1 00:00:00,090 --> 00:00:02,430 The following content is provided under a Creative 2 00:00:02,430 --> 00:00:03,820 Commons license. 3 00:00:03,820 --> 00:00:06,030 Your support will help MIT OpenCourseWare 4 00:00:06,030 --> 00:00:10,150 continue to offer high quality educational resources for free. 5 00:00:10,150 --> 00:00:12,690 To make a donation, or to view additional materials 6 00:00:12,690 --> 00:00:16,620 from hundreds of MIT courses, visit MIT OpenCourseWare 7 00:00:16,620 --> 00:00:17,830 at ocw.mit.edu. 8 00:00:26,354 --> 00:00:27,770 ANDREW LO: What I want to do today 9 00:00:27,770 --> 00:00:31,910 is to continue where we left off last time in talking 10 00:00:31,910 --> 00:00:34,400 about the capital asset pricing model, 11 00:00:34,400 --> 00:00:36,050 and we're going to finish that off 12 00:00:36,050 --> 00:00:37,770 in the next 15 or 20 minutes. 13 00:00:37,770 --> 00:00:41,120 And then, I'm going to turn to applications of the capital 14 00:00:41,120 --> 00:00:42,170 asset pricing model. 15 00:00:42,170 --> 00:00:45,350 In particular, I want to focus on capital budgeting. 16 00:00:45,350 --> 00:00:48,380 That's going to be the last major topic we take on 17 00:00:48,380 --> 00:00:49,740 for this course. 18 00:00:49,740 --> 00:00:52,589 So let me finish the capital asset pricing model 19 00:00:52,589 --> 00:00:54,380 and then I'll talk a little bit about where 20 00:00:54,380 --> 00:00:58,670 we're going to go for the remainder of the lectures. 21 00:00:58,670 --> 00:01:01,820 You remember last time where we left off was, 22 00:01:01,820 --> 00:01:05,600 I decided to estimate the CAPM relationship for a couple 23 00:01:05,600 --> 00:01:08,660 of stocks, Biogen and Motorola. 24 00:01:08,660 --> 00:01:14,720 And we found that the estimated alphas, the deviations 25 00:01:14,720 --> 00:01:16,790 from the CAPM, were pretty sizable 26 00:01:16,790 --> 00:01:18,780 for both of these companies. 27 00:01:18,780 --> 00:01:20,990 And the interpretation is either, 28 00:01:20,990 --> 00:01:25,460 wow these companies are really exceptional values, 29 00:01:25,460 --> 00:01:27,920 they offer investors much, much larger 30 00:01:27,920 --> 00:01:32,360 expected return than justified by the appropriate market 31 00:01:32,360 --> 00:01:33,260 betas. 32 00:01:33,260 --> 00:01:36,050 That's one interpretation, or the other interpretation 33 00:01:36,050 --> 00:01:39,380 is there something missing with the CAPM. 34 00:01:39,380 --> 00:01:42,650 The CAPM doesn't quite capture all 35 00:01:42,650 --> 00:01:45,830 of the risks that are giving you these kinds of expected 36 00:01:45,830 --> 00:01:47,130 rates of return. 37 00:01:47,130 --> 00:01:49,970 So I'm going to come back to that debate 38 00:01:49,970 --> 00:01:51,480 in just a few minutes. 39 00:01:51,480 --> 00:01:55,040 But I thought, that to continue along these lines, let's 40 00:01:55,040 --> 00:01:59,120 explore a little bit about the goodness of fit 41 00:01:59,120 --> 00:02:00,080 of these measures. 42 00:02:00,080 --> 00:02:03,230 Now, I mentioned last time that the R-squareds, 43 00:02:03,230 --> 00:02:08,990 as a measure of goodness of fit, was 17.5 percent for Biogen 44 00:02:08,990 --> 00:02:12,950 and 33% for Motorola. 45 00:02:12,950 --> 00:02:15,980 Both of which are reasonably representative 46 00:02:15,980 --> 00:02:18,740 of the kind of goodness of fit measures 47 00:02:18,740 --> 00:02:21,050 that you're going to see with financial data, 48 00:02:21,050 --> 00:02:24,470 for the simple reason that financial data is very noisy. 49 00:02:24,470 --> 00:02:26,990 And so you're not going to get any single theory that 50 00:02:26,990 --> 00:02:31,640 can explain 99.9 percent of the fluctuations 51 00:02:31,640 --> 00:02:33,440 in any kind of financial series. 52 00:02:33,440 --> 00:02:38,120 So here's a plot of Biogen versus the market. 53 00:02:38,120 --> 00:02:41,000 Now the market, as I reminded you last time, 54 00:02:41,000 --> 00:02:43,580 is the valuated return, including 55 00:02:43,580 --> 00:02:47,390 dividends, of all stocks on the NYSE, Amex, and NASDAQ. 56 00:02:47,390 --> 00:02:50,480 So this market portfolio, you can 57 00:02:50,480 --> 00:02:55,430 think of as being a broader version than the S&P 500, 58 00:02:55,430 --> 00:02:57,510 but it's meant to capture the market. 59 00:02:57,510 --> 00:03:01,370 So this is a plot of Biogen versus the market. 60 00:03:01,370 --> 00:03:05,690 And you can see that there is some slope that 61 00:03:05,690 --> 00:03:08,930 fits this scatter of points, and of course the equation 62 00:03:08,930 --> 00:03:14,750 is 1.42 times the market, minus a particular value 63 00:03:14,750 --> 00:03:18,440 for the alpha, and then R-squared of about 33% 64 00:03:18,440 --> 00:03:21,350 over this particular sample period. 65 00:03:21,350 --> 00:03:25,380 So there is a line that goes through these points, 66 00:03:25,380 --> 00:03:28,280 but it's not a perfect straight line by any means. 67 00:03:28,280 --> 00:03:30,620 You can see there's a scatter. 68 00:03:30,620 --> 00:03:34,460 And so there's a tendency for Biogen 69 00:03:34,460 --> 00:03:36,470 to move together with the market, 70 00:03:36,470 --> 00:03:40,610 but it's not a perfect linear relationship by any means. 71 00:03:40,610 --> 00:03:43,700 That's why the R-squared is not 100%. 72 00:03:43,700 --> 00:03:47,480 It's because we're not able to explain all of the fluctuations 73 00:03:47,480 --> 00:03:49,220 with a simple linear relationship. 74 00:03:49,220 --> 00:03:51,420 Life is more complicated than that, 75 00:03:51,420 --> 00:03:54,800 and so the CAPM is really just an approximation 76 00:03:54,800 --> 00:03:57,000 to a much more complex reality. 77 00:03:57,000 --> 00:04:02,780 Now, a particular stock has a lot of idiosyncratic risk. 78 00:04:02,780 --> 00:04:06,350 That's what we talked about last time as the dancing 79 00:04:06,350 --> 00:04:10,070 the Irish jig on that catwalk when you're window 80 00:04:10,070 --> 00:04:12,020 washing on these skyscrapers. 81 00:04:12,020 --> 00:04:15,590 So you can see that that idiosyncratic risk is really 82 00:04:15,590 --> 00:04:17,370 quite significant. 83 00:04:17,370 --> 00:04:21,680 What happens if we plot, not Biogen against the market, 84 00:04:21,680 --> 00:04:25,550 but another market portfolio against the market. 85 00:04:25,550 --> 00:04:27,010 like let's say NASDAQ. 86 00:04:27,010 --> 00:04:30,180 Well, the next plot shows you. 87 00:04:30,180 --> 00:04:33,430 Look at NASDAQ versus the market as a whole. 88 00:04:33,430 --> 00:04:37,410 Now NASDAQ, as you know, tends to have smaller stocks, stocks 89 00:04:37,410 --> 00:04:41,970 that seem to be technology oriented, and as a result 90 00:04:41,970 --> 00:04:44,380 NASDAQ might be more volatile. 91 00:04:44,380 --> 00:04:48,480 But nevertheless, there is a very strong common relationship 92 00:04:48,480 --> 00:04:52,630 between these two market indexes. 93 00:04:52,630 --> 00:04:54,360 And so now, look at this. 94 00:04:54,360 --> 00:04:56,160 Scatter of points is a lot tighter. 95 00:04:56,160 --> 00:04:57,510 Right? 96 00:04:57,510 --> 00:05:01,816 Still, it's not exactly linear, but comparing this to that, 97 00:05:01,816 --> 00:05:02,940 you can see the difference. 98 00:05:02,940 --> 00:05:03,439 Right? 99 00:05:03,439 --> 00:05:05,550 There was a stronger relationship here. 100 00:05:05,550 --> 00:05:08,520 And not surprisingly, when you put securities 101 00:05:08,520 --> 00:05:13,559 into a portfolio, what gets averaged out? 102 00:05:13,559 --> 00:05:14,350 AUDIENCE: Outliers. 103 00:05:14,350 --> 00:05:17,590 ANDREW LO: Exactly, the outliers, and what else? 104 00:05:17,590 --> 00:05:18,830 What other component? 105 00:05:18,830 --> 00:05:19,330 Leland. 106 00:05:19,330 --> 00:05:20,500 AUDIENCE: The idiosyncratic risk. 107 00:05:20,500 --> 00:05:21,291 ANDREW LO: Exactly. 108 00:05:21,291 --> 00:05:25,090 The Idiosyncratic risk, The unusual stock 109 00:05:25,090 --> 00:05:28,974 specific kinds of randomness that gets averaged out. 110 00:05:28,974 --> 00:05:30,640 So not surprisingly, when you put things 111 00:05:30,640 --> 00:05:35,830 into portfolios the noise, or the idiosyncratic risks average 112 00:05:35,830 --> 00:05:43,020 out and what you're left with is whatever common factors remain. 113 00:05:43,020 --> 00:05:46,090 So I'm going to show you some evidence for how well, 114 00:05:46,090 --> 00:05:48,970 or how poorly the CAPM works by looking 115 00:05:48,970 --> 00:05:50,590 not at individual stocks, because we 116 00:05:50,590 --> 00:05:52,715 know there's a lot of noise with individual stocks. 117 00:05:52,715 --> 00:05:55,060 I want to show you what happens when you put stocks 118 00:05:55,060 --> 00:05:59,680 into portfolios and you look at how those portfolios do. 119 00:05:59,680 --> 00:06:03,280 So let's do one simple example, market cap portfolios. 120 00:06:03,280 --> 00:06:06,940 Let's take a look at small stocks and big stocks. 121 00:06:06,940 --> 00:06:10,340 Remember at the introduction of this series of lectures, 122 00:06:10,340 --> 00:06:12,400 I showed you some empirical evidence 123 00:06:12,400 --> 00:06:16,330 that illustrated the fact that small stocks seem 124 00:06:16,330 --> 00:06:21,940 to do really well relative to large stocks, the size anomaly. 125 00:06:21,940 --> 00:06:24,610 So let's now take the size anomaly 126 00:06:24,610 --> 00:06:26,530 and look at it through the lens of the CAPM 127 00:06:26,530 --> 00:06:28,540 and ask the question, with the CAPM 128 00:06:28,540 --> 00:06:33,071 can we explain the difference between small and large? 129 00:06:33,071 --> 00:06:33,570 OK. 130 00:06:33,570 --> 00:06:35,640 Well, let's take a look. 131 00:06:35,640 --> 00:06:41,220 Over the 40 years from 1960 to 2000, 132 00:06:41,220 --> 00:06:45,990 approximately, we see that the small stock portfolio, 133 00:06:45,990 --> 00:06:50,280 the smallest decile, the smallest tenth of stocks, 134 00:06:50,280 --> 00:06:54,030 in terms of market cap, as a group, as a portfolio, 135 00:06:54,030 --> 00:06:59,790 had an average monthly return of 1.33% and a beta of 1.4. 136 00:06:59,790 --> 00:07:02,400 On the other hand, the large stock portfolio 137 00:07:02,400 --> 00:07:08,890 had an average monthly return of 0.9% and a beta of 0.94. 138 00:07:08,890 --> 00:07:11,530 So that seems like it's sort of consistent. 139 00:07:11,530 --> 00:07:15,520 Lower risk, lower expected return, but let's plug it in 140 00:07:15,520 --> 00:07:19,990 and see if the CAPM relationship actually can tell us something. 141 00:07:19,990 --> 00:07:25,630 So the expected return of the stock, according to the CAPM, 142 00:07:25,630 --> 00:07:28,510 is going to be given by the risk free rate, plus beta, 143 00:07:28,510 --> 00:07:31,607 multiplied by the market risk premium over the sample period 144 00:07:31,607 --> 00:07:32,440 that I'm looking at. 145 00:07:32,440 --> 00:07:34,939 The market risk premium is about a half a percent per month. 146 00:07:34,939 --> 00:07:38,500 So roughly 6% a year. 147 00:07:38,500 --> 00:07:42,640 And the risk free rate is also about a half a percent 148 00:07:42,640 --> 00:07:45,970 per month during this time period. 149 00:07:45,970 --> 00:07:49,960 So now, let's ask the question, what 150 00:07:49,960 --> 00:07:53,140 is the expected return of a large stock portfolio? 151 00:07:53,140 --> 00:07:55,390 Well according to this, it should 152 00:07:55,390 --> 00:07:59,760 be 93 basis points per month. 153 00:07:59,760 --> 00:08:01,380 What about the small stock portfolio? 154 00:08:01,380 --> 00:08:06,880 According to this, it should be 1.16% per month. 155 00:08:06,880 --> 00:08:10,140 Now, this is an amazingly good fit, 156 00:08:10,140 --> 00:08:15,090 so I wouldn't take this as typical in the finance 157 00:08:15,090 --> 00:08:15,990 literature. 158 00:08:15,990 --> 00:08:19,230 But it just so happens that over this 40 year period, 159 00:08:19,230 --> 00:08:21,870 the CAPM actually works pretty darn well. 160 00:08:21,870 --> 00:08:27,540 0.99 is the average realize return and 0.93 is 161 00:08:27,540 --> 00:08:29,070 what was predicted. 162 00:08:29,070 --> 00:08:34,080 For the small cap portfolio, 1.33 is what was realized 163 00:08:34,080 --> 00:08:37,320 and 1.16 was what was predicted. 164 00:08:37,320 --> 00:08:38,809 So that's pretty good. 165 00:08:38,809 --> 00:08:41,240 Now, I want to emphasize the point 166 00:08:41,240 --> 00:08:43,669 that this is really good because, let's take 167 00:08:43,669 --> 00:08:47,630 a look at other ways of dividing up the universe 168 00:08:47,630 --> 00:08:50,390 and seeing whether or not we can get a better explanation 169 00:08:50,390 --> 00:08:53,280 of risk and expected return. 170 00:08:53,280 --> 00:08:57,410 Here's a picture of size sorted portfolios along the security 171 00:08:57,410 --> 00:08:57,960 market line. 172 00:08:57,960 --> 00:08:59,660 So remember, security market line 173 00:08:59,660 --> 00:09:03,110 is a graph of beta and expected return. 174 00:09:03,110 --> 00:09:03,890 Right? 175 00:09:03,890 --> 00:09:07,010 The security market line applies to all portfolios 176 00:09:07,010 --> 00:09:09,140 and securities, unlike the capital market 177 00:09:09,140 --> 00:09:12,500 line that applies only to efficient portfolios 178 00:09:12,500 --> 00:09:13,640 and securities. 179 00:09:13,640 --> 00:09:16,500 So in this case, we expect a linear relationship. 180 00:09:16,500 --> 00:09:20,300 And with the exception of this little outlier up here. 181 00:09:20,300 --> 00:09:23,510 From 1960 to 2001 there was actually 182 00:09:23,510 --> 00:09:28,580 a pretty reasonable relationship between beta and expected 183 00:09:28,580 --> 00:09:29,120 return. 184 00:09:29,120 --> 00:09:33,140 In other words, the CAPM looks like it's actually doing OK 185 00:09:33,140 --> 00:09:35,030 for size sorted portfolios. 186 00:09:35,030 --> 00:09:38,300 The higher the beta, the higher the expected return. 187 00:09:38,300 --> 00:09:41,270 The lower the beta, the lower the expected return 188 00:09:41,270 --> 00:09:43,550 for size sorted portfolios. 189 00:09:43,550 --> 00:09:45,770 Now, what about for beta sorted portfolios? 190 00:09:45,770 --> 00:09:47,390 Suppose you took a bunch of portfolio 191 00:09:47,390 --> 00:09:50,240 and grouped them into beta's and asked the question, 192 00:09:50,240 --> 00:09:53,440 do the high beta portfolios have higher expected return? 193 00:09:53,440 --> 00:09:55,740 Low betas have low expected return? 194 00:09:55,740 --> 00:09:58,880 It turns out that, again you get a reasonable relationship. 195 00:09:58,880 --> 00:10:02,420 Not exactly what ' would expect according to the CAPM. 196 00:10:02,420 --> 00:10:04,220 So the slope of this line, remember, 197 00:10:04,220 --> 00:10:08,060 is going to be given by the risk premium, the market risk 198 00:10:08,060 --> 00:10:09,350 premium. 199 00:10:09,350 --> 00:10:13,040 In fact, the realized relationship looks linear, 200 00:10:13,040 --> 00:10:15,080 but it's at a slightly different slope. 201 00:10:15,080 --> 00:10:18,189 It doesn't look like the risk premium is the right slope, 202 00:10:18,189 --> 00:10:19,730 something a little bit less than that 203 00:10:19,730 --> 00:10:21,390 seems to be the right slope. 204 00:10:21,390 --> 00:10:24,680 And it turns out that in 15.433, you're 205 00:10:24,680 --> 00:10:27,020 going to learn a new theory of the CAPM 206 00:10:27,020 --> 00:10:30,980 that was developed by Fisher Black called the Balck CAPM. 207 00:10:30,980 --> 00:10:35,750 And the Black CAPM says that there is no risk-free rate. 208 00:10:35,750 --> 00:10:37,790 In fact, what you ought to be using 209 00:10:37,790 --> 00:10:40,490 is the rate of return of something called a zero beta 210 00:10:40,490 --> 00:10:41,390 portfolio. 211 00:10:41,390 --> 00:10:43,970 Well it turns out that if you do that, you would actually 212 00:10:43,970 --> 00:10:47,630 get a line that fits this line almost exactly. 213 00:10:47,630 --> 00:10:50,300 So the Black Zero-Beta CAPM seems 214 00:10:50,300 --> 00:10:53,900 to be a better approximation, but for now the CAPM 215 00:10:53,900 --> 00:10:56,660 is actually a pretty reasonable first approximation, 216 00:10:56,660 --> 00:10:59,980 so let's finish off that first and I'll come back to the Black 217 00:10:59,980 --> 00:11:02,010 Zero-Beta CAPM in a minute. 218 00:11:02,010 --> 00:11:02,600 OK. 219 00:11:02,600 --> 00:11:05,390 So this is a plot of the expected return 220 00:11:05,390 --> 00:11:07,460 of beta sorted portfolios. 221 00:11:07,460 --> 00:11:10,190 Higher beta, higher average return. 222 00:11:10,190 --> 00:11:12,050 Lower beta, lower average return. 223 00:11:12,050 --> 00:11:15,960 So it seems like a CAPM is actually pretty reasonable. 