Chapter 1 - The Fundamental Concept: Money has a Time Value

01-01 - Liquidity and the Time Value of Money (17 min.) Sample Lesson

Chapter 2 - Lenders and the Time Value of Money

02-01 - Bonds (20 min.)
02-02 - Risks in Lending and Repayment Schedules (20 min.)
02-03 - Mortgages (17 min.)
02-04 - How and Why Has The Time Value of Money Changed? (15 min.)
02-05 - Specific Interest Rates, and WACC (Weighted Average Cost of Capital) (14 min.)

Chapter 3 - Making Investment Decisions

03-01 - Deciding to Spend Money, and the Impact of Financing (17 min.)
03-02 - Getting to Yes, and Sensitivity (12 min.)
03-03 - When DCF IRR Analysis Does Not Work (14 min.)
03-04 - Incremental Investment, and Tax (13 min.)
03-05 - How, and Whether, to Mitigate Risk (22 min.) Quiz: 03-05 - How, and Whether, to Mitigate Risk

Investment Analysis by Discounted Cash Flow / Chapter 1 - The Fundamental Concept: Money has a Time Value

Lesson 01-01 - Liquidity and the Time Value of Money

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Transcript

01. Lesson 1.01: Liquidity and the Time Value of Money 02. Why This Course?03. Why This Instructor?04. The Fundamental Concept 05. What is a Future Dollar Worth Today?

01. Lesson 1.01: Liquidity and the Time Value of Money

Welcome to Investment Analysis by Discounted Cash Flow. Three comments before we get into the material. The first is I want to point out my stock market tie. This goes back to before the internet days, when every serious newspaper ran almost every stock every day; low price, high price, closing price, dividend yield, price to earnings ratio. So whenever I'm doing anything related to finance, I like to get in the mood with the tie. Second comment. My background is oil and gas and electricity. And so the examples I'm naturally going to give from my experience are going to be drawn to that; oil, gas, chemicals, and power. But what we're going to cover here addresses all spending of capital dollars, whether it's real estate, residential, office building, a machine shop, whatever, oil field, refinery, power plant, all are going to try to make sense of is it worth spending this money. My third comment is, I don't presume any prior knowledge in this, so I will include some basics in this. If you have experience, you may find part of this going over stuff you learned a long time ago. But for those that don't, I'm not going to presume any higher knowledge. And by the end, I want to get to a more sophisticated thinking about this with what senior management ends up doing before they say yes let's spend this one million or one billion or ten billion dollars on a project.

02. Why This Course?

OK, why this course? The essence of most commercial activity is spending money today to make money or value or earnings in the future. But I want to be clear that we are going to focus on spending cash to make cash in the future, and we'll talk more about that as the course unfolds. But that's the essence of what we do. Most people in business are either planning, designing, or building something, or running something that got built in the past, because people thought it would make sense.
So it's important to get this right. Should we spend money on this? And there are spectacular examples of hindsight where we're sorry we spent money on that. Get this wrong and you're soon out of money. Get this right and you create wealth for your company and for your society. And if you go around the globe, there are huge differences in wealth, which we typically measure as gross domestic product per capita. Per person, per every person there; child, retired person, working person, whatever. Now, it's worth saying that not all value is captured by dollars, so we're only going to talk about the commercial stuff that we make; love, good health care, decent schooling, that's not captured by the same metric. But years ago, I went to Bangladesh on a consulting assignment for the University of Alberta, and it was a shock. People in Bangladesh work hard. They get up in the morning, go to work, pay attention, work eight hours, are diligent, care about what they do. But at the time I was there, Bangladesh gross domestic product per person was 1/50th that of Canada or the U.S. Now, why is that? Corruption is always a factor. It's the bane of developing countries. It's wolves shearing off the wealth. And the country's so corrupt they don't want to keep it in the country so it goes to Switzerland. So there's not a pool of capital to spend in the first place, but beyond that bad choices. We invested in stuff that in hindsight really turned out to be a bad idea. So get this right and you create wealth. Get this wrong and you lose it.
We're going to look at three techniques. We are going to look at calculating the return on investment, although I will more frequently use IRR, the internal rate of return. Those two labels are now used interchangeably. There's not a difference for them. And that is the primary technique used for saying, yes, we are going to go ahead. Anything from a $1 million project to the largest I was involved with was a $12 billion project that ended up being rejected because it didn't have a high enough internal rate of return. There are some cases where IRR does not work, and we're going to look at those as well. Mandatory investment. A regulator comes along and says there's a pollution problem, fix it or it we'll shut you down. You have some options for how to spend money, none of which are going to generate money for you. It's just the price of keeping your plan open. And so internal rate of return doesn't work there because there's no income, there's no cash coming in. We'll look at another discounted cash flow technique, least negative net present value. We'll look at times where a non-discounted number payback makes sense. Payback is how long does it take me to get my money back? And I'll say more about that in a bit.

