0:00

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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