224 00:11:15,960 --> 00:11:21,050 I'm not perfect, but it gets at the heart 225 00:11:21,050 --> 00:11:23,851 of what risk really means. 226 00:11:23,851 --> 00:11:25,350 Now in order to emphasize the point, 227 00:11:25,350 --> 00:11:27,570 let me show you a couple of other graphs. 228 00:11:27,570 --> 00:11:30,930 This is volatility sorted portfolios. 229 00:11:30,930 --> 00:11:35,160 So now, I'm sorting stocks based upon their total volatility, 230 00:11:35,160 --> 00:11:36,630 not just their beta. 231 00:11:36,630 --> 00:11:41,220 Remember, the beta measures a part of their total volatility. 232 00:11:41,220 --> 00:11:42,150 Right? 233 00:11:42,150 --> 00:11:45,510 The beta is the systematic component of the risk. 234 00:11:45,510 --> 00:11:50,590 Volatility is the entire amount of risk of a security. 235 00:11:50,590 --> 00:11:54,640 If you use volatility as a way of sorting stocks, 236 00:11:54,640 --> 00:11:58,160 then look at the expected rate of return. 237 00:11:58,160 --> 00:12:00,820 There is no systematic relationship 238 00:12:00,820 --> 00:12:04,120 between volatility and return. 239 00:12:04,120 --> 00:12:08,900 The higher the volatility, you don't get necessarily the 240 00:12:08,900 --> 00:12:10,890 higher the return. 241 00:12:10,890 --> 00:12:15,800 So in other words, volatility is not the right measure 242 00:12:15,800 --> 00:12:17,900 of the risk reward trade-off. 243 00:12:17,900 --> 00:12:20,660 One of the first things I talked to you about in this course 244 00:12:20,660 --> 00:12:23,180 is that, if we've learned anything in modern finance 245 00:12:23,180 --> 00:12:26,010 we've learned that you don't get something for nothing, 246 00:12:26,010 --> 00:12:29,000 and in particular, if you are gonna bear more risk, 247 00:12:29,000 --> 00:12:32,180 you have to be paid to bear more risk, 248 00:12:32,180 --> 00:12:34,430 but you have to define risk appropriately. 249 00:12:34,430 --> 00:12:38,510 In this case this diagram shows that volatility is not 250 00:12:38,510 --> 00:12:39,710 the right measure of risk. 251 00:12:39,710 --> 00:12:43,640 You might have to bear more volatility for whatever reason, 252 00:12:43,640 --> 00:12:45,990 but you won't always get rewarded. 253 00:12:45,990 --> 00:12:46,490 Right? 254 00:12:46,490 --> 00:12:49,760 Because volatility is not the relevant measure 255 00:12:49,760 --> 00:12:52,920 of risk from the capital markets point of view. 256 00:12:52,920 --> 00:12:55,640 What you get rewarded for is the risk that you cannot get rid 257 00:12:55,640 --> 00:13:00,500 of by diversification and that kind of risk is not sigma, 258 00:13:00,500 --> 00:13:01,755 it's beta. 259 00:13:01,755 --> 00:13:05,620 So beta, you do get rewarded. 260 00:13:05,620 --> 00:13:09,130 Sigma, you do not get rewarded necessarily. 261 00:13:09,130 --> 00:13:10,150 Right? 262 00:13:10,150 --> 00:13:13,360 Higher risk does not mean necessarily higher 263 00:13:13,360 --> 00:13:16,150 expected rates of return when you measure risk 264 00:13:16,150 --> 00:13:17,620 with volatility. 265 00:13:17,620 --> 00:13:20,710 Higher risk in the form of beta does 266 00:13:20,710 --> 00:13:23,770 seem to be associated with higher 267 00:13:23,770 --> 00:13:25,680 expected rates of return. 268 00:13:25,680 --> 00:13:26,610 OK. 269 00:13:26,610 --> 00:13:29,260 Now, in the most recent literature 270 00:13:29,260 --> 00:13:31,153 there have been-- oh, question? 271 00:13:31,153 --> 00:13:33,880 AUDIENCE: So if I remember the definition of volatiility-- 272 00:13:33,880 --> 00:13:36,375 or based [INAUDIBLE],, it's a ratio of two 273 00:13:36,375 --> 00:13:37,600 standard deviations, right? 274 00:13:37,600 --> 00:13:42,050 ANDREW LO: Beta is the ratio of a covariance to the variance. 275 00:13:42,050 --> 00:13:43,900 It's not the ratio of standard deviations. 276 00:13:43,900 --> 00:13:46,780 In the case of an efficient portfolio, 277 00:13:46,780 --> 00:13:48,715 it's the ratio of two standard deviations. 278 00:13:52,180 --> 00:13:55,150 Other questions? 279 00:13:55,150 --> 00:13:55,890 OK. 280 00:13:55,890 --> 00:13:58,050 So what I'm going to tell you now 281 00:13:58,050 --> 00:14:00,600 is about the most current research. 282 00:14:00,600 --> 00:14:02,730 The most current research suggests 283 00:14:02,730 --> 00:14:08,160 that, while beta does seem to have some impact on explaining 284 00:14:08,160 --> 00:14:12,120 expected returns, there are other factors out there 285 00:14:12,120 --> 00:14:14,820 that seem to contribute to that explanation. 286 00:14:14,820 --> 00:14:16,920 In other words, the CAPM, while it's 287 00:14:16,920 --> 00:14:22,300 a very interesting and compelling first approximation, 288 00:14:22,300 --> 00:14:24,880 it is only an approximation. 289 00:14:24,880 --> 00:14:28,480 There are other factors, like book to market, 290 00:14:28,480 --> 00:14:31,660 like liquidity, like trading volume, 291 00:14:31,660 --> 00:14:35,980 that seems to also add to the explanatory power 292 00:14:35,980 --> 00:14:37,990 of these kinds of relationships. 293 00:14:37,990 --> 00:14:41,020 So what we're at today is that we 294 00:14:41,020 --> 00:14:44,050 think there are multiple betas out there, not just 295 00:14:44,050 --> 00:14:45,770 one market beta. 296 00:14:45,770 --> 00:14:49,480 So the basic vanilla flavored theory of finance, 297 00:14:49,480 --> 00:14:51,760 and what you're going to be learning how to use over 298 00:14:51,760 --> 00:14:54,490 the next few lectures remaining in this course, 299 00:14:54,490 --> 00:14:58,420 is the single beta CAPM. 300 00:14:58,420 --> 00:15:00,660 But where we are at the cutting edge of research, 301 00:15:00,660 --> 00:15:03,460 or some would argue the bleeding edge of research, 302 00:15:03,460 --> 00:15:07,240 is that there are multiple betas out there, multiple sources 303 00:15:07,240 --> 00:15:09,830 of common risk. 304 00:15:09,830 --> 00:15:11,290 So it's not just the market risk, 305 00:15:11,290 --> 00:15:15,550 that is by far the biggest, but there is liquidity risk, 306 00:15:15,550 --> 00:15:19,400 there is currency risk, there is term structure risk, 307 00:15:19,400 --> 00:15:23,560 there is a variety of risks that cannot be diversified away with 308 00:15:23,560 --> 00:15:28,090 a large portfolio of very, very different kinds of assets. 309 00:15:28,090 --> 00:15:31,720 And So a better version of the CAPM, one 310 00:15:31,720 --> 00:15:35,800 that you might use if you are becoming an expert in finance 311 00:15:35,800 --> 00:15:39,760 theory, is to try to identify other sources of betas, 312 00:15:39,760 --> 00:15:43,360 other sources of expected return that have risks attached 313 00:15:43,360 --> 00:15:46,390 to them and to use these multiple factors 314 00:15:46,390 --> 00:15:49,050 in your analysis. 315 00:15:49,050 --> 00:15:52,660 So these are some references that you can take a look at, 316 00:15:52,660 --> 00:15:57,510 but the fact is that the CAPM is used, almost universally, 317 00:15:57,510 --> 00:16:03,900 among portfolio managers, among venture capitalist, and project 318 00:16:03,900 --> 00:16:06,670 managers, and chief financial officers. 319 00:16:06,670 --> 00:16:10,230 So the CAPM is a very, very powerful framework 320 00:16:10,230 --> 00:16:13,260 for thinking about risk and return. 321 00:16:13,260 --> 00:16:16,230 And so it's important to understand it, but just 322 00:16:16,230 --> 00:16:19,800 keep in mind that like any other finance theory 323 00:16:19,800 --> 00:16:23,010 it's just a theory, its just meant to be an approximation 324 00:16:23,010 --> 00:16:25,399 to a much more complex reality. 325 00:16:25,399 --> 00:16:26,690 So what we're going to do now-- 326 00:16:26,690 --> 00:16:29,385 Yeah, question. 327 00:16:29,385 --> 00:16:31,176 AUDIENCE: Would the other betas always have 328 00:16:31,176 --> 00:16:33,636 to be associated with like some kind of market 329 00:16:33,636 --> 00:16:35,604 portfolio or some representative portfolio, 330 00:16:35,604 --> 00:16:38,556 or do they just track a defaulted [INAUDIBLE] 331 00:16:38,556 --> 00:16:40,040 or something like that. 332 00:16:40,040 --> 00:16:42,456 ANDREW LO: So that's a great question, let me repeat that. 333 00:16:42,456 --> 00:16:46,820 The question is, does factors that are useful for the CAPM 334 00:16:46,820 --> 00:16:49,160 always have to be associated with some kind 335 00:16:49,160 --> 00:16:52,490 of a tradable market portfolio, or index, 336 00:16:52,490 --> 00:16:55,580 or can it be some other factor, like macroeconomic like 337 00:16:55,580 --> 00:16:56,900 unemployment? 338 00:16:56,900 --> 00:17:00,950 Well, there's a big difference between factors 339 00:17:00,950 --> 00:17:03,770 that are economically relevant and factors 340 00:17:03,770 --> 00:17:05,540 that are financially relevant, and let 341 00:17:05,540 --> 00:17:07,069 me explain the difference. 342 00:17:07,069 --> 00:17:08,869 Factors that are economically relevant 343 00:17:08,869 --> 00:17:12,950 may well explain the returns of certain securities. 344 00:17:12,950 --> 00:17:15,319 A good case in point is unemployment. 345 00:17:15,319 --> 00:17:17,270 Unemployment is a factor that does 346 00:17:17,270 --> 00:17:21,470 seem to have some explanatory power for stock market returns. 347 00:17:21,470 --> 00:17:24,260 The reason that we don't focus on those kinds of factors 348 00:17:24,260 --> 00:17:26,690 from a financial decision making point of view 349 00:17:26,690 --> 00:17:30,890 is that while they may identify interesting economic 350 00:17:30,890 --> 00:17:34,250 relationships between certain parts of one 351 00:17:34,250 --> 00:17:37,070 part of the economy and other, it doesn't really 352 00:17:37,070 --> 00:17:39,870 allow you to make any kind of market decisions. 353 00:17:39,870 --> 00:17:42,510 In other words, if you can't trade it, 354 00:17:42,510 --> 00:17:44,190 then you can't manage it. 355 00:17:44,190 --> 00:17:46,880 So from the perspective of financial applications, 356 00:17:46,880 --> 00:17:49,580 most of the factor models that you will see 357 00:17:49,580 --> 00:17:52,130 are factor models where the risk factors 358 00:17:52,130 --> 00:17:57,140 are portfolios of securities, or in some other sense tradable 359 00:17:57,140 --> 00:18:01,640 So for example, if I had a particular beta exposure-- 360 00:18:01,640 --> 00:18:04,550 For example, if I'm holding a portfolio over here 361 00:18:04,550 --> 00:18:06,830 and this is more beta than I want, 362 00:18:06,830 --> 00:18:10,070 I can get rid of that beta by trading in S&P futures 363 00:18:10,070 --> 00:18:13,940 contracts to decrease the beta. 364 00:18:13,940 --> 00:18:16,220 You can't trade unemployment. 365 00:18:16,220 --> 00:18:17,240 All right? 366 00:18:17,240 --> 00:18:20,930 At least not as easily as you could market beta's. 367 00:18:20,930 --> 00:18:23,840 So while there are many research papers out there that 368 00:18:23,840 --> 00:18:26,210 try to document the relationship between all sorts 369 00:18:26,210 --> 00:18:29,090 of economic indicators and financial markets 370 00:18:29,090 --> 00:18:31,700 from the applications perspective the kind of models 371 00:18:31,700 --> 00:18:33,080 that we will be dealing with will 372 00:18:33,080 --> 00:18:35,810 be factors that are associated with portfolios 373 00:18:35,810 --> 00:18:38,210 of marketable securities that you can trade, 374 00:18:38,210 --> 00:18:42,015 purely from a practical perspective. 375 00:18:42,015 --> 00:18:43,380 OK. 376 00:18:43,380 --> 00:18:46,470 So the key points for these series of lectures, 377 00:18:46,470 --> 00:18:50,670 lectures 15 through 17, what I want you to take with you 378 00:18:50,670 --> 00:18:53,460 is that there are two critical relationships 379 00:18:53,460 --> 00:18:55,050 that you must understand. 380 00:18:55,050 --> 00:18:59,070 The first, is the risk reward trade for efficient portfolios, 381 00:18:59,070 --> 00:19:01,320 that's the capital market line. 382 00:19:01,320 --> 00:19:04,560 And the second, is the risk reward relationship 383 00:19:04,560 --> 00:19:08,460 for all other kinds of portfolios, that's the security 384 00:19:08,460 --> 00:19:10,920 market line of the CAPM. 385 00:19:10,920 --> 00:19:12,360 The CAPM. 386 00:19:12,360 --> 00:19:15,660 requires equilibrium. 387 00:19:15,660 --> 00:19:18,030 That's a departure from everything 388 00:19:18,030 --> 00:19:20,720 we've done in this course up until now. 389 00:19:20,720 --> 00:19:23,790 All of the pricing relationships that I've argued 390 00:19:23,790 --> 00:19:29,370 have to hold things like present values of bonds, 391 00:19:29,370 --> 00:19:35,070 of stocks, of futures, of forwards, of options, 392 00:19:35,070 --> 00:19:38,040 all of those pricing models, all of them, 393 00:19:38,040 --> 00:19:41,910 rely just on this notion of no free lunch, 394 00:19:41,910 --> 00:19:45,270 that people prefer more money to less money. 395 00:19:45,270 --> 00:19:47,700 But with the CAPM, I actually had 396 00:19:47,700 --> 00:19:50,670 to invoke a much stronger condition. 397 00:19:50,670 --> 00:19:54,510 I actually had to require that supply equals demand. 398 00:19:54,510 --> 00:19:56,220 It was through supply equaling demand 399 00:19:56,220 --> 00:19:59,760 that I was able to identify that the tangency portfolio is 400 00:19:59,760 --> 00:20:01,830 equal to the market portfolio. 401 00:20:01,830 --> 00:20:02,910 OK? 402 00:20:02,910 --> 00:20:08,040 So what we've done is to look into the heart of the market 403 00:20:08,040 --> 00:20:11,760 and try to infer from that what the market is actually 404 00:20:11,760 --> 00:20:16,050 doing by coming up with a particular discount rate that 405 00:20:16,050 --> 00:20:19,620 is consistent with those market views. 406 00:20:19,620 --> 00:20:23,790 And that now provides us with a complete theory of finance 407 00:20:23,790 --> 00:20:25,800 from your perspectives. 408 00:20:25,800 --> 00:20:31,140 You now know how to value 99.9% of anything that's out there, 409 00:20:31,140 --> 00:20:33,100 you've got the tools to do that. 410 00:20:33,100 --> 00:20:36,014 So what I want to do with the remainder of the course 411 00:20:36,014 --> 00:20:37,430 is I'm going to force you to apply 412 00:20:37,430 --> 00:20:40,490 those tools In several different contexts 413 00:20:40,490 --> 00:20:44,540 until you understand how the tools work. 414 00:20:44,540 --> 00:20:45,230 OK? 415 00:20:45,230 --> 00:20:50,050 So that's a we're going to do for the rest of the course. 416 00:20:50,050 --> 00:20:53,170 Let me just pull up the syllabus. 417 00:20:53,170 --> 00:20:58,750 Amazingly, we're actually on schedule despite the crisis 418 00:20:58,750 --> 00:21:02,570 and all our discussions thereof. 419 00:21:02,570 --> 00:21:06,730 We are to be focusing on capital budgeting today, next lecture, 420 00:21:06,730 --> 00:21:09,340 and the third lecture, where we take 421 00:21:09,340 --> 00:21:12,160 the tools of net present value calculations and risk 422 00:21:12,160 --> 00:21:13,876 adjustments and then just apply them 423 00:21:13,876 --> 00:21:15,250 to a bunch of different contexts. 424 00:21:15,250 --> 00:21:18,080 We're going apply them left and right. 425 00:21:18,080 --> 00:21:22,240 And what I'd like to do after that is to put it all together. 426 00:21:22,240 --> 00:21:24,640 In the very last lecture I'm going 427 00:21:24,640 --> 00:21:28,000 to try to give you a sense of where we stand 428 00:21:28,000 --> 00:21:31,780 today in terms of how to apply these tools more broadly given 429 00:21:31,780 --> 00:21:34,600 the market conditions that prevail. 430 00:21:34,600 --> 00:21:37,150 So I'm going to talk about market efficiency 431 00:21:37,150 --> 00:21:39,370 versus behavioral finance, psychology 432 00:21:39,370 --> 00:21:41,470 and I'm going to bring in some evidence 433 00:21:41,470 --> 00:21:43,720 from the cognitive neurosciences that 434 00:21:43,720 --> 00:21:47,510 will integrate all of the different parts of the course. 435 00:21:47,510 --> 00:21:49,780 So make sure if you're going to come for one lecture, 436 00:21:49,780 --> 00:21:50,770 you're going to come to that one, 437 00:21:50,770 --> 00:21:53,353 because that's where I'm going to put it all together for you. 438 00:21:53,353 --> 00:21:54,490 OK. 439 00:21:54,490 --> 00:21:57,970 So we're going to turn now to this notion of capital 440 00:21:57,970 --> 00:21:59,380 budgeting. 441 00:21:59,380 --> 00:22:02,830 I'm going to take the perspective that we now 442 00:22:02,830 --> 00:22:05,230 understand how markets work. 443 00:22:05,230 --> 00:22:07,600 We understand how pricing works, we 444 00:22:07,600 --> 00:22:09,340 know how to make risk adjustments, 445 00:22:09,340 --> 00:22:11,170 and we're going to take those ideas 446 00:22:11,170 --> 00:22:14,200 and apply them to very practical settings. 