0:00

So, let's go back to what we were talking about because we were talking, we now know

Â how to do NPV, and the NPV of this is 1400. Right? What is the generic formula?

Â So the generic formula, just stare at it for a little while, and I will encourage

Â you to write it down, it's right there for you, it's very simple. Npv starts off with

Â a negative number, your investment. And once you get your investment, you, put a

Â negative sign in front of it, because that's how the world works usually. Then

Â what does C1 stand for? C1 stands for the cash flow in the first period. What does

Â C2 stand for? C2 stands for the cash flow in the second period, in our problem we

Â just stopped there. What did we have? Negative 1,000, 1320, 1452, numbers were

Â changing, but very conveniently in multiples that were easy to calculate. And

Â then you can go on to and, important point, this framework can be used for any

Â length of time. And as the time gets longer, refining your numbers too much

Â doesn't pay off and we'll talk about it later. Don't try to think about the number

Â your getting as an exact number. Try to think about the process. So, okay?

Â Properties of NPV, and then we'll take a break. I want to go through the properties

Â of all three criteria I'm discussing today at the end, because I just want to remind

Â myself and you about what's good, what's not so good about it. Okay? Within the

Â context of what we know. And within the larger context of how the world should

Â operate, there is a should here. Okay? Does it make sense? Think about it for a

Â second, what are you trying to do? You're trying to figure out whether this is a

Â value creating idea or not. Does this make sense? I think so, for the most part,

Â right? So what are you doing? Are you discounting for the fact that the time has

Â passed, answer is yes. How are you discounting it? Remember, how did you get

Â the ten%? And by the way, this, if you've spent three classes on how you calculate

Â that ten percent I gave you, because risk will be coming in and so on and so forth.

Â But for the time being, you need, you already know what's the most important

Â thing about R. Which is, the discomfort is coming not from your business, per say,

Â but from similar businesses that are already exist. Why? Because even if you

Â had the resources, $1000 or millions of dollars, you would like to put it in a

Â value creating idea. Right? So, if it's a better value creating ideas, well, you may

Â want to think about investing in there even yourself. Okay. Unit of measurement.

Â Now the make sense part in some senses captures all the following parts. So I'm

Â just going to highlight the, one or two issues and make sense. And then you'll get

Â the feeling for unit of measurement, what is it? So let's, let's just make some

Â notes as we go along. Benefits minus cost time value of money, makes sense. What is

Â the unit of measurement? It is our unit of measurement of measuring value. Dollar.

Â Now you may use cows to value things or smiles or whatever. The point here is not

Â the dollar again, it's, you recognize it. You are able to say, yup. So, I made $1400

Â NPV. The two things to remember about this is this. One, this number is not right.

Â It's as right as it is wrong because it's based on my predictions on the future,

Â right? So there is lot of art involved in judging NPV. But, if it's 1400, sound like

Â a good number, a big number. It could be 700, it could be 2100 because of

Â uncertainty and we'll deal with that as we come later. Okay? Next point. Is the

Â benchmark obvious? So what is the benchmark of value? I'm pausing here,

Â yeah. [laugh] When will you do a project? When the NPV is greater than? Right? Now

Â here's some, I hope you don't mind the next bit I'll talk about. Most people

Â think they understand zero. Zero was the last number created as far as I can tell.

Â Imagine, imagining nothing. Nothingness is not easy to imagine but for the time being

Â we'll pretend like we know what zero is. I think when you says zero, almost everybody

Â is not there they don't have a clue like me, but that's okay. We know that this

Â 1400 is greater than zero. Easy to communicate. I w ould say it is the

Â easiest thing to communicate. Why? Because of all of the above. I've taken the

Â benefits into account, I've taken the costs into account and I'm saying, on a

Â net basis, you are creating positive value. The tough part here to communicate

Â is time value money. But I think people intrinsically understand that $100 today

Â versus $100 in the future is not the same. Next, easy to compare ideas in projects.

Â Turns out, yes. So if you have two ideas, one is 1400 and one is 1200 and for just

Â because you don't have the time to do both or whatever, there's something making you

Â choose between the two, which one should you choose? This one. So look at the

Â beauty of it. Because of all the things that we talked about, in the end, after

Â you have done all the discounting and after you have used the right discount

Â rate, you can compare similar ideas and pick the one that's creating the most

Â value. Right? So, that's so cool. I mean, that's exactly what common sense dictates,

Â right? Is it easy to calculate? And here I'm going to put maybe a question mark and

Â then say mm-hm, not right. Why did I do that? Okay, so if you went 40 years ago,

Â 50 years ago, right? Calculating NPV in a real world context, with not just two cash

Â flows, with multiple cash flows is a challenge. And the culprit is what? Pause

Â again, compounding. So it's not easy to do, I agree. But in today's world, with

Â Excel being your slave and you being in charge of machines rather than the other

Â way around, this is not a legitimate answer. This is not. You have so much

Â power in your laptop that you could send the, the first rocket to the moon, using

Â just your laptop, right? Don't try to do it, though but, but you know I mean.

Â There's, there's absolutely no need to settle me. I understand NPV but I can't

Â calculate it, it's not easy to calculate. Yes, as a person, I would encourage you to

Â do divisions of something raised to the power n. But, a laptop can do it for you.

Â Any other benefits. I think when you take them all, I would encourage you to talk

Â amongst yourselves. The forum that is created is great for talking about issues

Â like this, because I do think that it has a weakness. And I'm not going to talk

Â about that weakness right now. Just give you a hint. Npv unfortunately, though

Â very, very good, misses one component. It has a static view of the world after

Â today. So you make a decision today and you say, yes, if it's positive I'll do it.

Â No, if it's zero or negative I won't do it. But what happens is, you are in

Â charge. You're making good decisions in the future too. You have the flexibility

Â to change the world as the world changes in the future. So NPV kind of because it

Â predicts all the future cash flows, does an analysis up and down once, is missing

Â out of something called flexibility. And in a more advanced class, we will do

Â something called real options, you know? You must have heard of option pricing, it

Â got an noble prize. It's a very powerful way to think but NPV is a necessary

Â ingredient of that idea. It's not separate, it just adds flexibility. So

Â let's do this. I think I've spent a fair amount of time on probably the most

Â useful, practical way of measuring value and of comparing ideas. I want you to

Â think about it, I want you to even go, take the time, do some problems from the

Â assessment. Don't wait 'till the whole video is over because that's not a good

Â way to learn. So I'm going to take a break here, and you take a break to do

Â significant work or whatever. But let's pause here and you pick up whenever next

Â you are able to. What are we going to do next? We're going to talk a couple of

Â other ideas, criteria that are used in the real world and we'll come back to this

Â session. We are still, please remember, we are still in week three. And may the, may

Â the force be with you, whether you're drinking coffee, doing yoga, going for a

Â walk or taking a nap. See you soon. Bye.

Â