03. Why This Instructor?

OK, why this instructor? I graduated as an engineer. I practiced engineering for a brief time. I was the 375th employee of a mineable oil sands project that had 5,000 employees two years later. If you had the least hint of management talent, you got vacuumed up into a management role, as I did. And so I continued in that, I got into some executive roles, and through the executive roles ended up serving on some boards, including the board of one publicly traded company. In all three of those roles, or three and a half, if you count the directorship, I did this, like both doing it and then reviewing it as I rose up in management. So this was a part of my life for 25 years.
In my mid-50s, I went back to the University of Alberta to teach management-related topics to engineers. And that included understanding financial statements and analyzing investment with discounted cash flow, and the material that we talk about here comes from that. All this had to be packed in a single course for engineers, so I wrote a textbook that would compress that material into that course. It's in the reference book list. I'm hoping that the material I present here is detailed enough that you don't need to go to that. But if you ever decide to, I don't make any money from that book. I waived royalties to keep the price of the book down and because I thought there was an ethical conflict for assigning a book you gained from. So it's there If you want more information on either of those topics.
Dr. Peter Flynn, "Financial Management for Engineers, 4th Edition"

04. The Fundamental Concept

OK, the fundamental concept is that money has a time value. A dollar in the future is not worth what a dollar today is. And we have a general knowledge of this. You don't need to take this course to have a gentle sense that that's true. When I was teaching this to undergraduates, I would say, I need some money. Give me $10, and I'll give you $20 tomorrow. And being students, they'd all think there's a trick that I'm going to embarrass myself, and so nobody ever raised their hand. So I said, listen, if you think this is a bad deal, I'll do it the other way around. I'll give you $10, and you give me $20 tomorrow. Because you don't need to be a genius to say, if I have a high likelihood of doubling my money in a day, this is good deal. It's not risk-free. I could die tonight. The student could take the chance and say, nah, I'm not gonna pay you, it was a dumb idea. But neither, well, first of all, it's not likely I'm going to die tonight. And I'm not going to risk my university career over $10, and the student's not going risk failing the course over $10. So there's a low risk chance to double your money in a day. You don't need to take a course to say do that. If I came along and said, give me $10 today, and I'll give you $20 15 years from now. Again, you don't need to take this course to say, I'm not gonna do that. The risk is way higher. You'd have to track me down. I might be on the other side, who knows. And, even beyond that, to give up that money for 15 years, it's not enough.
This gets at the concept of liquidity. Liquidity means how close is something to a dollar in my hand. And cash, cash in my bank that I can walk in and get out, cash in a short-term credit line that I can write a check on, cash, cash in my pocket, that is liquid. I may have a billion dollars of assets out in the field, but I can't pay a salary with that. I can't pay a supplier with that. And we use the word liquidity when companies are in trouble. They have a liquidity crisis, meaning no matter how much stuff they have, they can't pay the bills in the next 30 days. They can't meet payroll. That is a liquidity crisis. And liquidity is tied up with this time value of money. Now, if all the world presented investment decisions as simple as double your money in a day or double your in 15 years, you wouldn't need this course. But the real world is way more complex than that. We're a big user of electricity. Should we build a wind farm that is going to, when the wind blows, sell power into a grid, hoping to offset power that we take out of that grid? And the cost of the windmills we think is $422 million and this is what we think the price of power is going to be over 25 years because that's the expected life of those should we do this. That requires precision. You can't use double your money in a day to do that. And so we get to the magic equation. A very simple equation that I like to call the tail that wags the dog of the commercial world.

05. What is a Future Dollar Worth Today?

And that is this equation. It's two forms here. On the left-hand side, P equals F divided by 1 plus the time value of money raised to the n. F is a future dollar, P is the present value, n is the number of years or months or whatever compounding period you are looking at. And "i" is the time value of money. It has many names, and they're used interchangeably in this; discount rate, interest rate, return rate. We'll just float between those names for this.
Let me start with the right-hand side of this equation. It's the same equation; F = P*(1 + i)^n. When I was a kid, your grandma would send you money and you could go to a savings and loan association and get your first bank book. You're 12 or 13 years old and you're so proud and there was interest, let's say 4%. Well, grandma back then wasn't giving me $100, but I'll use $100 as an example. If I put that money in the savings loan, one year later, my bank balance will be $104. Wow! And then if I leave all that in there, it'll be 1.04 times $104. And if I leave it in a third... And that's all that equation is saying. That's a simple compounding equation. We are going to use the left hand variant of that the most. And we are going to, at different times, solve for what's the present value of future dollars that I expect. We're going to look at what's the future cost of present dollars that I get. But we will get to, towards the back half of the course, what is most important in industry, which is, if I spend money today to earn money in the future, or more accurately, if I spend cash today to get cash in the future, what am I earning on that? How good an investment is this? I mentioned payback. Payback you don't discount. You just say, when do I get my money back? So payback is going to be measured in time, typically years. So, I spend a million dollars and I bring in $200,000 of cash a year. My payback is 5 years. It takes me 5 years to get my money back. This was the way investment decisions were made back in Roman times because they didn't have fancy calculations. We will see that it still has a role today. It's a sanity check. Well, we do have an internal rate of return, but there were times when we're only going to use payback.
So we'll end this lesson here, and we will start next time with an application of one of these two equations that is the tail that wags the dog of the economic world. See you then.