447 00:22:14,200 --> 00:22:17,179 And so in that respect I'm going to ask 448 00:22:17,179 --> 00:22:18,220 you to change your focus. 449 00:22:18,220 --> 00:22:20,770 Up until now we've been looking at markets 450 00:22:20,770 --> 00:22:23,710 from the perspective of an investor, either Warren 451 00:22:23,710 --> 00:22:29,530 Buffett, or the investor that's steeped in portfolio theory. 452 00:22:29,530 --> 00:22:31,780 Now, I want you to change your perspective 453 00:22:31,780 --> 00:22:36,070 and say that you are a corporate financial officer, 454 00:22:36,070 --> 00:22:38,500 or you're a project manager and you're 455 00:22:38,500 --> 00:22:40,360 trying to make financial decisions 456 00:22:40,360 --> 00:22:42,310 about various different alternatives. 457 00:22:42,310 --> 00:22:45,160 You're not principally trying to beat the market, 458 00:22:45,160 --> 00:22:47,740 or you're not principally trying to invest you're wealth, 459 00:22:47,740 --> 00:22:49,656 you're trying to make a decision about whether 460 00:22:49,656 --> 00:22:51,850 or not to take on certain projects. 461 00:22:51,850 --> 00:22:54,760 And the question is, how do we use the tools that we've 462 00:22:54,760 --> 00:22:56,540 developed to do that? 463 00:22:56,540 --> 00:22:59,410 So we're going to start with the NPV rule, which 464 00:22:59,410 --> 00:23:01,960 is the rule that we've developed at the very beginning 465 00:23:01,960 --> 00:23:03,110 of this course. 466 00:23:03,110 --> 00:23:06,430 It's very appropriate that we end the course 467 00:23:06,430 --> 00:23:08,350 with a discussion on this rule, but now 468 00:23:08,350 --> 00:23:10,480 with a much more sophisticated understanding of how 469 00:23:10,480 --> 00:23:11,590 to apply it. 470 00:23:11,590 --> 00:23:13,600 I'm going to talk about cash flow computations 471 00:23:13,600 --> 00:23:16,600 because it will turn out that cash flows are what you need 472 00:23:16,600 --> 00:23:20,830 to discount with NPV, not accounting earnings which 473 00:23:20,830 --> 00:23:23,710 have all sorts of conventions that are not necessarily 474 00:23:23,710 --> 00:23:27,190 realistic, or relevant for economic decision making, 475 00:23:27,190 --> 00:23:30,730 but rather I want you to focus on actual dollars and cents 476 00:23:30,730 --> 00:23:33,700 that you're going to be getting period by period. 477 00:23:33,700 --> 00:23:35,990 I'm going to talk about discount rates 478 00:23:35,990 --> 00:23:40,000 and applying them over time, project interactions, 479 00:23:40,000 --> 00:23:43,840 alternatives to the NPV role, and how capital budgeting is 480 00:23:43,840 --> 00:23:45,910 currently done. 481 00:23:45,910 --> 00:23:50,060 There are going to be three different main points 482 00:23:50,060 --> 00:23:52,070 to this sequence of lectures. 483 00:23:52,070 --> 00:23:57,360 The first main point is to use proper risk adjustments 484 00:23:57,360 --> 00:23:58,940 in doing NPV calculations. 485 00:23:58,940 --> 00:24:00,980 That's something that I think by now 486 00:24:00,980 --> 00:24:03,980 should be already ingrained in your way of thinking, 487 00:24:03,980 --> 00:24:06,570 but I want to make sure that that's true. 488 00:24:06,570 --> 00:24:08,450 The second main point I want to get across 489 00:24:08,450 --> 00:24:13,490 is that, there are lots of different ways of doing capital 490 00:24:13,490 --> 00:24:18,200 budgeting, but in this case there's 491 00:24:18,200 --> 00:24:20,840 only one right way to do it from the perspective 492 00:24:20,840 --> 00:24:22,180 of economic analysis. 493 00:24:22,180 --> 00:24:25,940 Now, economic analysis may not be the only consideration. 494 00:24:25,940 --> 00:24:29,490 When you make a decision about whether to take on a project, 495 00:24:29,490 --> 00:24:31,160 there are economic considerations, 496 00:24:31,160 --> 00:24:35,510 but there are also political, social, practical, cultural, 497 00:24:35,510 --> 00:24:37,550 all sorts of other considerations. 498 00:24:37,550 --> 00:24:39,883 I'm not going to say anything about those because that's 499 00:24:39,883 --> 00:24:42,470 outside the purview of this finance course, 500 00:24:42,470 --> 00:24:45,050 but from the business and financial decision 501 00:24:45,050 --> 00:24:48,560 making perspective, NPV is always the right thing to do 502 00:24:48,560 --> 00:24:52,940 and I want to emphasize that by showing you three wrong ways 503 00:24:52,940 --> 00:24:54,440 of doing capital budgeting. 504 00:24:54,440 --> 00:24:57,770 These are ways that people still will make use of today. 505 00:24:57,770 --> 00:25:02,060 So things like using IRR, or using payback, 506 00:25:02,060 --> 00:25:04,479 or using profitability indexes. 507 00:25:04,479 --> 00:25:06,020 I'm going to go through each of those 508 00:25:06,020 --> 00:25:09,740 and argue why those are not the correct way of making 509 00:25:09,740 --> 00:25:11,600 financial decisions, but because they're 510 00:25:11,600 --> 00:25:14,870 so prevalent I want you to at least be aware of them 511 00:25:14,870 --> 00:25:19,170 and understand how they relate to NPV. 512 00:25:19,170 --> 00:25:21,140 And the last thing I want to do is 513 00:25:21,140 --> 00:25:23,090 to tell you about the complexities 514 00:25:23,090 --> 00:25:25,790 of financial decision making by talking 515 00:25:25,790 --> 00:25:28,620 about time as an element. 516 00:25:28,620 --> 00:25:31,580 In other words, the fact that decisions 517 00:25:31,580 --> 00:25:35,150 are being made over time makes these kinds 518 00:25:35,150 --> 00:25:38,919 of interactions among projects very, very complicated. 519 00:25:38,919 --> 00:25:40,460 And I'm not going to be able to solve 520 00:25:40,460 --> 00:25:42,170 all of those for you, that's what 521 00:25:42,170 --> 00:25:44,780 15.434 of this course on capital budgeting 522 00:25:44,780 --> 00:25:47,150 and corporate financing will do, but I want to give you 523 00:25:47,150 --> 00:25:49,670 a taste of it so you are aware that there 524 00:25:49,670 --> 00:25:51,470 is a whole other world out there where 525 00:25:51,470 --> 00:25:53,690 you've got to take these tools and understand 526 00:25:53,690 --> 00:25:55,270 how to apply them. 527 00:25:55,270 --> 00:25:56,030 OK. 528 00:25:56,030 --> 00:25:59,020 So let's talk about the NPV role. 529 00:25:59,020 --> 00:26:02,140 We started this course with a statement 530 00:26:02,140 --> 00:26:08,360 that all assets are nothing more than a sequence of cash flows. 531 00:26:08,360 --> 00:26:09,940 That's what I call an asset. 532 00:26:09,940 --> 00:26:13,450 Every single asset can be reduced, essentially, 533 00:26:13,450 --> 00:26:15,560 to a sequence of task flows. 534 00:26:15,560 --> 00:26:19,240 So this is a sequence of cash flows for a particular project, 535 00:26:19,240 --> 00:26:20,620 or asset. 536 00:26:20,620 --> 00:26:22,870 And the current market value is simply 537 00:26:22,870 --> 00:26:26,050 the NPV where now you've got a discount 538 00:26:26,050 --> 00:26:29,020 by the appropriate cost of capital that 539 00:26:29,020 --> 00:26:32,620 is an appropriate risk adjusted cost of capital 540 00:26:32,620 --> 00:26:36,250 where you are adjusting the risk relevant to that particular 541 00:26:36,250 --> 00:26:38,110 cash flow. 542 00:26:38,110 --> 00:26:41,800 So you'll notice that I use r1 for cash flow one, 543 00:26:41,800 --> 00:26:46,210 and I use rT for cash T. What that means is that you can have 544 00:26:46,210 --> 00:26:49,060 two different discount rates for two different cash 545 00:26:49,060 --> 00:26:52,120 flows of the same project because those two 546 00:26:52,120 --> 00:26:54,190 different cash flows may actually 547 00:26:54,190 --> 00:26:57,770 have two different risks. 548 00:26:57,770 --> 00:27:01,610 So now when you see this expression, which is exactly 549 00:27:01,610 --> 00:27:04,070 the same expression I showed you at the very beginning 550 00:27:04,070 --> 00:27:07,100 of this course, it should have much more meaning to you 551 00:27:07,100 --> 00:27:10,010 because now you understand what amount of effort 552 00:27:10,010 --> 00:27:15,140 goes in to coming up with that appropriate discount rate. 553 00:27:15,140 --> 00:27:17,930 It turns out that because of something called value 554 00:27:17,930 --> 00:27:21,980 additivity we can make decisions about how 555 00:27:21,980 --> 00:27:27,290 to allocate our resources simply by picking those projects 556 00:27:27,290 --> 00:27:30,930 with big positive NPVs. 557 00:27:30,930 --> 00:27:34,290 In other words, you don't have to worry about project 558 00:27:34,290 --> 00:27:37,830 interactions unless there are interactions 559 00:27:37,830 --> 00:27:44,060 that are explicitly involving your decisions. 560 00:27:44,060 --> 00:27:47,390 Having a firm and combining high NPV projects 561 00:27:47,390 --> 00:27:50,600 is the best way to increase the value of that firm. 562 00:27:50,600 --> 00:27:53,330 So you look at each project on a standalone basis 563 00:27:53,330 --> 00:27:55,160 and if there are project interactions 564 00:27:55,160 --> 00:27:57,560 you then evaluate those interactions separately, 565 00:27:57,560 --> 00:27:59,460 and I'll give you examples of that. 566 00:27:59,460 --> 00:27:59,960 OK. 567 00:27:59,960 --> 00:28:01,450 So we're all familiar with this. 568 00:28:01,450 --> 00:28:03,110 This is just the standard approach 569 00:28:03,110 --> 00:28:05,990 to calculating market value. 570 00:28:05,990 --> 00:28:09,666 Now, the investment criteria that I'm 571 00:28:09,666 --> 00:28:11,290 going to propose for capital budgeting, 572 00:28:11,290 --> 00:28:14,870 for project selection is this. 573 00:28:14,870 --> 00:28:16,460 For a single project, if you've got 574 00:28:16,460 --> 00:28:18,560 one project you're trying to decide upon, 575 00:28:18,560 --> 00:28:23,510 take it if and only if the NPV is positive. 576 00:28:23,510 --> 00:28:25,810 If it's positive take it, if it's negative 577 00:28:25,810 --> 00:28:27,340 do not take it, or sell it. 578 00:28:27,340 --> 00:28:28,521 Short it, if you can. 579 00:28:28,521 --> 00:28:29,020 [LAUGHTER] 580 00:28:29,020 --> 00:28:29,710 OK? 581 00:28:29,710 --> 00:28:31,660 It's hard to short projects it's not 582 00:28:31,660 --> 00:28:35,400 that hard to short securities. 583 00:28:35,400 --> 00:28:39,300 For many independent projects, take all of them 584 00:28:39,300 --> 00:28:40,440 with positive NPV. 585 00:28:40,440 --> 00:28:43,740 If they're independent, meaning that taking one 586 00:28:43,740 --> 00:28:45,480 doesn't preclude you from doing another, 587 00:28:45,480 --> 00:28:47,580 or there's no project interactions, 588 00:28:47,580 --> 00:28:51,930 take them all as long as they have positive NPV. 589 00:28:51,930 --> 00:28:55,410 If there are project interactions, 590 00:28:55,410 --> 00:28:58,510 then you have to take that into account. 591 00:28:58,510 --> 00:29:00,780 So one simple example of a project interaction 592 00:29:00,780 --> 00:29:04,530 is you can only take one of many. 593 00:29:04,530 --> 00:29:06,480 And if that's the case, then you pick the one 594 00:29:06,480 --> 00:29:10,530 that's got the highest NPV. 595 00:29:10,530 --> 00:29:13,950 Where you have to use the proper risk adjustment 596 00:29:13,950 --> 00:29:16,980 for that particular project. 597 00:29:16,980 --> 00:29:20,130 So in order to compute NPV you need three things, 598 00:29:20,130 --> 00:29:23,550 you need cash flows, obviously, you need the discount rates, 599 00:29:23,550 --> 00:29:26,310 and you need to consider strategic options. 600 00:29:26,310 --> 00:29:29,690 The first and the third I'm not going to help you with, 601 00:29:29,690 --> 00:29:30,660 that's your business. 602 00:29:30,660 --> 00:29:32,160 That's the business of business. 603 00:29:32,160 --> 00:29:35,340 You've got to identify what those cash flows are 604 00:29:35,340 --> 00:29:38,100 and you've got to identify what your options are. 605 00:29:38,100 --> 00:29:42,270 What I could help you with, in the context of this course, 606 00:29:42,270 --> 00:29:47,220 is evaluating the market value of those possibilities. 607 00:29:47,220 --> 00:29:49,230 Those strategic options, you now understand 608 00:29:49,230 --> 00:29:51,420 how to use option pricing analysis 609 00:29:51,420 --> 00:29:53,010 and for discount rates, you now know 610 00:29:53,010 --> 00:29:54,750 how to use risk adjustments to calculate 611 00:29:54,750 --> 00:29:57,210 the appropriate discount rates. 612 00:29:57,210 --> 00:30:00,150 But the other stuff is domain specific expertise 613 00:30:00,150 --> 00:30:01,962 that you bring to the table. 614 00:30:01,962 --> 00:30:04,170 And so I told you at the very beginning of the course 615 00:30:04,170 --> 00:30:07,590 that finance is the language of business, this is what I mean. 616 00:30:07,590 --> 00:30:10,350 You can't even talk about making a decision 617 00:30:10,350 --> 00:30:12,240 unless you speak the language of finance, 618 00:30:12,240 --> 00:30:16,080 unless you evaluate projects in this kind of a framework. 619 00:30:16,080 --> 00:30:16,860 OK. 620 00:30:16,860 --> 00:30:19,740 So in terms of cash flow calculations, 621 00:30:19,740 --> 00:30:22,110 I'm going to give you some examples in a few minutes, 622 00:30:22,110 --> 00:30:24,550 but let me summarize what I'm going to tell you 623 00:30:24,550 --> 00:30:27,720 and then we can talk about the specifics through that example. 624 00:30:27,720 --> 00:30:30,780 The first point, is you should use cash flows, not 625 00:30:30,780 --> 00:30:33,870 accounting earnings because again, accounting earnings 626 00:30:33,870 --> 00:30:38,250 are meant for purposes other than decision making. 627 00:30:38,250 --> 00:30:41,700 Accounting is really meant as a kind of a checkup 628 00:30:41,700 --> 00:30:43,920 to see how you've done. 629 00:30:43,920 --> 00:30:45,480 How you've done is not the same thing 630 00:30:45,480 --> 00:30:47,490 as how you're going to do. 631 00:30:47,490 --> 00:30:51,870 One of the things that I think is apparently not 632 00:30:51,870 --> 00:30:54,090 emphasized enough is that when you 633 00:30:54,090 --> 00:30:57,400 look at accounting data you're looking 634 00:30:57,400 --> 00:31:00,820 at numbers that are not random variables, 635 00:31:00,820 --> 00:31:01,990 they have been realized. 636 00:31:01,990 --> 00:31:06,400 There's no uncertainty in what a balance sheet, or an income 637 00:31:06,400 --> 00:31:07,840 statement says. 638 00:31:07,840 --> 00:31:09,550 It's about the past. 639 00:31:09,550 --> 00:31:11,737 And accountants hate uncertainties. 640 00:31:11,737 --> 00:31:13,820 I don't know how many people are accountants here, 641 00:31:13,820 --> 00:31:15,850 or how many accountants you know, but if you know them 642 00:31:15,850 --> 00:31:18,058 you know there's a certain personality type that gets 643 00:31:18,058 --> 00:31:20,320 drawn into that profession. 644 00:31:20,320 --> 00:31:23,690 And these are not big risk takers, 645 00:31:23,690 --> 00:31:27,111 they want to see order and certainty in what they're 646 00:31:27,111 --> 00:31:27,610 doing. 647 00:31:27,610 --> 00:31:29,193 That's what a good accountant will do, 648 00:31:29,193 --> 00:31:32,500 is to try to understand where to put all the expenses 649 00:31:32,500 --> 00:31:37,170 and revenues into the proper boxes so that it all adds up. 650 00:31:37,170 --> 00:31:39,330 Accounting is incapable. 651 00:31:39,330 --> 00:31:44,900 It is not designed to manage and reflect uncertainty. 652 00:31:44,900 --> 00:31:47,330 You've heard the term off-balance sheet item, right? 653 00:31:47,330 --> 00:31:49,640 For example, I've spoken before about a credit default 654 00:31:49,640 --> 00:31:51,620 swap, or a futures contract. 655 00:31:51,620 --> 00:31:55,450 If you engage in a futures transaction, the moment 656 00:31:55,450 --> 00:31:58,150 you engage in that transaction what's 657 00:31:58,150 --> 00:32:00,640 the NPV of a futures contract? 658 00:32:00,640 --> 00:32:01,544 AUDIENCE: Zero. 659 00:32:01,544 --> 00:32:02,210 ANDREW LO: Zero. 660 00:32:02,210 --> 00:32:03,560 Exactly. 661 00:32:03,560 --> 00:32:07,580 And as a result, that does not go on the balance sheet 662 00:32:07,580 --> 00:32:10,700 because it is neither an asset nor is it a liability. 663 00:32:10,700 --> 00:32:13,920 It's both, or neither, depending on how you look at it. 664 00:32:13,920 --> 00:32:16,490 It's an off-balance sheet item because it doesn't-- 665 00:32:16,490 --> 00:32:18,140 Where do you put it? 666 00:32:18,140 --> 00:32:20,590 It has zero value. 