happens is that
fluctuations in the price of gold are going to cause very large profit gains and very large
losses, okay. So, in this case if you decide to wait and open the mine only tomorrow,
you are essentially avoiding a very large loss, right? By waiting you can avoid the state
of the world that the gold price is very low, and you're going to be stuck with a very
unprofitable mine, okay? So, waiting eliminates this large loss, zero looks great, right? If
you're going to lose money, zero looks great, okay?

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The other issue that we're going to talk about is that competition also matters.
Remember from the very beginning we assumed that you have an exclusive right to
open this mine. So, you have a monopoly. In most cases companies do not have a
monopoly. They may not have the ability to wait because competitors may decide to
start similar projects.

Let's think of this here in our decision tree. In many cases, companies are going to be in

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a situation where if they decide to wait, they lose the profit today. But they may also lose
profits tomorrow if the competitor decides to start a similar project. Then you're going to
lose profits and the profit is going to be low. The profit might have been higher if you
had started today because that might deter the competitor from starting a similar
project. So, this is how we would think about the effect of the competition on the option
to wait. So, every time you're trying to value an option to wait, you have to consider
whether the company really has the ability to wait and whether that would not be bad
from a competitive stand point, right. Waiting in some cases may give an opportunity for
competitors to come in and take your profits away.

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Lesson 3-11: The Option to Abandon

Lesson 3-11.1: The Option to Abandon a Project

The final real option that we're going to talk about is the option to abandon an
unprofitable project, okay? Sometimes closing a project, abandoning a project is the
right thing to do, okay?

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Of course, all projects have to be constantly reevaluated, right? You know, once you
decide to invest in a drug, for example, to invest in R&D, to buy a machine, to open a
division, any cooperative decision has to be constantly reevaluated. In fact, one of the
topics we're going to talk about in module four is how to evaluate ongoing projects and
divisions, that's one of our topics. For now, let's talk about the value of this option to
abandon. So, the idea is that you can exercise this option, you can use this option by
shutting down a project That has become negative NPV. The other way that companies
can exercise this option of course is by selling projects. Perhaps the project is not as
valuable to you as it is to a competitor so it may be worthwhile to abandon this project,
move on, sell it to someone else. Try to make some cash and go do something else.
So, shutting down projects in many cases is the right thing to do, okay?

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Let's talk about this option in the context of our example, the gold mine, right? We
assumed in the beginning that the gold mine was irreversible, so you could not close the
mine once it's opened. That is likely to be a little bit not realistic assumption, unless the
government forces you to keep the mine, right? You probably have a license from the
government. The government might force you to extract gold anyway. But if that's not
the case, the company is very likely to be able to close the mine by paying a closing
cost. We call that a decommissioning cost. Those are synonyms. You could think about
the decommissioning cost as the closing cost. So, let's say in our example there is a
closing cost of $5,000. So that's not a huge cost. How would that change your analysis?
Now, we have to consider the option of opening today and then closing tomorrow if the
gold price goes down. Remember the main benefit of waiting was that we could wait
until tomorrow and avoid opening the mine if the gold price we went down. Now, we
have a third option which is too open today. Make the profit, pocket the money, but then
close tomorrow if the gold price goes down.

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So, I've made the profit tree for you in this case. Now, what we have, we have the profit
here at the beginning, and this is the important change, if the gold price goes down, and
the mine becomes unprofitable, you can close it by paying $5K. Okay, you pay $5,000
and you close the mine, and then of course, the mine remains closed until the end, you
just make a zero profit. If the gold price goes up, of course, you're going to keep the
mine open and make the profit, right? It's not worth closing the mine in that case. So
that is the three that correspond to this third option and notice that the $5K here is
precisely the decommissioning.

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So now the question for you, previously in the previous question you worked out the
decision tree. Now I've done the decision tree for you. Try to use the decision tree to
compute the NPV.