667 00:32:20,590 --> 00:32:23,200 But the point is that entering into one of those agreements 668 00:32:23,200 --> 00:32:27,030 has a big impact on your future risk. 669 00:32:27,030 --> 00:32:28,930 So accounting, the language of accounting 670 00:32:28,930 --> 00:32:32,530 is not ideally suited for thinking about the future. 671 00:32:32,530 --> 00:32:35,056 It's a wonderful method for understanding 672 00:32:35,056 --> 00:32:36,430 what happened in the past and you 673 00:32:36,430 --> 00:32:38,980 need to understand that in order to plan for the future, 674 00:32:38,980 --> 00:32:41,320 you need to know what your current assets are 675 00:32:41,320 --> 00:32:43,150 and what your current liabilities are, 676 00:32:43,150 --> 00:32:46,070 but that doesn't tell you where your risks are going to be 677 00:32:46,070 --> 00:32:47,560 and it doesn't allow you to speak 678 00:32:47,560 --> 00:32:50,680 about the dynamics of cash flows because that's not 679 00:32:50,680 --> 00:32:52,930 what an accountants job is. 680 00:32:52,930 --> 00:32:54,806 That's not what accounting is designed to do. 681 00:32:54,806 --> 00:32:55,305 Right? 682 00:32:55,305 --> 00:32:57,400 This is not meant to be a critique of accounting, 683 00:32:57,400 --> 00:33:00,670 but simply that you can't use it for purposes that it wasn't 684 00:33:00,670 --> 00:33:03,640 ideally designed to serve. 685 00:33:03,640 --> 00:33:06,190 So the first point is, you've got to use cash flows, 686 00:33:06,190 --> 00:33:07,510 not accounting earnings. 687 00:33:07,510 --> 00:33:10,290 Second point, you've got to use after-tax cash flows. 688 00:33:10,290 --> 00:33:10,790 Why? 689 00:33:10,790 --> 00:33:12,640 Because you have to pay taxes. 690 00:33:12,640 --> 00:33:14,440 That's one of the, along with death 691 00:33:14,440 --> 00:33:18,610 and some other unavoidable aspects of life, 692 00:33:18,610 --> 00:33:19,900 you have to pay taxes. 693 00:33:19,900 --> 00:33:22,720 So if you have to pay taxes, then you may as well 694 00:33:22,720 --> 00:33:25,750 look at after-tax cash flows. 695 00:33:25,750 --> 00:33:27,670 The reason this is important is because there 696 00:33:27,670 --> 00:33:32,300 are certain things that show up as cash flows that you wouldn't 697 00:33:32,300 --> 00:33:35,550 ordinarily think of as cash flows because of the tax code. 698 00:33:35,550 --> 00:33:38,770 For example, depreciation. 699 00:33:38,770 --> 00:33:41,670 Depreciation is an accounting technique 700 00:33:41,670 --> 00:33:46,680 for attributing the decline of capital assets. 701 00:33:46,680 --> 00:33:50,640 When you buy a machine it's new on day one, but after 50 years 702 00:33:50,640 --> 00:33:53,100 it's not new anymore and it's not worth the same 703 00:33:53,100 --> 00:33:55,960 after 15 years as it is on day one. 704 00:33:55,960 --> 00:34:00,990 Now, how you account for the loss in value of that machine, 705 00:34:00,990 --> 00:34:03,150 how you account for how the machine gets used up 706 00:34:03,150 --> 00:34:07,950 over 15 years, that's a matter of accounting practice 707 00:34:07,950 --> 00:34:11,489 that may have no bearing on the actual economics 708 00:34:11,489 --> 00:34:14,730 of the machine, but it has absolute bearing 709 00:34:14,730 --> 00:34:17,070 on the cash flows that you are going 710 00:34:17,070 --> 00:34:20,159 to receive because you get to deduct depreciation 711 00:34:20,159 --> 00:34:22,590 expenses off of your taxes. 712 00:34:22,590 --> 00:34:25,480 So after tax cash flow is as important. 713 00:34:25,480 --> 00:34:29,670 And finally, this third point sounds simple, 714 00:34:29,670 --> 00:34:33,420 but it's anything but simple unless you practice with it 715 00:34:33,420 --> 00:34:36,070 and do a lot of examples. 716 00:34:36,070 --> 00:34:40,199 Use cash flows attributable to the project. 717 00:34:40,199 --> 00:34:42,250 In other words, you've got to compare 718 00:34:42,250 --> 00:34:44,750 the firm with and without the project 719 00:34:44,750 --> 00:34:46,570 and look at the cash flows. 720 00:34:46,570 --> 00:34:47,770 OK? 721 00:34:47,770 --> 00:34:52,480 It's very, very easy to forget certain cash flows that either 722 00:34:52,480 --> 00:34:54,820 come along with the project, or have 723 00:34:54,820 --> 00:34:58,630 to be spent if you take on the project 724 00:34:58,630 --> 00:35:01,720 and you'll end up missing one element or another. 725 00:35:01,720 --> 00:35:05,830 And in many cases those kinds of omissions 726 00:35:05,830 --> 00:35:08,440 can have a huge impact on whether or not 727 00:35:08,440 --> 00:35:11,200 you decide to take on the project. 728 00:35:11,200 --> 00:35:13,150 So there are lots of examples about how 729 00:35:13,150 --> 00:35:17,050 you might do that here, but in the end practice, practice, 730 00:35:17,050 --> 00:35:19,780 practice is going to get you to understand 731 00:35:19,780 --> 00:35:23,130 how to take into account each of the features. 732 00:35:23,130 --> 00:35:25,620 So I want to just go through a few of these now 733 00:35:25,620 --> 00:35:27,864 and then I'm going to talk about the point 734 00:35:27,864 --> 00:35:29,280 that I started with earlier, which 735 00:35:29,280 --> 00:35:32,070 is I want to show you some techniques for capital 736 00:35:32,070 --> 00:35:34,650 budgeting that are incorrect and how 737 00:35:34,650 --> 00:35:37,290 they relate to the NPV rule. 738 00:35:37,290 --> 00:35:39,990 So let me just tell you a little bit more 739 00:35:39,990 --> 00:35:44,170 about accounting earnings versus cash flows. 740 00:35:44,170 --> 00:35:48,120 Cash flows are what you need to use for calculating NPV 741 00:35:48,120 --> 00:35:50,940 because in the end what matters is the cash that you get, 742 00:35:50,940 --> 00:35:56,040 not the accounting profits that may or may not be realizable. 743 00:35:56,040 --> 00:36:01,710 So cash flows are simply equal to cash cash inflows minus cash 744 00:36:01,710 --> 00:36:02,760 outflows. 745 00:36:02,760 --> 00:36:04,590 That sounds simple, right? 746 00:36:04,590 --> 00:36:06,600 It's not simple because you've got 747 00:36:06,600 --> 00:36:09,630 to figure out what those cash inflows or outflows are 748 00:36:09,630 --> 00:36:12,541 from, in many cases, accounting data. 749 00:36:12,541 --> 00:36:14,040 And so you need to know a little bit 750 00:36:14,040 --> 00:36:16,110 about how the accounting interacts 751 00:36:16,110 --> 00:36:18,250 with these kinds of calculations. 752 00:36:18,250 --> 00:36:20,560 So I'll just give you a little bit more detail, 753 00:36:20,560 --> 00:36:25,020 and I'll leave it up to you to focus on specific applications 754 00:36:25,020 --> 00:36:26,640 because the accounting rules, first 755 00:36:26,640 --> 00:36:29,730 of all they change fairly often and actually right now 756 00:36:29,730 --> 00:36:33,420 at the heart of the debate in the financial crisis 757 00:36:33,420 --> 00:36:37,680 is this notion of fair value accounting, FAS 157, which 758 00:36:37,680 --> 00:36:40,590 says that you've got to use market values for updating 759 00:36:40,590 --> 00:36:42,480 your assets and liabilities. 760 00:36:42,480 --> 00:36:45,270 And that's a new ruling that has created some problems 761 00:36:45,270 --> 00:36:48,450 because market values, during times of stress, 762 00:36:48,450 --> 00:36:50,310 can drop precipitously. 763 00:36:50,310 --> 00:36:53,160 And this is why I told you early on that accounting 764 00:36:53,160 --> 00:36:56,040 is not ideally suited to deal with a lot of issues 765 00:36:56,040 --> 00:36:59,640 having to do with risky assets because risk is not 766 00:36:59,640 --> 00:37:03,060 an element that the accounting framework is 767 00:37:03,060 --> 00:37:06,480 well-suited to deal with. 768 00:37:06,480 --> 00:37:09,720 So how do we get cash inflows minus cash outflows. 769 00:37:09,720 --> 00:37:12,060 Well, operating revenues is typically 770 00:37:12,060 --> 00:37:16,890 what cash inflows involve for a given project, operating 771 00:37:16,890 --> 00:37:18,030 revenues. 772 00:37:18,030 --> 00:37:21,690 And then, you subtract from that operating expenses 773 00:37:21,690 --> 00:37:24,150 without depreciation. 774 00:37:24,150 --> 00:37:26,430 The reason you don't take into account depreciation 775 00:37:26,430 --> 00:37:28,140 is, as I told you, depreciation is 776 00:37:28,140 --> 00:37:32,100 one of these magic accounting concepts that 777 00:37:32,100 --> 00:37:34,710 has no bearing on reality. 778 00:37:34,710 --> 00:37:37,800 It's a mechanism for simply accounting 779 00:37:37,800 --> 00:37:41,910 for a decline in the market value of a particular kind 780 00:37:41,910 --> 00:37:43,980 of equipment, or asset. 781 00:37:43,980 --> 00:37:46,350 And there are a lot of different accounting conventions 782 00:37:46,350 --> 00:37:49,110 that are a function of tax code changes. 783 00:37:49,110 --> 00:37:52,440 For example, in some cases you can accelerate 784 00:37:52,440 --> 00:37:53,760 the depreciation of an asset. 785 00:37:53,760 --> 00:37:55,584 Even though a machine is working fine, 786 00:37:55,584 --> 00:37:57,000 there are certain situations where 787 00:37:57,000 --> 00:37:59,190 you can assume that half of the machine 788 00:37:59,190 --> 00:38:01,770 evaporated after one year. 789 00:38:01,770 --> 00:38:03,160 Now how does that happen? 790 00:38:03,160 --> 00:38:07,080 Well it's an accounting tool that Congress passed years 791 00:38:07,080 --> 00:38:10,920 ago to allow companies, businesses, to accelerate 792 00:38:10,920 --> 00:38:14,351 the depreciation and therefore get a tax advantage. 793 00:38:14,351 --> 00:38:14,850 Question? 794 00:38:14,850 --> 00:38:19,690 AUDIENCE: Aren't income taxes linked to the accounting 795 00:38:19,690 --> 00:38:20,658 nuances? 796 00:38:20,658 --> 00:38:22,836 So if we're using taxes, I'm saying, 797 00:38:22,836 --> 00:38:25,014 sort of, we can't use accounting [INAUDIBLE] 798 00:38:25,014 --> 00:38:26,466 because it's a depreciation-- 799 00:38:26,466 --> 00:38:27,966 Depending what depreciation that you 800 00:38:27,966 --> 00:38:29,505 used, do income taxes change? 801 00:38:29,505 --> 00:38:30,130 ANDREW LO: Yes. 802 00:38:30,130 --> 00:38:30,590 That's right. 803 00:38:30,590 --> 00:38:32,464 And so we're going to take that into account, 804 00:38:32,464 --> 00:38:35,270 but the point is that for the purposes of cash flow, 805 00:38:35,270 --> 00:38:37,510 the depreciation schedule will impact the cash 806 00:38:37,510 --> 00:38:42,220 flow only in terms of the actual tax shields that it generates. 807 00:38:42,220 --> 00:38:45,580 Not that it will decrease the value of the machine 808 00:38:45,580 --> 00:38:48,370 when the accountants tell you that it will. 809 00:38:48,370 --> 00:38:49,790 OK? 810 00:38:49,790 --> 00:38:52,430 So the idea is that your operating expenses 811 00:38:52,430 --> 00:38:55,490 are expenses you have to pay irrespective of what 812 00:38:55,490 --> 00:38:58,220 the depreciation schedule is. 813 00:38:58,220 --> 00:39:02,000 So accounting expenses without depreciation 814 00:39:02,000 --> 00:39:04,040 is what you're paying out in cash. 815 00:39:04,040 --> 00:39:08,520 It's the actual cash outflow every single year. 816 00:39:08,520 --> 00:39:12,660 Capital expenditures is what you spend on new equipment, 817 00:39:12,660 --> 00:39:14,670 and then income taxes. 818 00:39:14,670 --> 00:39:16,050 So this is your point, Louis. 819 00:39:16,050 --> 00:39:19,770 All of the effect of depreciation on your income tax 820 00:39:19,770 --> 00:39:21,510 gets included in here. 821 00:39:21,510 --> 00:39:23,590 Income taxes you have to pay every year, 822 00:39:23,590 --> 00:39:25,080 so that's a cash outflow. 823 00:39:25,080 --> 00:39:25,830 Right? 824 00:39:25,830 --> 00:39:28,350 So if there's something that can reduce your cash outflow, 825 00:39:28,350 --> 00:39:30,486 you better take that into account. 826 00:39:30,486 --> 00:39:32,110 And that's where depreciation comes in. 827 00:39:32,110 --> 00:39:36,030 It's a tax shield that allows you not to pay as much taxes, 828 00:39:36,030 --> 00:39:39,810 so it reduces your tax burden, it reduces your income taxes. 829 00:39:39,810 --> 00:39:42,870 But again, the focus is on cash flows. 830 00:39:42,870 --> 00:39:45,450 Money in versus money out. 831 00:39:45,450 --> 00:39:47,730 That's what you're trying to measure. 832 00:39:47,730 --> 00:39:52,540 And once you get the measure of money in minus money out, 833 00:39:52,540 --> 00:39:54,720 then you can start discounting using 834 00:39:54,720 --> 00:39:56,770 your appropriate cost of capital, 835 00:39:56,770 --> 00:39:59,090 but you got to get the cash flows right. 836 00:39:59,090 --> 00:40:02,910 And so there are a number of other subtleties. 837 00:40:02,910 --> 00:40:06,540 For example, the project income taxes 838 00:40:06,540 --> 00:40:09,960 that you pay for your project is going to be the corporate tax 839 00:40:09,960 --> 00:40:14,760 rate, times the operating profit, minus the tax rate, 840 00:40:14,760 --> 00:40:17,400 times your depreciation. 841 00:40:17,400 --> 00:40:20,880 So your depreciation doesn't actually 842 00:40:20,880 --> 00:40:25,140 affect the profitability of the particular piece of equipment, 843 00:40:25,140 --> 00:40:29,130 or the project, except in so far as it affects 844 00:40:29,130 --> 00:40:31,760 the taxes you have to pay. 845 00:40:31,760 --> 00:40:35,660 So project income taxes, that income taxes associated 846 00:40:35,660 --> 00:40:37,910 with your particular project, are 847 00:40:37,910 --> 00:40:40,850 going to simply be the tax rate multiplied by the operating 848 00:40:40,850 --> 00:40:44,960 profit, minus the tax rate, times whatever depreciation 849 00:40:44,960 --> 00:40:48,500 you can claim, and so this is how you can get depreciation 850 00:40:48,500 --> 00:40:50,000 into your cash flows. 851 00:40:50,000 --> 00:40:52,250 It affects the amount of income taxes you're paying 852 00:40:52,250 --> 00:40:54,670 and that's it. 853 00:40:54,670 --> 00:40:57,650 So the bottom line, what's your task flow? 854 00:40:57,650 --> 00:41:01,090 It's going to be one, minus your tax rate, 855 00:41:01,090 --> 00:41:04,070 times the operating profits. 856 00:41:04,070 --> 00:41:07,940 Operating profits is operating revenues, minus operating 857 00:41:07,940 --> 00:41:11,720 expenses without depreciation. 858 00:41:11,720 --> 00:41:13,850 Without depreciation. 859 00:41:13,850 --> 00:41:18,260 Depreciation comes in later when you're talking about the taxes. 860 00:41:18,260 --> 00:41:20,840 So here is where the depreciation comes in. 861 00:41:20,840 --> 00:41:23,930 So your cash flow is operating profits, 862 00:41:23,930 --> 00:41:27,470 multiplied by one, minus the tax rate, 863 00:41:27,470 --> 00:41:30,979 minus your capital expenditures, and by the way, 864 00:41:30,979 --> 00:41:33,020 your capital expenditures, notice that you're not 865 00:41:33,020 --> 00:41:35,180 getting taxed on that. 866 00:41:35,180 --> 00:41:37,250 Nor do you get a deduction for that. 867 00:41:37,250 --> 00:41:40,520 You don't get to deduct capital expenditures the way 868 00:41:40,520 --> 00:41:44,420 you get to deduct ordinary expenses from running a company 869 00:41:44,420 --> 00:41:47,060 because capital expenditures are treated differently 870 00:41:47,060 --> 00:41:48,890 by the tax code. 871 00:41:48,890 --> 00:41:50,250 Does that make sense? 872 00:41:50,250 --> 00:41:50,930 Who knows. 873 00:41:50,930 --> 00:41:53,760 That's for the tax experts to decide upon. 874 00:41:53,760 --> 00:41:55,986 The fact is that capital expenditures have 875 00:41:55,986 --> 00:41:57,360 a different tax treatment and you 876 00:41:57,360 --> 00:41:59,776 have to know that, that's why you need accountants to tell 877 00:41:59,776 --> 00:42:01,530 you how they get treated. 878 00:42:01,530 --> 00:42:06,660 The way they get treated is you get to depreciate the capital 879 00:42:06,660 --> 00:42:12,000 expenditures as the accountants tell you you're using them up. 880 00:42:12,000 --> 00:42:15,030 So if you buy a piece of equipment for $25 million, 881 00:42:15,030 --> 00:42:18,570 you don't get to deduct it right away because you're not 882 00:42:18,570 --> 00:42:21,050 using all of it right away. 883 00:42:21,050 --> 00:42:23,780 You're using part of it every year. 884 00:42:23,780 --> 00:42:25,130 How much are you using? 885 00:42:25,130 --> 00:42:29,340 That's where the depreciation schedule becomes relevant. 886 00:42:29,340 --> 00:42:33,350 So here what you're getting, in terms of cash flows, 887 00:42:33,350 --> 00:42:36,380 what you're getting is the depreciation 888 00:42:36,380 --> 00:42:40,880 that you report every year, multiplied by the tax rate. 889 00:42:40,880 --> 00:42:45,000 You're getting that as a positive cash flow. 890 00:42:45,000 --> 00:42:45,954 Why is that? 891 00:42:45,954 --> 00:42:47,120 Who can tell me why that is? 892 00:42:52,540 --> 00:42:53,251 Yeah. 893 00:42:53,251 --> 00:42:56,860 AUDIENCE: Because you're not paying any expenses. 894 00:42:56,860 --> 00:43:00,900 ANDREW LO: That's not quite right. 895 00:43:00,900 --> 00:43:04,830 It's along those lines, but not exactly, that's not exactly 896 00:43:04,830 --> 00:43:05,640 the mechanism. 897 00:43:05,640 --> 00:43:06,172 [INAUDIBLE]? 898 00:43:06,172 --> 00:43:07,630 AUDIENCE: This position is expense, 899 00:43:07,630 --> 00:43:09,942 but it's not out of cash flow. 900 00:43:09,942 --> 00:43:10,650 ANDREW LO: Right. 901 00:43:10,650 --> 00:43:13,530 Depreciation is an expense you get to deduct, 902 00:43:13,530 --> 00:43:15,330 so you're right about that, but you're 903 00:43:15,330 --> 00:43:18,340 getting to deduct it purely because of the tax code. 904 00:43:18,340 --> 00:43:20,070 And because you get to deduct it you 905 00:43:20,070 --> 00:43:22,260 don't have to pay this much tax. 906 00:43:22,260 --> 00:43:24,780 In other words, without the depreciation 907 00:43:24,780 --> 00:43:26,780 you would be out this much money. 908 00:43:26,780 --> 00:43:28,800 But because you have that deduction, 909 00:43:28,800 --> 00:43:30,469 it's like a get out of jail free card, 910 00:43:30,469 --> 00:43:32,010 you basically take this card and say, 911 00:43:32,010 --> 00:43:34,740 here I don't have to pay this much tax, how much is that card 912 00:43:34,740 --> 00:43:35,610 worth? 913 00:43:35,610 --> 00:43:37,500 Well, it's worth this. 914 00:43:37,500 --> 00:43:39,330 So this is actually the amount of cash 915 00:43:39,330 --> 00:43:41,130 you're going to get to keep in your pocket 916 00:43:41,130 --> 00:43:44,377 if you have this depreciation tax shield. 917 00:43:44,377 --> 00:43:45,960 That's what it's called, a tax shield. 918 00:43:45,960 --> 00:43:48,990 It prevents you from paying a certain amount of taxes. 919 00:43:48,990 --> 00:43:51,790 You actually get to keep that money in your company. 920 00:43:51,790 --> 00:43:53,280 So it's actual cash flows to you. 921 00:43:55,790 --> 00:44:00,050 So the accounting impact of depreciation is here. 922 00:44:00,050 --> 00:44:03,440 And it's important, I know it seems like it's a waste of time 923 00:44:03,440 --> 00:44:05,870 for us to spend time for my telling you 924 00:44:05,870 --> 00:44:09,470 how to do accounting, but this is an important enough point 925 00:44:09,470 --> 00:44:12,860 that people forget when you're doing NPV calculations that I 926 00:44:12,860 --> 00:44:14,540 want to hammer this home. 927 00:44:14,540 --> 00:44:17,390 What matters, from an economic perspective, 928 00:44:17,390 --> 00:44:19,580 is the cash that you're getting for your project 929 00:44:19,580 --> 00:44:21,260 year in and year out. 930 00:44:21,260 --> 00:44:22,970 Keep your eyes on the cash. 931 00:44:22,970 --> 00:44:26,600 Don't keep it on the accounting numbers, keep it on the cash. 932 00:44:26,600 --> 00:44:29,800 And if you do that, you'll never go wrong. 933 00:44:29,800 --> 00:44:30,880 OK. 934 00:44:30,880 --> 00:44:35,050 Here's an example just to make the point. 935 00:44:35,050 --> 00:44:39,100 A machine is purchased for a $1 million with a life of 10 years 936 00:44:39,100 --> 00:44:41,440 and it generates annual revenues of 300,000 937 00:44:41,440 --> 00:44:44,092 and operating expenses of 100,000. 938 00:44:44,092 --> 00:44:45,550 If you assume that the machine gets 939 00:44:45,550 --> 00:44:50,200 depreciated over 10 years using straight line depreciation. 940 00:44:50,200 --> 00:44:52,086 What does that mean, straight line? 941 00:44:52,086 --> 00:44:52,585 Yeah. 942 00:44:52,585 --> 00:44:53,920 AUDIENCE: Equal amounts every year. 943 00:44:53,920 --> 00:44:54,670 AUDIENCE: Exactly. 944 00:44:54,670 --> 00:44:57,220 So if the machine is worth a million bucks 945 00:44:57,220 --> 00:45:00,290 and you're depreciating it over 10 years straight line, 946 00:45:00,290 --> 00:45:01,803 what do you deduct every year? 947 00:45:01,803 --> 00:45:02,928 AUDIENCE: 1,000 [INAUDIBLE] 948 00:45:02,928 --> 00:45:03,750 ANDREW LO: 100,000. 949 00:45:03,750 --> 00:45:04,249 Yeah. 950 00:45:04,249 --> 00:45:05,140 Yeah, that's right. 951 00:45:05,140 --> 00:45:06,990 It'd be 100 years if you did 10,000. 952 00:45:06,990 --> 00:45:09,570 That would be a long life of the machine. 953 00:45:09,570 --> 00:45:12,500 That's right $10,000-- $100,000 a year 954 00:45:12,500 --> 00:45:16,010 for 10 years, that's how much the accountants are telling you 955 00:45:16,010 --> 00:45:17,990 you're using up the machine. 956 00:45:17,990 --> 00:45:21,350 And so every year you get to deduct $100,000 957 00:45:21,350 --> 00:45:23,820 from that kind of depreciation. 958 00:45:23,820 --> 00:45:25,630 So what is your after-tax cash flow? 959 00:45:25,630 --> 00:45:28,250 Now, you're accounting earnings, the way 960 00:45:28,250 --> 00:45:32,930 that an accountant would accrue the earnings would be this. 961 00:45:32,930 --> 00:45:39,450 It's 3 million, minus 100k, minus a 300k, 962 00:45:39,450 --> 00:45:44,680 minus 100k, minus 100k, that's 100k of earnings. 963 00:45:44,680 --> 00:45:48,570 So an accountant would tell you that your earnings 964 00:45:48,570 --> 00:45:51,600 for this situation is $100,000 a year. 965 00:45:51,600 --> 00:45:53,140 Right? 966 00:45:53,140 --> 00:45:56,200 However, that's not the cash flows. 967 00:45:56,200 --> 00:45:57,760 Let's look at the task flows. 968 00:45:57,760 --> 00:46:00,580 The cash flows on an after tax basis, 969 00:46:00,580 --> 00:46:07,780 assuming a 40% corporate tax rate is 1 minus 0.4, 970 00:46:07,780 --> 00:46:12,430 times revenue of 300, minus operating expenses of 100. 971 00:46:12,430 --> 00:46:17,350 So you're making $200 cash every year before tax, 972 00:46:17,350 --> 00:46:21,670 but then you've got to pay tax, but then you're 973 00:46:21,670 --> 00:46:25,760 getting a depreciation deduction of $100,000 a year. 974 00:46:25,760 --> 00:46:31,170 So you're actually getting $160,000 of cash every year. 975 00:46:31,170 --> 00:46:35,340 Not a 100, but 160. 976 00:46:35,340 --> 00:46:37,230 So when you do an NPV calculation 977 00:46:37,230 --> 00:46:40,500 it makes a world of difference whether your NPVing this guy, 978 00:46:40,500 --> 00:46:42,320 or your NPVing this guy. 979 00:46:42,320 --> 00:46:43,800 They're not the same. 980 00:46:43,800 --> 00:46:44,460 Right? 981 00:46:44,460 --> 00:46:46,620 And from an economic decision perspective, 982 00:46:46,620 --> 00:46:49,600 this is what you ought to focus on, not on this. 983 00:46:49,600 --> 00:46:50,924 Yeah, Edward? 984 00:46:50,924 --> 00:46:51,507 AUDIENCE: Yes. 985 00:46:51,507 --> 00:46:53,423 Probably through the accounting calculation, 986 00:46:53,423 --> 00:46:55,339 you will have the million up front. 987 00:46:55,339 --> 00:46:58,692 While here you will have a cash flow and a cash in flow 988 00:46:58,692 --> 00:47:00,130 from here [INAUDIBLE], right? 989 00:47:00,130 --> 00:47:00,270 ANDREW LO: Yeah. 990 00:47:00,270 --> 00:47:01,200 AUDIENCE: In the accounting. 991 00:47:01,200 --> 00:47:02,200 ANDREW LO: That's right. 992 00:47:02,200 --> 00:47:03,660 So there are other considerations 993 00:47:03,660 --> 00:47:05,800 that you might want to bring into the analysis, 994 00:47:05,800 --> 00:47:07,929 but my point is simply using accounting earnings 995 00:47:07,929 --> 00:47:10,470 versus after tax cash flows will give you a different number. 996 00:47:10,470 --> 00:47:13,520 In both cases, I'm not I'm not taking into account 997 00:47:13,520 --> 00:47:16,050 the upfront outlay of a million. 998 00:47:16,050 --> 00:47:16,550 Right? 999 00:47:16,550 --> 00:47:17,800 AUDIENCE: But in the accounting you would never. 1000 00:47:17,800 --> 00:47:18,040 ANDREW LO: Right. 1001 00:47:18,040 --> 00:47:18,664 AUDIENCE: Yeah. 1002 00:47:18,664 --> 00:47:19,290 [INAUDIBLE] 1003 00:47:19,290 --> 00:47:20,040 ANDREW LO: Agreed. 1004 00:47:20,040 --> 00:47:21,000 That's right. 1005 00:47:21,000 --> 00:47:22,687 And that's part of the problem. 1006 00:47:22,687 --> 00:47:24,270 That's one of the reasons, by the way, 1007 00:47:24,270 --> 00:47:27,210 why certain companies are incentivized 1008 00:47:27,210 --> 00:47:29,220 to acquire other companies. 1009 00:47:29,220 --> 00:47:30,930 It's because the acquisition costs 1010 00:47:30,930 --> 00:47:34,086 aren't accounted for in the same way that the operating costs. 1011 00:47:34,086 --> 00:47:35,460 So if you've got a company that's 1012 00:47:35,460 --> 00:47:38,430 generating a lot of profits, it's very profitable, 1013 00:47:38,430 --> 00:47:41,010 but it cost you a lot of money to acquire, from the counting 1014 00:47:41,010 --> 00:47:42,390 perspective it can make you look really 1015 00:47:42,390 --> 00:47:44,723 good because your earnings are going to get a big boost, 1016 00:47:44,723 --> 00:47:47,130 but in fact the NPV of the situation 1017 00:47:47,130 --> 00:47:49,250 may not be as attractive. 1018 00:47:49,250 --> 00:47:51,780 The bottom line from shareholder wealth, 1019 00:47:51,780 --> 00:47:54,715 if you are doing this for your own personal account 1020 00:47:54,715 --> 00:47:56,090 you'd want to be making decisions 1021 00:47:56,090 --> 00:47:59,660 not on accounting earnings alone, but rather on cash 1022 00:47:59,660 --> 00:48:00,270 flows. 1023 00:48:00,270 --> 00:48:00,530 All right? 1024 00:48:00,530 --> 00:48:01,140 NPVs. 1025 00:48:01,140 --> 00:48:02,950 Yeah, [INAUDIBLE]. 1026 00:48:02,950 --> 00:48:05,560 AUDIENCE: What about if you can give a working capital? 1027 00:48:05,560 --> 00:48:09,440 Aren't you supposed to take it also in to consideration? 1028 00:48:09,440 --> 00:48:10,660 ANDREW LO: In what sense? 1029 00:48:10,660 --> 00:48:13,110 You're looking at the net incremental impact 1030 00:48:13,110 --> 00:48:16,440 on your working capital and this take that into account. 1031 00:48:16,440 --> 00:48:19,410 Wokring capital is the change-- 1032 00:48:19,410 --> 00:48:21,885 is demanding opportunity to invest in the business 1033 00:48:21,885 --> 00:48:23,800 in order to make the business to grow. 1034 00:48:23,800 --> 00:48:25,050 ANDREW LO: Yeah, that's right. 1035 00:48:25,050 --> 00:48:26,760 So I haven't talked about what the NPV. 1036 00:48:26,760 --> 00:48:29,710 Is if you want to do the NPV you've got to ask the question, 1037 00:48:29,710 --> 00:48:33,180 does the after tax cash flow justify a million dollars? 1038 00:48:33,180 --> 00:48:36,420 I haven't talked about that yet. 1039 00:48:36,420 --> 00:48:38,970 So I'm not I'm not suggesting that we've 1040 00:48:38,970 --> 00:48:40,350 got an answer for what you should 1041 00:48:40,350 --> 00:48:42,344 do with this particular situation, 1042 00:48:42,344 --> 00:48:44,010 I'm simply using this as an illustration 1043 00:48:44,010 --> 00:48:45,930 to point out that accounting earnings is not 1044 00:48:45,930 --> 00:48:50,277 the same thing as after tax net cash task flows. 1045 00:48:50,277 --> 00:48:50,776 Yeah. 1046 00:48:50,776 --> 00:48:53,242 AUDIENCE: So from a finance [INAUDIBLE] point, 1047 00:48:53,242 --> 00:48:57,098 we don't care about this [INAUDIBLE] company, as well as 1048 00:48:57,098 --> 00:49:00,480 this ability to generate future cash flows? 1049 00:49:00,480 --> 00:49:03,846 ANDREW LO: Well, no I didn't I did not say that. 1050 00:49:03,846 --> 00:49:05,220 The question about whether or not 1051 00:49:05,220 --> 00:49:08,250 you care about the solvency of the company 1052 00:49:08,250 --> 00:49:11,460 is a question about what the ultimate costs of bankruptcy 1053 00:49:11,460 --> 00:49:14,970 are, but from a shareholder's perspective, 1054 00:49:14,970 --> 00:49:17,730 if you ask the question what does the shareholder want 1055 00:49:17,730 --> 00:49:21,070 you, the corporate manager, to do, the answer is simple. 1056 00:49:21,070 --> 00:49:24,060 The shareholder wants you to maximize the net present value 1057 00:49:24,060 --> 00:49:26,580 of the business. 1058 00:49:26,580 --> 00:49:27,410 OK? 1059 00:49:27,410 --> 00:49:29,780 If there are dramatic costs of bankruptcy, 1060 00:49:29,780 --> 00:49:31,730 or financial stress, then you're going 1061 00:49:31,730 --> 00:49:34,340 to have to incorporate that into your calculation for what 1062 00:49:34,340 --> 00:49:35,060 you should do. 1063 00:49:35,060 --> 00:49:36,320 Absolutely. 1064 00:49:36,320 --> 00:49:37,700 But the point is that when you're 1065 00:49:37,700 --> 00:49:41,120 looking at net present value, net present value gives you 1066 00:49:41,120 --> 00:49:43,280 the appropriate data to make that trade off. 1067 00:49:46,090 --> 00:49:49,150 Always use net present value to at least calculate 1068 00:49:49,150 --> 00:49:51,820 the implications of the various different investments. 1069 00:49:51,820 --> 00:49:53,800 In the case of bankruptcy costs, if there 1070 00:49:53,800 --> 00:49:56,156 are dramatic costs of financial distress, 1071 00:49:56,156 --> 00:49:58,280 then you don't want to go there because then you're 1072 00:49:58,280 --> 00:50:01,580 not going to be serving the best interest of the shareholders. 1073 00:50:01,580 --> 00:50:04,700 But if on the other hand, there are very little risks 1074 00:50:04,700 --> 00:50:06,650 of financial distress and there's 1075 00:50:06,650 --> 00:50:08,420 an incredibly good opportunity for you 1076 00:50:08,420 --> 00:50:12,290 to take on certain risk that looks more than worthwhile 1077 00:50:12,290 --> 00:50:14,480 relative to the compensation you're getting, 1078 00:50:14,480 --> 00:50:17,660 then I would argue that it makes sense to do so. 1079 00:50:17,660 --> 00:50:21,130 So the question is one about magnitude. 1080 00:50:21,130 --> 00:50:24,190 What are the bankruptcy costs versus the value 1081 00:50:24,190 --> 00:50:27,700 of the upside for the particular project at hand? 1082 00:50:27,700 --> 00:50:29,200 And you've got to make that decision 1083 00:50:29,200 --> 00:50:33,059 with all the various different data properly computed. 1084 00:50:33,059 --> 00:50:35,350 What I'm telling you how to do is to compute that data. 1085 00:50:39,290 --> 00:50:40,130 All right. 1086 00:50:40,130 --> 00:50:44,540 Here are some other calculations that describe 1087 00:50:44,540 --> 00:50:46,340 what went on in the previous. 1088 00:50:46,340 --> 00:50:49,640 This is a case of accounting earnings after tax, cash flow 1089 00:50:49,640 --> 00:50:50,990 after tax. 1090 00:50:50,990 --> 00:50:53,510 The bottom line is that they're different. 1091 00:50:53,510 --> 00:50:57,200 So for the perspective of NPV calculations 1092 00:50:57,200 --> 00:51:00,500 you ought to focus on the particular calculation that 1093 00:51:00,500 --> 00:51:02,420 gives you net cash flows. 1094 00:51:05,450 --> 00:51:10,130 So now I'm going to turn to focusing on the denominator, 1095 00:51:10,130 --> 00:51:12,530 discount rates. 1096 00:51:12,530 --> 00:51:15,680 We already went through an analysis about how 1097 00:51:15,680 --> 00:51:17,640 to pick the discount rate. 1098 00:51:17,640 --> 00:51:20,030 The discount rate that you use is the one 1099 00:51:20,030 --> 00:51:22,910 that adjusts for the risk of the project, 1100 00:51:22,910 --> 00:51:25,580 but keep in mind that a project's discount 1101 00:51:25,580 --> 00:51:27,620 rate, the required rate of return 1102 00:51:27,620 --> 00:51:32,300 is the expected return demanded by investors for the project. 1103 00:51:32,300 --> 00:51:35,240 The way you ought to think about it is the project, 1104 00:51:35,240 --> 00:51:40,160 think of it like a stock and ask the question, for people who 1105 00:51:40,160 --> 00:51:41,840 are going to buy that project, they're 1106 00:51:41,840 --> 00:51:44,960 going to buy the stock, what kind of a discount rate 1107 00:51:44,960 --> 00:51:49,310 are they going to place on the riskiness of that stock. 1108 00:51:49,310 --> 00:51:52,250 It's just like Gillette versus General Motors, 1109 00:51:52,250 --> 00:51:54,600 we talked about that last time. 1110 00:51:54,600 --> 00:51:59,600 Depending on how risk averse the population is, 1111 00:51:59,600 --> 00:52:02,450 that will determine a particular market risk premium. 1112 00:52:02,450 --> 00:52:04,370 The market risk premium and the beta 1113 00:52:04,370 --> 00:52:07,310 is going to determine what the appropriate discount rate is 1114 00:52:07,310 --> 00:52:10,820 for that particular stock, and the idiosyncratic risk 1115 00:52:10,820 --> 00:52:13,280 is going to be assumed away because nobody 1116 00:52:13,280 --> 00:52:15,110 has to bear that risk. 1117 00:52:15,110 --> 00:52:18,545 Everybody can be diversified if they want to be. 1118 00:52:18,545 --> 00:52:21,780 The second thing is that the discount rate, in general, 1119 00:52:21,780 --> 00:52:24,655 depends on the timing and the risks of the cash flows. 