Okay, so let's check your answer. Right, let's see if you've done the right calculation, all
right. So, what we have, we have the NPV right, is going to be 2 minus 70 because you
open at times zero. Plus, the date zero profit right, so let's mark the numbers when we

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take that into account right. And then here, next year we have a 50% chance of a profit
of 90. We have to discount that by 5%. And then there is a 50% chance of a loss. The
loss now is only $5K, times the -5, okay? Again, we're going to discount that one period
okay. There is nothing here if you close the mine there is zero. So, the only numbers we
need to consider are the numbers there, so it's 25 times 140, right? divided by 1 plus
5% to the second, okay? Plus 25% times 40. Okay, so we're taking this number into
account. Okay? So, here's the entire calculation done for you. Remember, here we
have to discount by two periods as well, right? Because we are two periods ahead. So
that's how the NPV would look like, okay?

If you do this calculation, you should have obtained an NPV of 51, 292. So that's the
NPV of opening now and closing tomorrow if the gold price goes down. So now we have
three NPVs if you open now and keep it open is 44. If you don't open now and wait it's
50, 340. If you open now and close tomorrow, it's 51,292. So now the optimal decision
is to open today and exercise the option to abandon. So, in this case, the option to
abandon, to close the mine becomes valuable, right? It actually makes it more likely
you're going to start the mine today.

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Okay, an important observation here is the notion of irreversibility, right. We can capture
the notion of irreversibility which is the commissioning cost. If the cost of closing the
mine was very high, then it would obviously not make sense to open today and close
tomorrow. In the first example that we gave we assume that this cost was infinite so you
could never close the mine. And then we worked with a cost of 5.5k, okay? So of
course, the cost would be at any specific value right, the notion that is important to
realize is that this cost is what's going to capture reversibility for us. Investments that
have high shut down costs are going to be reversible and those are going to be the
investments for which the option to wait is the most valuable. Because if an investment
is irreversible, it really makes sense to wait. Until you are sure that this investment is
going to be positive NPV.

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If the investment is not irreversible, then you might as well start today and close it
tomorrow if things turn out to be bad. Okay? So, let's give a few examples of irreversible
investments. For example, building a factory maybe and irreversible investment, right?
Once you have put all the equipment into, in place, it may be very difficult to close the
factory. There are lots of fixed costs. So, you may end up having to operate the factory
even if your sales turn out to be worse than expected, for example, okay? Or testing a
drug on thousands of patients which is the example we just talked about for R&D. Once
you've done that testing, it gone, right? You can't go back and recover that money.
That's completely irreversible, right? So, companies, drug companies, have to really
evaluate, think about whether it makes sense to continue doing research or not,
because those are definitely reversible investments.

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Lesson 3-12: Review

Lesson 3-12.1: Module 3 Review

On this module we learned how to think about investment decisions okay, in particular
we learn several tools that companies can use to try to ensure that they are making
investments that create shareholder value. Right, we talked about net present value
which really is the most important concept in corporate investments. Okay. Because net
present value is equivalent to shareholder value, right? It's exactly equivalent to
maximizing shareholder value on the third, right? We learn how to build cash flow for
NPV calculations. We learn how to compute NPV, and how to use NPV to make
decisions. Okay? Then we talked about rates of return, which in many cases are very
similar. You know you can either make decisions with NPV or you can make decisions
with IRR, the rate of return on the projects.

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And we also talked about situations in which you should not use IRR to make
investment decisions. So now you should know how to compute NPV and IRR and also
when you can use IRR and when you cannot use IRR. After we finish that we started
talking about real options. The cost of real options is extremely important because many
investment decisions are going to come in bad that are going to come with options to
wait, options to abandon, options to expand, okay? And we learned that to incorporate
real options into investment decisions, we have to think about decision trees, right?
There are different states of the world. We have to think about what's going to happen in
the future. And how the company could change its original decision.

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Okay? We talked about specific applications of real options including R&D investments.
We learned how to value an R&D investment. How to try to put the numbers. To make
sure that companies are spending money in that indeed that is going to create
shareholder value, right? And then we talked about the option to wait and the option to
abandon and we learned how to incorporate those options into investment decisions
using decision trees.

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