1120 00:52:24,655 --> 00:52:27,030 I'm going to give you an example in a few minutes that'll 1121 00:52:27,030 --> 00:52:28,530 throw you off a bit because there's 1122 00:52:28,530 --> 00:52:30,197 going to be two different kinds of risks 1123 00:52:30,197 --> 00:52:32,613 and you're going to have to differentiate between the two. 1124 00:52:32,613 --> 00:52:34,050 So let me come back to that point 1125 00:52:34,050 --> 00:52:37,080 with an example that will be much clearer. 1126 00:52:37,080 --> 00:52:41,160 And the last couple of points is that, the discount rate 1127 00:52:41,160 --> 00:52:43,300 is usually different for different projects. 1128 00:52:43,300 --> 00:52:45,630 Now, this is something that, again, a lot 1129 00:52:45,630 --> 00:52:47,340 of corporate managers miss. 1130 00:52:47,340 --> 00:52:51,330 They feel that if they're in a particular division then 1131 00:52:51,330 --> 00:52:54,044 that division has a particular cost of capital 1132 00:52:54,044 --> 00:52:55,710 and from that point on you should always 1133 00:52:55,710 --> 00:52:57,270 use the cost of capital for anything 1134 00:52:57,270 --> 00:52:59,460 that the division does. 1135 00:52:59,460 --> 00:53:01,500 What if it's the case that the division is 1136 00:53:01,500 --> 00:53:04,440 doing something so different from what it originally 1137 00:53:04,440 --> 00:53:06,390 started with? 1138 00:53:06,390 --> 00:53:08,990 And I'm going to give you an example of that. 1139 00:53:08,990 --> 00:53:12,060 An example is something that happened just a couple of years 1140 00:53:12,060 --> 00:53:12,880 ago. 1141 00:53:12,880 --> 00:53:14,421 I don't know how many of you realize, 1142 00:53:14,421 --> 00:53:16,920 but Bloomberg, you know the maker of those nice terminals 1143 00:53:16,920 --> 00:53:20,040 that everybody uses, Bloomberg has actually a publishing 1144 00:53:20,040 --> 00:53:21,730 company. 1145 00:53:21,730 --> 00:53:22,480 Yeah that's right. 1146 00:53:22,480 --> 00:53:24,730 There's a Bloomberg Business press. 1147 00:53:24,730 --> 00:53:29,350 They publish books and this particular business just 1148 00:53:29,350 --> 00:53:32,382 got launched a couple of years ago. 1149 00:53:32,382 --> 00:53:34,090 They already have a whole bunch of books. 1150 00:53:34,090 --> 00:53:35,710 In fact, they're publishing a book 1151 00:53:35,710 --> 00:53:38,950 that I've been working on with a former student of mine 1152 00:53:38,950 --> 00:53:42,660 a series of interviews of technical analysts. 1153 00:53:42,660 --> 00:53:48,100 And so as part of this idea of setting up a business press, 1154 00:53:48,100 --> 00:53:51,700 they had to figure out what the appropriate cost of capital 1155 00:53:51,700 --> 00:53:55,390 is for that activity, and then ask for money from the parent 1156 00:53:55,390 --> 00:53:58,360 company to launch this. 1157 00:53:58,360 --> 00:54:00,970 So the question is, how do they do that? 1158 00:54:00,970 --> 00:54:04,660 Do they use the appropriate cost of capital for Bloomberg? 1159 00:54:04,660 --> 00:54:07,540 Bloomberg's business is not publishing. 1160 00:54:07,540 --> 00:54:08,320 All right? 1161 00:54:08,320 --> 00:54:11,765 They're an information vendor, and they're 1162 00:54:11,765 --> 00:54:13,280 a technology company. 1163 00:54:13,280 --> 00:54:16,460 And as such, they have a certain multiple, right? 1164 00:54:16,460 --> 00:54:19,130 Those of you who are in venture capital, project financing, 1165 00:54:19,130 --> 00:54:20,750 you know about multiples, right? 1166 00:54:20,750 --> 00:54:23,690 If you have a company with a particular kind of earnings, 1167 00:54:23,690 --> 00:54:26,750 then the value of the company is typically 1168 00:54:26,750 --> 00:54:31,380 stated as a multiple of those earnings. 1169 00:54:31,380 --> 00:54:35,520 The multiple for an IT company, a technology company, 1170 00:54:35,520 --> 00:54:38,240 a financial services company, a multiple 1171 00:54:38,240 --> 00:54:40,010 there is not the same as the multiple 1172 00:54:40,010 --> 00:54:42,240 for a publishing company. 1173 00:54:42,240 --> 00:54:45,000 By the way, which multiple is higher? 1174 00:54:45,000 --> 00:54:47,790 Does anybody know? 1175 00:54:47,790 --> 00:54:49,665 AUDIENCE: IT? 1176 00:54:49,665 --> 00:54:50,290 ANDREW LO: Yes? 1177 00:54:50,290 --> 00:54:52,275 AUDIENCE: Actually, publishing is higher. 1178 00:54:52,275 --> 00:54:54,150 ANDREW LO: Multiple for publishing is higher? 1179 00:54:54,150 --> 00:54:57,040 AUDIENCE: [INAUDIBLE] I think it would be higher unless 1180 00:54:57,040 --> 00:54:59,355 it's [INAUDIBLE] particular-- 1181 00:54:59,355 --> 00:55:00,480 ANDREW LO: And why is that? 1182 00:55:00,480 --> 00:55:02,640 What's the logic for IT being higher? 1183 00:55:02,640 --> 00:55:04,372 AUDIENCE: Higher growth potential. 1184 00:55:04,372 --> 00:55:06,330 ANDREW LO: Higher growth potential, that's one. 1185 00:55:06,330 --> 00:55:08,760 Also, profit margins tend to be higher. 1186 00:55:08,760 --> 00:55:10,620 Publishing is not a growing business. 1187 00:55:10,620 --> 00:55:12,369 I don't know how many of you realize that. 1188 00:55:12,369 --> 00:55:14,670 Because of the internet, because of text messaging, 1189 00:55:14,670 --> 00:55:17,250 all sorts of innovations have really 1190 00:55:17,250 --> 00:55:18,610 hurt the publishing business. 1191 00:55:18,610 --> 00:55:20,717 And that's why a lot of publishers 1192 00:55:20,717 --> 00:55:22,800 have either gone out of business or have combined, 1193 00:55:22,800 --> 00:55:25,450 so that now we have a few mega publishers. 1194 00:55:25,450 --> 00:55:26,460 Yeah. 1195 00:55:26,460 --> 00:55:31,350 So if you're an entrepreneur that's 1196 00:55:31,350 --> 00:55:34,140 looking to set up Bloomberg Press 1197 00:55:34,140 --> 00:55:38,410 and now Bloomberg is using a particular cost of capital, 1198 00:55:38,410 --> 00:55:40,350 you may say, "Well, hey, wait a minute, that's 1199 00:55:40,350 --> 00:55:42,600 not the right cost of capital because publishing 1200 00:55:42,600 --> 00:55:43,984 is a different multiple." 1201 00:55:43,984 --> 00:55:45,150 How would you do that, then? 1202 00:55:45,150 --> 00:55:49,750 How would you figure out what to use in order 1203 00:55:49,750 --> 00:55:52,980 to calculate the value of a venture for Bloomberg Press? 1204 00:55:52,980 --> 00:55:53,480 Courtney? 1205 00:55:53,480 --> 00:55:55,438 AUDIENCE: Just look at the comparable companies 1206 00:55:55,438 --> 00:55:57,728 and take, like, look at all the betas of all of them, 1207 00:55:57,728 --> 00:55:59,049 and do analysis from them. 1208 00:55:59,049 --> 00:55:59,840 ANDREW LO: Exactly. 1209 00:55:59,840 --> 00:56:03,590 So let's look at other companies that are in the business 1210 00:56:03,590 --> 00:56:07,767 that we want to get into and see what kind of beta they have, 1211 00:56:07,767 --> 00:56:09,600 and what the appropriate cost of capital is. 1212 00:56:09,600 --> 00:56:10,784 Anant? 1213 00:56:10,784 --> 00:56:12,752 AUDIENCE: So I understand why they doing that. 1214 00:56:12,752 --> 00:56:16,196 But at the end of the day, if Bloomberg, the company, has, 1215 00:56:16,196 --> 00:56:19,640 you know, $1 million or whatever to invest, why would it 1216 00:56:19,640 --> 00:56:23,248 look at going into an area like this with a lower 1217 00:56:23,248 --> 00:56:26,282 rate of return than, you know, a product where it could 1218 00:56:26,282 --> 00:56:28,004 get a high rate of return? 1219 00:56:28,004 --> 00:56:31,563 Unless you have some facilities, in which case facilities plus 1220 00:56:31,563 --> 00:56:34,132 rate of return should be at least equal to the rate 1221 00:56:34,132 --> 00:56:36,000 of return for the economy. 1222 00:56:36,000 --> 00:56:38,940 ANDREW LO: So let's hold off on that discussion for a moment. 1223 00:56:38,940 --> 00:56:41,425 I'm not going to try to justify why they get into it, 1224 00:56:41,425 --> 00:56:43,050 I just want to understand the mechanics 1225 00:56:43,050 --> 00:56:45,970 of how they decide on whether or not to get into it. 1226 00:56:45,970 --> 00:56:47,532 I'll come back to why later. 1227 00:56:47,532 --> 00:56:49,740 Let's come back to that in just a few minutes though. 1228 00:56:49,740 --> 00:56:51,810 Before we get to that, let's figure out 1229 00:56:51,810 --> 00:56:53,370 how they even evaluate. 1230 00:56:53,370 --> 00:56:53,970 All right? 1231 00:56:53,970 --> 00:56:56,940 So I've suggested here that they might use 1232 00:56:56,940 --> 00:56:59,940 the beta of John Wiley & Sons. 1233 00:56:59,940 --> 00:57:01,800 That's a publicly-traded publishing company. 1234 00:57:01,800 --> 00:57:06,290 But they could also use the beta of McGraw-Hill. 1235 00:57:06,290 --> 00:57:07,250 Which should we pick? 1236 00:57:07,250 --> 00:57:09,760 McGraw-Hill or John Wiley? 1237 00:57:09,760 --> 00:57:10,260 Louis? 1238 00:57:10,260 --> 00:57:11,220 AUDIENCE: John Wiley. 1239 00:57:11,220 --> 00:57:11,700 ANDREW LO: Why? 1240 00:57:11,700 --> 00:57:14,116 AUDIENCE: Because McGraw-Hill's not a pure play publisher. 1241 00:57:14,116 --> 00:57:15,110 ANDREW LO: Exactly. 1242 00:57:15,110 --> 00:57:18,760 McGraw-Hill has lots of other businesses besides publishing. 1243 00:57:18,760 --> 00:57:21,100 So while they do do a lot of publishing, 1244 00:57:21,100 --> 00:57:22,559 they also do a lot of other things. 1245 00:57:22,559 --> 00:57:25,058 Give me another business that McGraw-Hill is involved in it. 1246 00:57:25,058 --> 00:57:25,610 Anybody? 1247 00:57:25,610 --> 00:57:26,110 Yeah? 1248 00:57:26,110 --> 00:57:26,850 AUDIENCE: Standard & Poor's? 1249 00:57:26,850 --> 00:57:27,641 ANDREW LO: Exactly. 1250 00:57:27,641 --> 00:57:29,960 McGraw-Hill owns Standard & Poor's. 1251 00:57:29,960 --> 00:57:33,530 And Standard & Poor's does a lot of things, including publishing 1252 00:57:33,530 --> 00:57:36,200 ratings as well as indexes. 1253 00:57:36,200 --> 00:57:40,290 So those businesses are not the same as publishing books. 1254 00:57:40,290 --> 00:57:44,780 McGraw-Hill has lots of other subsidiaries, 1255 00:57:44,780 --> 00:57:48,790 whereas John Wiley & Sons, all they do is publishing. 1256 00:57:48,790 --> 00:57:51,890 They are what is known as a pure play company. 1257 00:57:51,890 --> 00:57:53,660 So let's take a look. 1258 00:57:53,660 --> 00:58:01,220 This is the revenues of John Wiley & Sons in 2007. 1259 00:58:01,220 --> 00:58:04,430 If you look at the core business-- 1260 00:58:04,430 --> 00:58:09,420 39% professional trade, 70% higher ed, 44% scientific, 1261 00:58:09,420 --> 00:58:12,000 technical, and medical-- 1262 00:58:12,000 --> 00:58:16,380 that's not a perfect match for Bloomberg, 1263 00:58:16,380 --> 00:58:18,150 but that's not bad, right? 1264 00:58:18,150 --> 00:58:21,540 That's within the same general area. 1265 00:58:21,540 --> 00:58:25,080 What we would really prefer is if it were just this slice 1266 00:58:25,080 --> 00:58:26,970 that we could carve out and figure out 1267 00:58:26,970 --> 00:58:28,590 what that business looked like. 1268 00:58:28,590 --> 00:58:31,786 But that's not so easy to do because of the fact 1269 00:58:31,786 --> 00:58:33,660 that it's one company that's doing all of it. 1270 00:58:33,660 --> 00:58:33,840 Ken? 1271 00:58:33,840 --> 00:58:35,274 AUDIENCE: How much does size matter? 1272 00:58:35,274 --> 00:58:37,186 How much should Bloomberg take into consideration 1273 00:58:37,186 --> 00:58:39,186 the fact that John Wyley is [INAUDIBLE] doing it 1274 00:58:39,186 --> 00:58:40,420 at a different scale? 1275 00:58:40,420 --> 00:58:43,990 ANDREW LO: Well, so I guess I would be lying if I told you 1276 00:58:43,990 --> 00:58:46,030 that size didn't matter. 1277 00:58:46,030 --> 00:58:47,620 That's usually the case. 1278 00:58:47,620 --> 00:58:50,320 Size matters in the sense that you 1279 00:58:50,320 --> 00:58:52,210 want to have a company that's representative 1280 00:58:52,210 --> 00:58:53,710 of what you're trying to do. 1281 00:58:53,710 --> 00:58:56,470 And smaller companies bear certain risks that larger 1282 00:58:56,470 --> 00:58:57,640 companies don't. 1283 00:58:57,640 --> 00:59:00,700 And vice versa, larger companies have access to certain benefits 1284 00:59:00,700 --> 00:59:03,010 and technologies that smaller companies don't. 1285 00:59:03,010 --> 00:59:05,380 So the point is that we don't always 1286 00:59:05,380 --> 00:59:07,277 get to choose what's available. 1287 00:59:07,277 --> 00:59:09,610 You've got to look at the various different alternatives 1288 00:59:09,610 --> 00:59:12,980 out there and the best way to approach it is to get a range. 1289 00:59:12,980 --> 00:59:14,590 So if you're going to be doing this 1290 00:59:14,590 --> 00:59:16,450 in a more serious fashion, what you do 1291 00:59:16,450 --> 00:59:18,850 is to make a study of the publishing business. 1292 00:59:18,850 --> 00:59:21,370 Find companies at both ends of the spectrum. 1293 00:59:21,370 --> 00:59:24,160 The small ones and the big ones, the pure plays 1294 00:59:24,160 --> 00:59:26,830 and the conglomerates, and estimate 1295 00:59:26,830 --> 00:59:28,720 the cost of capital for all of them. 1296 00:59:28,720 --> 00:59:32,140 And then say, given this spectrum of results, 1297 00:59:32,140 --> 00:59:36,430 we think that the appropriate cost of capital should be here. 1298 00:59:36,430 --> 00:59:39,130 And basically make a choice after having 1299 00:59:39,130 --> 00:59:40,390 looked at the evidence. 1300 00:59:40,390 --> 00:59:43,390 So what I'm giving you is not a simple recipe 1301 00:59:43,390 --> 00:59:45,100 that will work in every circumstance 1302 00:59:45,100 --> 00:59:48,550 but rather an approach that, with sufficient study 1303 00:59:48,550 --> 00:59:51,571 and analysis, will yield an intelligent answer. 1304 00:59:51,571 --> 00:59:54,070 So let's actually take a look at the answer here, all right? 1305 00:59:54,070 --> 00:59:56,170 So we've got John Wiley & Sons, we've 1306 00:59:56,170 --> 01:00:00,040 got their performance over a period of time, the share price 1307 01:00:00,040 --> 01:00:01,210 and so on. 1308 01:00:01,210 --> 01:00:06,910 If you take the beta of John Wiley & Sons series A shares, 1309 01:00:06,910 --> 01:00:10,210 and you can get that from Yahoo, it's a beta of 1.29 as 1310 01:00:10,210 --> 01:00:11,560 of last year. 1311 01:00:11,560 --> 01:00:15,940 Then, with a risk-free rate of 5% and a market-risk premium 1312 01:00:15,940 --> 01:00:16,654 of 6%-- 1313 01:00:16,654 --> 01:00:18,070 which is when Bloomberg was trying 1314 01:00:18,070 --> 01:00:21,640 to decide when to go into the business, about two years ago-- 1315 01:00:21,640 --> 01:00:26,770 it turns out that the cost of capital is 12.7%. 1316 01:00:26,770 --> 01:00:28,990 So that's actually a pretty reasonable cost 1317 01:00:28,990 --> 01:00:31,510 of capital, which says that that's 1318 01:00:31,510 --> 01:00:36,430 the number you use in figuring out whether or not 1319 01:00:36,430 --> 01:00:40,180 the cash flows from a publishing business make sense. 1320 01:00:40,180 --> 01:00:41,140 OK? 1321 01:00:41,140 --> 01:00:43,270 Now to Anant's question, why on earth 1322 01:00:43,270 --> 01:00:45,040 would you do that when you could invest 1323 01:00:45,040 --> 01:00:47,950 in a business that may have a higher cost of capital 1324 01:00:47,950 --> 01:00:49,540 or a higher rate of return? 1325 01:00:49,540 --> 01:00:50,770 We don't know that they do. 1326 01:00:50,770 --> 01:00:52,630 In other words, at this point, Bloomberg 1327 01:00:52,630 --> 01:00:55,030 may not have any ability to invest 1328 01:00:55,030 --> 01:00:57,970 in its current business or others that 1329 01:00:57,970 --> 01:00:59,750 have a higher rate of return. 1330 01:00:59,750 --> 01:01:04,120 So one could argue that a cost of capital of about 12.7% 1331 01:01:04,120 --> 01:01:07,120 is actually a pretty reasonable hurdle rate for a new business. 1332 01:01:07,120 --> 01:01:09,940 So in other words, I would only invest in this business 1333 01:01:09,940 --> 01:01:12,710 if it yielded a positive NPV. 1334 01:01:12,710 --> 01:01:16,330 Now a positive NPV means it's earning more than 12.7% 1335 01:01:16,330 --> 01:01:18,210 on average, right? 1336 01:01:18,210 --> 01:01:21,340 That's a pretty good rate of return for a new business. 1337 01:01:21,340 --> 01:01:24,320 Now, there is another business that Bloomberg 1338 01:01:24,320 --> 01:01:27,774 could get into which is the hedge fund business, right? 1339 01:01:27,774 --> 01:01:28,440 I mean, why not? 1340 01:01:28,440 --> 01:01:30,856 They've got all this data, they may as well make use of it 1341 01:01:30,856 --> 01:01:32,420 and turn into a hedge fund. 1342 01:01:32,420 --> 01:01:35,420 Now, that business, I suspect that the cost of capital 1343 01:01:35,420 --> 01:01:36,800 is a lot higher. 1344 01:01:36,800 --> 01:01:40,580 Higher because the riskiness is more substantial. 1345 01:01:40,580 --> 01:01:43,280 And there, you have to start talking about the riskiness 1346 01:01:43,280 --> 01:01:44,570 of bankruptcy. 1347 01:01:44,570 --> 01:01:46,670 Would it really be a good idea to jeopardize 1348 01:01:46,670 --> 01:01:49,580 Bloomberg's entire franchise on one mega hedge fund? 1349 01:01:49,580 --> 01:01:50,830 I don't know, maybe? 1350 01:01:50,830 --> 01:01:53,630 But probably not, if you really are 1351 01:01:53,630 --> 01:01:56,870 serious about preserving the franchise value the company. 1352 01:01:56,870 --> 01:01:57,370 Mike? 1353 01:01:57,370 --> 01:01:58,486 AUDIENCE: So then, to that point, 1354 01:01:58,486 --> 01:02:00,870 how do you consider the impact on the rest of Bloomberg, 1355 01:02:00,870 --> 01:02:03,712 given this additonal-- if they go 1356 01:02:03,712 --> 01:02:04,962 into this additional division? 1357 01:02:04,962 --> 01:02:07,087 ANDREW LO: Well, so that's the project interactions 1358 01:02:07,087 --> 01:02:08,510 that I haven't talked about. 1359 01:02:08,510 --> 01:02:12,740 Up until now, I'm assuming this is a standalone subsidiary. 1360 01:02:12,740 --> 01:02:16,540 And I'm evaluating it as positive NPV or not. 1361 01:02:16,540 --> 01:02:17,300 OK? 1362 01:02:17,300 --> 01:02:20,180 The next step in the capital budgeting process 1363 01:02:20,180 --> 01:02:23,870 is to then ask the question, OK, as a standalone entity, 1364 01:02:23,870 --> 01:02:25,190 I think I understand it. 1365 01:02:25,190 --> 01:02:28,117 I got the cash flows down, I got the discount rate down. 1366 01:02:28,117 --> 01:02:29,450 I know what the comparisons are. 1367 01:02:29,450 --> 01:02:34,260 I've evaluated the NPV and it looks positive. 1368 01:02:34,260 --> 01:02:38,900 Now let me ask, what does this do strategically for the firm? 1369 01:02:38,900 --> 01:02:41,180 That's the third question, the strategic options. 1370 01:02:41,180 --> 01:02:42,410 Is it good? 1371 01:02:42,410 --> 01:02:43,940 Or is it not so good? 1372 01:02:43,940 --> 01:02:47,720 And if so can I put a number on that? 1373 01:02:47,720 --> 01:02:50,480 Now, from Bloomberg, I wasn't involved in any discussions 1374 01:02:50,480 --> 01:02:53,180 internally so I can't tell you what Bloomberg came up with. 1375 01:02:53,180 --> 01:02:55,400 But from what I gather, they decided 1376 01:02:55,400 --> 01:02:58,250 that there are some positive synergies between a business 1377 01:02:58,250 --> 01:03:03,949 press and their other media type of access. 1378 01:03:03,949 --> 01:03:05,990 That they felt that there were some cross-selling 1379 01:03:05,990 --> 01:03:08,152 opportunities so that, when there was a good book, 1380 01:03:08,152 --> 01:03:09,860 they could put it on the Bloomberg screen 1381 01:03:09,860 --> 01:03:12,390 and advertise free, basically. 1382 01:03:12,390 --> 01:03:14,150 And then the print media would actually 1383 01:03:14,150 --> 01:03:16,790 help to support attention to Bloomberg 1384 01:03:16,790 --> 01:03:19,460 as an outlet for news. 1385 01:03:19,460 --> 01:03:23,990 So in that case, they determined that this interaction was all 1386 01:03:23,990 --> 01:03:26,642 good, that there wasn't a downside to it. 1387 01:03:26,642 --> 01:03:28,100 And part of the reason, I think, is 1388 01:03:28,100 --> 01:03:29,516 because they were able to assemble 1389 01:03:29,516 --> 01:03:32,660 a team of very experienced publishers and editors. 1390 01:03:32,660 --> 01:03:35,000 They pulled them out of other publishing firms 1391 01:03:35,000 --> 01:03:37,010 to start this new venture, and they ended up 1392 01:03:37,010 --> 01:03:38,840 getting some really good people involved. 1393 01:03:38,840 --> 01:03:41,006 And I've had the pleasure to work with some of them. 1394 01:03:41,006 --> 01:03:42,680 They are very, very professional. 1395 01:03:42,680 --> 01:03:46,694 So Bloomberg actually made a pretty good decision, at least 1396 01:03:46,694 --> 01:03:48,860 from the perspective of getting this thing launched. 1397 01:03:48,860 --> 01:03:50,630 Whether or not it will be profitable, who knows? 1398 01:03:50,630 --> 01:03:52,520 It's only been around for a couple of years, 1399 01:03:52,520 --> 01:03:54,800 but so far they've developed a pretty impressive list 1400 01:03:54,800 --> 01:03:56,310 of authors. 1401 01:03:56,310 --> 01:03:56,895 Yeah? 1402 01:03:56,895 --> 01:03:57,765 AUDIENCE: I guess what I'm saying-- 1403 01:03:57,765 --> 01:03:59,264 Let's just say the rest of Bloomberg 1404 01:03:59,264 --> 01:04:00,970 had a cost of capital of 10. 1405 01:04:00,970 --> 01:04:04,110 They go to this, let's say it pulls everything up to 11. 1406 01:04:04,110 --> 01:04:06,487 The rest of their business is now more expensive. 1407 01:04:06,487 --> 01:04:07,570 That was more my question. 1408 01:04:07,570 --> 01:04:10,029 Will we include the value of destruction 1409 01:04:10,029 --> 01:04:12,570 on the rest of their business for raising their overall cost? 1410 01:04:12,570 --> 01:04:13,650 ANDREW LO: Well, so-- 1411 01:04:13,650 --> 01:04:16,620 If there's any kind of value creation or destruction, 1412 01:04:16,620 --> 01:04:21,720 you're implicitly assuming some kind of market irrationality. 1413 01:04:21,720 --> 01:04:22,290 Right? 1414 01:04:22,290 --> 01:04:25,620 Because what you're assuming is that, if they pull this thing 1415 01:04:25,620 --> 01:04:28,350 up, they pull up the cost of capital for the entire firm, 1416 01:04:28,350 --> 01:04:30,660 they lower the valuation of the entire firm. 1417 01:04:30,660 --> 01:04:32,850 You're assuming that people in the industry 1418 01:04:32,850 --> 01:04:36,060 can't see through the fact that they've got a subsidiary. 1419 01:04:36,060 --> 01:04:38,880 And in some cases, you may be right. 1420 01:04:38,880 --> 01:04:41,520 But I would argue that a better perspective is 1421 01:04:41,520 --> 01:04:44,490 to say that analysts are going to be 1422 01:04:44,490 --> 01:04:47,190 able to do division-by-division valuation 1423 01:04:47,190 --> 01:04:49,227 and say, OK, they got a publishing division. 1424 01:04:49,227 --> 01:04:51,060 These are the revenues, these are the costs, 1425 01:04:51,060 --> 01:04:53,197 they're segregated, and it makes sense for them, 1426 01:04:53,197 --> 01:04:54,030 given the synergies. 1427 01:04:54,030 --> 01:04:55,030 Blah, blah, blah. 1428 01:04:55,030 --> 01:04:57,690 So I would expect that those considerations may not 1429 01:04:57,690 --> 01:04:58,610 be as significant. 1430 01:04:58,610 --> 01:05:03,180 Now if, on the other hand, this publishing operation 1431 01:05:03,180 --> 01:05:05,254 were really big-- 1432 01:05:05,254 --> 01:05:07,670 In other words, if it ended up that it grew so big that it 1433 01:05:07,670 --> 01:05:11,810 accounted for half of the revenues of Bloomberg, 1434 01:05:11,810 --> 01:05:15,636 the entity, then I think your point would be well taken, 1435 01:05:15,636 --> 01:05:16,760 would be much more serious. 1436 01:05:16,760 --> 01:05:19,454 Right now, it's a tiny, little blip 1437 01:05:19,454 --> 01:05:20,870 in the grand scheme of things that 1438 01:05:20,870 --> 01:05:22,460 may turn into something big. 1439 01:05:22,460 --> 01:05:24,980 But for example, if you're an investment bank-- 1440 01:05:24,980 --> 01:05:27,410 Nowadays, we don't have any more of those but at one point 1441 01:05:27,410 --> 01:05:28,340 we did. 1442 01:05:28,340 --> 01:05:32,450 If you're an investment bank and you've got a franchise based 1443 01:05:32,450 --> 01:05:36,230 upon customer-driven business, very reliable, 1444 01:05:36,230 --> 01:05:42,470 very high multiples, very, very valuable kind of franchise-- 1445 01:05:42,470 --> 01:05:43,970 And then the question is, should you 1446 01:05:43,970 --> 01:05:46,330 get involved in prop trading? 1447 01:05:46,330 --> 01:05:48,160 Prop trading, proprietary trading, 1448 01:05:48,160 --> 01:05:51,550 basically being a hedge fund, carries 1449 01:05:51,550 --> 01:05:54,190 in the marketplace no multiple. 1450 01:05:54,190 --> 01:05:57,460 Actually in some cases, the multiple is negative, 1451 01:05:57,460 --> 01:05:59,240 I mean, that is, less than 1. 1452 01:05:59,240 --> 01:05:59,770 Right? 1453 01:05:59,770 --> 01:06:03,270 Because if you're thinking about acquiring a hedge fund, 1454 01:06:03,270 --> 01:06:04,895 the typical hedge fund will provide you 1455 01:06:04,895 --> 01:06:06,686 with whatever earnings they have this year, 1456 01:06:06,686 --> 01:06:08,250 but next year they could blow up. 1457 01:06:08,250 --> 01:06:12,000 So there is no multiple assigned to hedge funds, typically. 1458 01:06:12,000 --> 01:06:12,872 Not always. 1459 01:06:12,872 --> 01:06:15,330 I can give you examples over the last couple of years where 1460 01:06:15,330 --> 01:06:17,430 hedge funds have sold for multiples, 1461 01:06:17,430 --> 01:06:19,810 but there are not many of them. 1462 01:06:19,810 --> 01:06:22,410 And typically, a hedge fund, when 1463 01:06:22,410 --> 01:06:25,920 you look at the value of the future earnings, the multiple 1464 01:06:25,920 --> 01:06:27,840 that is applied can be less than 1 1465 01:06:27,840 --> 01:06:31,860 if there is a concern that the hedge fund can drag down 1466 01:06:31,860 --> 01:06:34,680 the value of the parent company. 1467 01:06:34,680 --> 01:06:37,370 So there are situations where, for a distress sale, 1468 01:06:37,370 --> 01:06:41,960 people have paid $0.50 on the dollar of assets of a hedge 1469 01:06:41,960 --> 01:06:42,890 fund. 1470 01:06:42,890 --> 01:06:45,464 Of the actual cash that the hedge fund has generated 1471 01:06:45,464 --> 01:06:46,880 for its shareholders, they've paid 1472 01:06:46,880 --> 01:06:50,750 less than a dollar for dollar because of that kind of effect 1473 01:06:50,750 --> 01:06:52,190 on the parent company. 1474 01:06:52,190 --> 01:06:54,050 Goldman Sachs, after they went public, 1475 01:06:54,050 --> 01:06:57,860 they really had a lot of difficulty internally, 1476 01:06:57,860 --> 01:07:00,770 thinking about prop trading, because prop trading accounted 1477 01:07:00,770 --> 01:07:04,100 during certain years for such a large fraction of the Goldman 1478 01:07:04,100 --> 01:07:07,014 franchise that it ended up having the effect 1479 01:07:07,014 --> 01:07:08,180 that Mike was talking about. 1480 01:07:08,180 --> 01:07:10,460 That is, people said, gee, Goldman is nothing 1481 01:07:10,460 --> 01:07:11,630 but a prop trading firm. 1482 01:07:11,630 --> 01:07:13,505 I'm not going to give it a multiple of seven. 1483 01:07:13,505 --> 01:07:15,350 Let's try a multiple of 2 and 1/2. 1484 01:07:15,350 --> 01:07:17,240 That is value destruction. 1485 01:07:17,240 --> 01:07:18,900 That's a concern. 1486 01:07:18,900 --> 01:07:21,110 But for small projects that aren't 1487 01:07:21,110 --> 01:07:23,150 about the entire corporation, that 1488 01:07:23,150 --> 01:07:25,100 aren't likely to affect the perception 1489 01:07:25,100 --> 01:07:28,010 of the entire corporation, you don't have to worry about that. 1490 01:07:28,010 --> 01:07:30,540 So size does matter in another way. 1491 01:07:30,540 --> 01:07:31,290 Yeah, [INAUDIBLE]? 1492 01:07:31,290 --> 01:07:32,664 AUDIENCE: How did you with, like, 1493 01:07:32,664 --> 01:07:33,990 [INAUDIBLE] and risk-free rate? 1494 01:07:33,990 --> 01:07:35,686 So today what rate would be used? 1495 01:07:35,686 --> 01:07:38,480 ANDREW LO: Today I'd use 1%. 1496 01:07:38,480 --> 01:07:42,470 So this is the time element that I mentioned to you before. 1497 01:07:42,470 --> 01:07:44,690 When you take on a project, you've 1498 01:07:44,690 --> 01:07:46,700 got to have the right time. 1499 01:07:46,700 --> 01:07:48,240 It's got to be the right time. 1500 01:07:48,240 --> 01:07:49,670 And so things change. 1501 01:07:49,670 --> 01:07:51,920 The cost of capital changes. 1502 01:07:51,920 --> 01:07:55,556 So right now, I would use 1% for this particular project. 1503 01:07:55,556 --> 01:07:56,930 So you might think it'd be easier 1504 01:07:56,930 --> 01:07:59,780 to get it launched, but try getting cash 1505 01:07:59,780 --> 01:08:02,000 in a setting like today. 1506 01:08:02,000 --> 01:08:02,500 Yeah? 1507 01:08:02,500 --> 01:08:03,125 AUDIENCE: If you start a project, 1508 01:08:03,125 --> 01:08:05,330 say it's a two-year project and you start it at 1%, 1509 01:08:05,330 --> 01:08:07,496 and then all of a sudden the risk-free rate goes up. 1510 01:08:07,496 --> 01:08:09,330 Does that mean that you might, economically, 1511 01:08:09,330 --> 01:08:11,162 need to cancel your project halfway through? 1512 01:08:11,162 --> 01:08:12,370 ANDREW LO: Yeah, absolutely. 1513 01:08:12,370 --> 01:08:13,220 Yeah. 1514 01:08:13,220 --> 01:08:16,130 At one point, John Maynard Keynes 1515 01:08:16,130 --> 01:08:19,380 was criticized for flip flopping on the gold standard 1516 01:08:19,380 --> 01:08:22,591 and Keynes had a very, very sensible reply, which I think 1517 01:08:22,591 --> 01:08:23,840 I may have mentioned in class. 1518 01:08:23,840 --> 01:08:27,510 Which is that, when the facts change, sir, I change my mind. 1519 01:08:27,510 --> 01:08:30,050 What do you do? 1520 01:08:30,050 --> 01:08:31,189 So absolutely. 1521 01:08:31,189 --> 01:08:33,501 If cost of capital changes a year from now, 1522 01:08:33,501 --> 01:08:35,000 you may have to cancel your project. 1523 01:08:35,000 --> 01:08:37,399 Or you may wish you had taken two of the projects, 1524 01:08:37,399 --> 01:08:38,960 but you didn't get to. 1525 01:08:38,960 --> 01:08:40,956 These kinds of project interactions over time 1526 01:08:40,956 --> 01:08:42,080 make it really complicated. 1527 01:08:42,080 --> 01:08:44,359 That's one of the reasons why we have a whole separate course 1528 01:08:44,359 --> 01:08:45,817 on capital budgeting, is to come up 1529 01:08:45,817 --> 01:08:48,200 with tools to deal with these kind of interactions. 1530 01:08:48,200 --> 01:08:49,140 So absolutely. 1531 01:08:49,140 --> 01:08:51,015 In fact, I'm going to give an example of that 1532 01:08:51,015 --> 01:08:54,080 in just a minute where that time element actually 1533 01:08:54,080 --> 01:08:56,240 is very important. 1534 01:08:56,240 --> 01:08:59,359 Let's actually go over that right now. 1535 01:08:59,359 --> 01:09:02,590 So here's an example that you don't know how to do yet. 1536 01:09:02,590 --> 01:09:04,590 We're going to figure out how to do it together. 1537 01:09:04,590 --> 01:09:05,240 All right? 1538 01:09:05,240 --> 01:09:08,330 And it has to do with time and with risks. 1539 01:09:08,330 --> 01:09:14,450 So a firm is investing in an oil exploration project. 1540 01:09:14,450 --> 01:09:18,215 We're going to drill a bunch of holes in a particular area 1541 01:09:18,215 --> 01:09:20,250 where I'm trying to find oil. 1542 01:09:20,250 --> 01:09:23,100 And it's going to take time to drill these holes. 1543 01:09:23,100 --> 01:09:26,500 So it's going to take at least a year. 1544 01:09:26,500 --> 01:09:28,529 And at the end of the first year, 1545 01:09:28,529 --> 01:09:31,260 there's going to be a probability of 1/3 1546 01:09:31,260 --> 01:09:34,200 that we find three million barrels of oil. 1547 01:09:34,200 --> 01:09:36,569 But there's a probability of 2/3 that we find nothing, 1548 01:09:36,569 --> 01:09:39,950 we come up dry. 1549 01:09:39,950 --> 01:09:43,000 1/3, 2/3 probability. 1550 01:09:43,000 --> 01:09:48,100 Now, if we are successful with that 1/3 probability, then 1551 01:09:48,100 --> 01:09:50,439 the 3 million barrels of oil will 1552 01:09:50,439 --> 01:09:54,262 be pumped out of the ground by the end of the second year. 1553 01:09:54,262 --> 01:09:56,470 So at the end of the first year, if we're successful, 1554 01:09:56,470 --> 01:09:58,300 we'll find oil. 1555 01:09:58,300 --> 01:10:01,330 And then it'll take a year to extract it and barrel it. 1556 01:10:01,330 --> 01:10:02,920 Put it in barrels and sell it. 1557 01:10:02,920 --> 01:10:05,140 And we'll have 3 million barrels to be 1558 01:10:05,140 --> 01:10:07,540 able to do that, and then after that, 1559 01:10:07,540 --> 01:10:11,000 the field will be depleted. 1560 01:10:11,000 --> 01:10:15,080 Now the expected after-tax profit per barrel is $20. 1561 01:10:15,080 --> 01:10:19,010 We're going to make $20 a barrel after-tax. 1562 01:10:19,010 --> 01:10:22,390 Not now, but a year from now. 1563 01:10:22,390 --> 01:10:24,940 The risk-free rate is 5%. 1564 01:10:24,940 --> 01:10:27,730 The industry discount rate of oil production is 20%. 1565 01:10:27,730 --> 01:10:30,130 That's a very high cost of capital. 1566 01:10:30,130 --> 01:10:33,640 But oil production is a high beta activity, 1567 01:10:33,640 --> 01:10:35,470 as you can sort of tell, right? 1568 01:10:35,470 --> 01:10:37,450 Market prices are down. 1569 01:10:37,450 --> 01:10:39,490 Oil prices down. 1570 01:10:39,490 --> 01:10:43,210 When the market was up, oil prices were pretty high. 1571 01:10:43,210 --> 01:10:45,130 Oil has a high beta, OK? 1572 01:10:45,130 --> 01:10:49,480 So the discount rate is 20%, but the exploration risk-- 1573 01:10:49,480 --> 01:10:52,630 this 1/3, 2/3 probability-- 1574 01:10:52,630 --> 01:10:53,790 that has a beta of 0. 1575 01:10:57,474 --> 01:10:58,765 What's the NPV of this project? 1576 01:11:01,270 --> 01:11:03,050 How do you figure that out? 1577 01:11:03,050 --> 01:11:05,810 Believe it or not, you actually have all the tools 1578 01:11:05,810 --> 01:11:07,590 to solve this problem. 1579 01:11:07,590 --> 01:11:09,140 But it's hard. 1580 01:11:09,140 --> 01:11:11,900 And not only is it hard for all of you, 1581 01:11:11,900 --> 01:11:14,325 it's actually hard for professionals. 1582 01:11:14,325 --> 01:11:16,700 A couple of years ago, I taught the Sloan Fellows program 1583 01:11:16,700 --> 01:11:18,230 during the summer. 1584 01:11:18,230 --> 01:11:20,813 I don't know how much you know about the Sloan Fellows program 1585 01:11:20,813 --> 01:11:23,810 but this is a program where we bring executives who've 1586 01:11:23,810 --> 01:11:27,200 worked for 15, 20, 30 years, made their fortunes, 1587 01:11:27,200 --> 01:11:30,680 and have decided to take a year off to get a degree. 1588 01:11:30,680 --> 01:11:36,020 And so these are very seasoned, senior professionals, 1589 01:11:36,020 --> 01:11:39,680 so teaching them is a whole other challenge. 1590 01:11:39,680 --> 01:11:42,460 They're very-- they know a lot. 1591 01:11:42,460 --> 01:11:44,300 And they know a lot about virtually anything 1592 01:11:44,300 --> 01:11:46,620 and everything you ever care to talk about. 1593 01:11:46,620 --> 01:11:49,220 To case in point, I gave this example 1594 01:11:49,220 --> 01:11:51,817 to the Sloan Fellows class. 1595 01:11:51,817 --> 01:11:53,900 Somebody in the back of the room said, "Excuse me. 1596 01:11:53,900 --> 01:11:57,130 First, Lo, but I don't recall that we actually used 1597 01:11:57,130 --> 01:12:02,092 this analysis when we were doing oil exploration." 1598 01:12:02,092 --> 01:12:04,550 And I said, well, why don't you tell us about what you did, 1599 01:12:04,550 --> 01:12:06,470 and who you are, and so on. 1600 01:12:06,470 --> 01:12:10,610 And the fellow said, "Well, I'm the senior vice-president 1601 01:12:10,610 --> 01:12:13,665 for oil exploration at Saudi Aramco." 1602 01:12:13,665 --> 01:12:16,880 This is the biggest oil company in the world, 1603 01:12:16,880 --> 01:12:20,990 and he was the man in charge of drilling those holes. 1604 01:12:20,990 --> 01:12:24,110 And he actually said that they didn't do this analysis, 1605 01:12:24,110 --> 01:12:26,390 but that he actually was going to try it out 1606 01:12:26,390 --> 01:12:29,930 because he thought it made a lot of sense. 1607 01:12:29,930 --> 01:12:32,685 So that was a little scary, I have to tell you. 1608 01:12:32,685 --> 01:12:35,480 A very intimidating audience. 1609 01:12:35,480 --> 01:12:39,176 But the point is that this is a very subtle idea. 1610 01:12:39,176 --> 01:12:40,300 Let me tell you what it is. 1611 01:12:40,300 --> 01:12:42,390 Let me tell you how it works, OK? 1612 01:12:42,390 --> 01:12:45,210 There are two risks going on here. 1613 01:12:45,210 --> 01:12:48,630 There is the market risk of pumping the oil out 1614 01:12:48,630 --> 01:12:50,460 of the ground and selling it. 1615 01:12:50,460 --> 01:12:52,890 And that we understand quite well. 1616 01:12:52,890 --> 01:12:57,870 That has a beta given by this particular cost of capital, 1617 01:12:57,870 --> 01:12:58,890 20%. 1618 01:12:58,890 --> 01:13:01,380 So we already know what the discount rate 1619 01:13:01,380 --> 01:13:05,057 is in that second year. 1620 01:13:05,057 --> 01:13:07,640 But we need to figure out how to discount from the second year 1621 01:13:07,640 --> 01:13:09,470 to the first year. 1622 01:13:09,470 --> 01:13:13,820 What should the appropriate risk-adjusted discount rate 1623 01:13:13,820 --> 01:13:17,960 is from the first year back to year zero. 1624 01:13:17,960 --> 01:13:18,901 That's the key. 1625 01:13:18,901 --> 01:13:19,400 Right? 1626 01:13:19,400 --> 01:13:20,600 That's the hard part. 1627 01:13:20,600 --> 01:13:22,280 At the end of the second year, we're 1628 01:13:22,280 --> 01:13:24,500 going to have 3 million barrels of oil, 1629 01:13:24,500 --> 01:13:31,460 each priced at $20 a barrel for a profit of $60 million, right? 1630 01:13:31,460 --> 01:13:33,120 Or $6 million here. 1631 01:13:33,120 --> 01:13:34,040 Yeah. 1632 01:13:34,040 --> 01:13:37,982 So $60 million at the end of two years. 1633 01:13:37,982 --> 01:13:39,440 Now we're going to discount it back 1634 01:13:39,440 --> 01:13:44,125 to the beginning of that two year period. 1635 01:13:44,125 --> 01:13:46,000 So in other words, we're going to discount it 1636 01:13:46,000 --> 01:13:48,910 from the end of the second year to the beginning 1637 01:13:48,910 --> 01:13:51,460 of that second year, or the end of the first year, 1638 01:13:51,460 --> 01:13:54,030 and that's what we get as $50 million, right? 1639 01:13:54,030 --> 01:13:58,180 $60 million discounted back by 20% discount rate, 1640 01:13:58,180 --> 01:14:04,850 that's $50 million at year one, if we strike oil. 1641 01:14:04,850 --> 01:14:08,690 But there's a 1/3 probability that we strike oil. 1642 01:14:08,690 --> 01:14:11,240 There's a 2/3 probability that we don't. 1643 01:14:11,240 --> 01:14:15,230 The question is, what do we discount this possibility back 1644 01:14:15,230 --> 01:14:16,550 to year zero? 1645 01:14:16,550 --> 01:14:22,070 And I'm going to argue you discount it back, not at 20% 1646 01:14:22,070 --> 01:14:24,460 but at 5%. 1647 01:14:24,460 --> 01:14:25,790 5%? 1648 01:14:25,790 --> 01:14:28,370 That's the risk-free rate. 1649 01:14:28,370 --> 01:14:30,420 Now, why on earth would you do that? 1650 01:14:30,420 --> 01:14:33,430 This is the oil industry we're talking about. 1651 01:14:33,430 --> 01:14:37,570 The reason you discount the first year back to year zero 1652 01:14:37,570 --> 01:14:42,540 at risk-free rate is because the risk of coming up dry, 1653 01:14:42,540 --> 01:14:47,310 that risk is completely diversifiable. 1654 01:14:47,310 --> 01:14:49,870 That is complete, idiosyncratic risk. 1655 01:14:49,870 --> 01:14:52,260 There is no beta, right? 1656 01:14:52,260 --> 01:14:55,980 The oil deposits underground don't 1657 01:14:55,980 --> 01:14:58,200 know whether it's a bull market or a bear market. 1658 01:14:58,200 --> 01:14:59,460 They couldn't care less. 1659 01:14:59,460 --> 01:15:01,690 They're either there or they're not there, 1660 01:15:01,690 --> 01:15:03,360 and you're drilling for it. 1661 01:15:03,360 --> 01:15:09,310 So your risk of not striking oil has no bearing on the market. 1662 01:15:09,310 --> 01:15:12,300 If you are well diversified, then that risk 1663 01:15:12,300 --> 01:15:14,010 is actually not something that you're 1664 01:15:14,010 --> 01:15:15,780 going to get rewarded for. 1665 01:15:15,780 --> 01:15:17,730 And therefore, you need to discount it 1666 01:15:17,730 --> 01:15:19,240 at the risk-free rate. 1667 01:15:19,240 --> 01:15:26,500 So in fact, the NPV of this project is $15.9 million, 1668 01:15:26,500 --> 01:15:29,820 which is a lot bigger number than if you were to discount it 1669 01:15:29,820 --> 01:15:32,095 by 20% both years. 1670 01:15:32,095 --> 01:15:34,620 But it's because the risks are different. 1671 01:15:34,620 --> 01:15:38,960 So to Brian's point, when risk changes over time, 1672 01:15:38,960 --> 01:15:40,710 you've got to use the appropriate discount 1673 01:15:40,710 --> 01:15:43,180 rate for that particular kind of risk. 1674 01:15:43,180 --> 01:15:46,470 Now, it just so happens that here ahead of time, we actually 1675 01:15:46,470 --> 01:15:49,200 understood where the risks were coming from. 1676 01:15:49,200 --> 01:15:52,200 So we know the risks between year zero and year one 1677 01:15:52,200 --> 01:15:55,430 are different from the risks between year one and year two. 1678 01:15:55,430 --> 01:15:57,180 You've got to use the appropriate discount 1679 01:15:57,180 --> 01:15:58,380 rate for that kind of risk. 1680 01:15:58,380 --> 01:16:01,710 This is a very subtle problem that you 1681 01:16:01,710 --> 01:16:06,270 have to think about carefully in order to understand it fully. 1682 01:16:06,270 --> 01:16:10,080 But it's an important one so that's why I spent time on it. 1683 01:16:10,080 --> 01:16:11,880 Any questions about this? 1684 01:16:11,880 --> 01:16:12,690 Any debate? 1685 01:16:12,690 --> 01:16:13,360 Any argument? 1686 01:16:13,360 --> 01:16:14,800 Do you agree with this? 1687 01:16:14,800 --> 01:16:16,020 Does this make sense to you? 1688 01:16:16,020 --> 01:16:19,530 If it doesn't make sense, speak up now 1689 01:16:19,530 --> 01:16:21,341 or forever hold your peace. 1690 01:16:21,341 --> 01:16:21,840 Right? 1691 01:16:21,840 --> 01:16:25,080 Because it's important that you absorb the lesson 1692 01:16:25,080 --> 01:16:27,160 from this particular example. 1693 01:16:27,160 --> 01:16:28,120 Yeah, Andy? 1694 01:16:28,120 --> 01:16:32,070 AUDIENCE: So suppose that you know for a fact there's 1695 01:16:32,070 --> 01:16:38,164 a third of 20 million barrels in the ground. 1696 01:16:38,164 --> 01:16:39,602 You consider the same project? 1697 01:16:39,602 --> 01:16:40,880 That has the exact same-- 1698 01:16:40,880 --> 01:16:41,880 ANDREW LO: That's right. 1699 01:16:41,880 --> 01:16:42,330 AUDIENCE: --value? 1700 01:16:42,330 --> 01:16:43,330 ANDREW LO: That's right. 1701 01:16:43,330 --> 01:16:43,860 Absolutely. 1702 01:16:43,860 --> 01:16:47,280 Because there, you have no uncertainty. 1703 01:16:47,280 --> 01:16:49,320 And you're just simply taking the expected value 1704 01:16:49,320 --> 01:16:51,900 and assuming that you're getting the expected value. 1705 01:16:51,900 --> 01:16:55,020 And it's because the uncertainty of this project 1706 01:16:55,020 --> 01:16:57,330 in the first year is completely diversifiable. 1707 01:16:57,330 --> 01:16:58,980 It's a coin flip. 1708 01:16:58,980 --> 01:16:59,790 It's a coin flip. 1709 01:16:59,790 --> 01:17:01,289 And you're not going to get rewarded 1710 01:17:01,289 --> 01:17:03,840 for bearing that coin flip because, if you diversify-- 1711 01:17:03,840 --> 01:17:04,800 Put it another way. 1712 01:17:04,800 --> 01:17:07,650 Suppose you were Saudi Aramco and, instead of doing one 1713 01:17:07,650 --> 01:17:11,490 of these fields, you did 100? 1714 01:17:11,490 --> 01:17:13,980 Well, then you've diversified across all sorts 1715 01:17:13,980 --> 01:17:18,120 of possible coin flips, and then the law of large numbers 1716 01:17:18,120 --> 01:17:23,100 would actually reduce your payoff to something very, very 1717 01:17:23,100 --> 01:17:25,240 riskless, or close to riskless. 1718 01:17:25,240 --> 01:17:25,740 Right? 1719 01:17:29,100 --> 01:17:29,746 Ted? 1720 01:17:29,746 --> 01:17:32,740 AUDIENCE: Would you just restate again 1721 01:17:32,740 --> 01:17:36,570 why the first year is at 5% as opposed to 20%? 1722 01:17:36,570 --> 01:17:37,260 ANDREW LO: Sure. 1723 01:17:37,260 --> 01:17:40,710 The first year is the 5% because I told you here 1724 01:17:40,710 --> 01:17:45,220 that the exploration risk is completely non-systematic. 1725 01:17:45,220 --> 01:17:46,920 It's zero beta. 1726 01:17:46,920 --> 01:17:49,680 So when you're drilling for holes, whether or not 1727 01:17:49,680 --> 01:17:51,600 you find oil or you don't find oil 1728 01:17:51,600 --> 01:17:55,620 has absolutely no bearing on whether the market is 1729 01:17:55,620 --> 01:17:56,520 up or down. 1730 01:17:56,520 --> 01:17:58,970 There's no correlation. 1731 01:17:58,970 --> 01:18:00,980 If there's no correlation, then that 1732 01:18:00,980 --> 01:18:03,317 means that it's a kind of risk that you're not 1733 01:18:03,317 --> 01:18:04,400 going to get rewarded for. 1734 01:18:04,400 --> 01:18:06,830 This is the Irish jig dance-- you know, the dancing 1735 01:18:06,830 --> 01:18:08,090 on that platform. 1736 01:18:08,090 --> 01:18:10,310 You're not going to get paid extra for dancing 1737 01:18:10,310 --> 01:18:13,410 an Irish jig on that platform when you're window washing. 1738 01:18:13,410 --> 01:18:14,240 OK? 1739 01:18:14,240 --> 01:18:17,330 So the key here is this statement right here. 1740 01:18:17,330 --> 01:18:19,970 The exploration risk is non-systematic. 1741 01:18:19,970 --> 01:18:23,895 If the exploration risk were systematic for any reason, then 1742 01:18:23,895 --> 01:18:25,520 of course, you'd have to use a discount 1743 01:18:25,520 --> 01:18:28,520 rate that would be commensurate with the appropriate beta. 1744 01:18:28,520 --> 01:18:30,090 And there's no telling that that beta 1745 01:18:30,090 --> 01:18:33,410 is going to be the same as pumping the oil out. 1746 01:18:33,410 --> 01:18:36,170 Oil exploration is not the same thing as oil production. 1747 01:18:36,170 --> 01:18:38,960 There are two different kinds of activities 1748 01:18:38,960 --> 01:18:43,070 that carry with it different kinds of risks. 1749 01:18:43,070 --> 01:18:45,800 OK? 1750 01:18:45,800 --> 01:18:48,760 Other questions or comments? 1751 01:18:48,760 --> 01:18:49,260 Yeah? 1752 01:18:49,260 --> 01:18:49,964 [INAUDIBLE] 1753 01:18:49,964 --> 01:18:52,005 AUDIENCE: How often does this happen in practice? 1754 01:18:52,005 --> 01:18:54,480 I mean, most of the time during my experience, 1755 01:18:54,480 --> 01:18:57,004 we would forecast that 15 or 20 years down the line. 1756 01:18:57,004 --> 01:18:57,670 ANDREW LO: Yeah. 1757 01:18:57,670 --> 01:19:00,010 AUDIENCE: Most of the time we would pick a discount 1758 01:19:00,010 --> 01:19:01,440 rate that, you know, tries to-- 1759 01:19:01,440 --> 01:19:02,982 It's a level discount rate. 1760 01:19:02,982 --> 01:19:05,019 We're not going to, you know, try and change 1761 01:19:05,019 --> 01:19:05,810 that discount rate. 1762 01:19:05,810 --> 01:19:06,450 ANDREW LO: Right. 1763 01:19:06,450 --> 01:19:07,290 AUDIENCE: It could be 10 year-- 1764 01:19:07,290 --> 01:19:08,190 ANDREW LO: Yeah. 1765 01:19:08,190 --> 01:19:10,560 So the answer is, it depends on the industry. 1766 01:19:10,560 --> 01:19:14,520 For certain industries where you cannot identify discrete 1767 01:19:14,520 --> 01:19:17,700 changes in the riskiness of the activities, 1768 01:19:17,700 --> 01:19:19,260 then it makes sense. 1769 01:19:19,260 --> 01:19:22,744 The only thing you can do is to come up with one discount rate. 1770 01:19:22,744 --> 01:19:24,160 But for industries like this where 1771 01:19:24,160 --> 01:19:27,370 there are discrete phases of these different projects, 1772 01:19:27,370 --> 01:19:29,830 then you actually do use different discount rates. 1773 01:19:29,830 --> 01:19:33,220 Because the uncertainty resolves in a different manner, 1774 01:19:33,220 --> 01:19:35,090 depending on the industry. 1775 01:19:35,090 --> 01:19:37,180 So if you keep in mind the lesson 1776 01:19:37,180 --> 01:19:39,880 that the appropriate discount rate should 1777 01:19:39,880 --> 01:19:43,510 be commensurate with the risks of that particular cash flow-- 1778 01:19:43,510 --> 01:19:46,600 Think of each cash flow as a piece of paper 1779 01:19:46,600 --> 01:19:49,720 that you're auctioning off to people in a marketplace. 1780 01:19:49,720 --> 01:19:52,570 And ask the question, what would those folks in the marketplace 1781 01:19:52,570 --> 01:19:55,690 demand in terms of the appropriate compensation 1782 01:19:55,690 --> 01:19:57,040 for that kind of risk? 1783 01:19:57,040 --> 01:19:59,390 You'll be able to make the right decisions. 1784 01:19:59,390 --> 01:20:00,160 OK? 1785 01:20:00,160 --> 01:20:02,320 And if you can't tell, then you may as well 1786 01:20:02,320 --> 01:20:03,650 use one discount rate. 1787 01:20:03,650 --> 01:20:05,620 If you can't tell one cash flow from another, 1788 01:20:05,620 --> 01:20:08,009 then what you're telling me is that, effectively, it's 1789 01:20:08,009 --> 01:20:09,050 the same kind of project. 1790 01:20:12,090 --> 01:20:12,590 OK. 1791 01:20:12,590 --> 01:20:13,520 We're out of time. 1792 01:20:13,520 --> 01:20:15,122 I wish you all a Happy Thanksgiving. 1793 01:20:15,122 --> 01:20:16,580 We'll see you on Monday where we're 1794 01:20:16,580 --> 01:20:18,620 going to continue on with capital budgeting 1795 01:20:18,620 --> 01:20:22,330 and do some more applications.