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The discount rate, as we said before this is in general the, the cost of capital.

We're going to discuss a little bit later that there might be exceptions to this.

So more often than not, we can think of this as the cost of capital for

companies that are operating just one country, or

companies that have only one division, or manufacture only one specific product of

service the cost of capital is a typical discount rate.

Now, there's a question again that we threw a couple times already at the end of

last session and at the beginning of this one.

What happens if you operate in many different countries or

you have many different divisions?

Then there's a question to be made here whether we need different discount rates

for different countries and different divisions.

And again we'll deal with that a little bit later on,

but for now we can think of that discount rate as being the cost of capital.

And whether it is the cap, the cost of capital or not what, what stands clear

is that, that discount rate is always going to be positively related to risk.

And that basically means that the riskier the investment that we have or

the riskier the company for which we're evaluating this project,

then the higher that discount rate is going to be, and

everything else equal the lower the net price in value is going to be.

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The idea of discounting, well we already discussed this.

There's two reasons for discounting, and

it's important that you keep both of them in mind.

We typically think of discounting whenever you see a present value expression or

a net present value expression, and let me open a quick parenthesis here.

The only difference between a present value and a net present value is

that initial cash flow, the CF 0 that you're seeing in the expression.

And remember, some people called it net simply because they take out, or

that they actually include,

the initial investment that you need to make in order to forecast the project.

So, you know, if you were only discounting what you expect to get out of

this project, then that typically is something that we

call the present value of all the cash flows that we expect to get.

But if we actually take into account the initial investment that we need to expect

those cash flows, then many people would call that the net present value.

At the end of the day, there's not a whole lot of difference but

because the tool is typically known as NPV or

net present value, that's the name that that we're going to use.

So press in val unit, press in value for our purposes is indistinguishable in

terms that what we really care about is foreseeing all the money that needs to

go out of the company and all the money that is expected to come into the company.

But back now to the issue of discounting.

Most people focus on discounting because of the passage of time.

That is, the further away you get those dollars,

then the higher the discount rate that you need to apply.

And that is perfectly correct.

But there's one other thing that we mentioned before and you do need to

keep into account that is a reason for discounting, and that is risk, right.

Remember if you look at the expression once again of the NPV the higher excuse me

the further away the cash flow, then the higher it's going to be the discount rate,

because the higher is the power at which we're raising 1 plus DR 2, 3,

4 all the way to T.

But also, the higher risk of the company,

the higher the require return, and the higher is going to be the discount rate.

So there's two reasons, not just one, two reasons for discounting.

One, is because we're not getting all the cash flows at the same time.

And two, because risk matters.

And the riskier the investment opportunity everything else equal,

then the lower will be the NPV.

So keep that in mind,

because there are two, not just one, reason for, for discounting.

As for the rule, the rule is kind of straightforward.

What are we doing when we discount?

Well, we're basically bringing future dollars into current value.

So if I discount, properly discount, adjusting by time and

by risk a dollar that I expect to get a year from now, when I

discount that I'm basically I'm expressing that dollar in today's currency.

And so now we can compare the money that we need to

put down today with the present value of the money I expect to get in the future.

So now instead of comparing dollars today and

dollars a year from now, which would be like comparing apple and

oranges, we're actually comparing apples and apples after the proper discounting.

So after discounting all the cash flow, what we're doing is

expressing all the future cash flows in current and present value.

And now when we actually aggregate all these numbers,

then we say something very simple.

Look, if the net inflows and outflows of cash out of this company is positive,

then we're going to invest in the project.

In other words, the net press in values project, it, it's positive, go for

this project and if the net present value is negative, then do not go for, for

this project.

But you can only do that after properly adjusting all the expected cash

flows by when are you going to get them and

by the risk of expecting those cash flows in the future.

But having done that, the rule is very simple.

If you get a positive NPV, you should go ahead with the project.

If you get a negative NPV you should not go ahead with this with this project.

5:30

One more thing on this.

What happens if you're comparing more than one project?

Lets suppose that your capital is restricted and

you have two projects in ways that initially the investment is more or

less the same but the expected cash flows are different.

The discount rate may be different too, and

therefore you end up with different net present values.

Well, the rule, as you might imagine, actually extends in a very simple way.

And the way that the rule extends is simply that, you know,

the higher the net present value, then the more you want to invest in a project.

So if you're comparing project a and

project b and you can only invest in either one or the other.

That's the, the, the standard definition of competing projects,

is not that you can invest, invest in both, but you can invest in either one or

the other, then you're going to invest in one, in the one with the higher MPV.

And that is another way of saying that, you know, the net of all the money

coming in and all the money coming out, properly adjusted by risk and

properly adjusted by when you're getting those cash flows,

well one has a higher value for the company than the other.

So, the rule for one individual project is very clear, positive or

negative NPV, you go or don't go for this project.

If you're evaluating competing projects, the higher than that

present value the more you want to invest in a project compared to all the others.

So, NPV there of project A higher than NPV or project B, then you go for project A.

And, and one final thing before, because we're going to look at an example and

then I think it's going to look a little bit simpler than it really is in

real life, is highlighting once again when you look at that formula, the NPV,

it doesn't look all that complicated.

If you're evaluating a long-term project it might be a messy calculation

about that seed.

You throw the numbers into Excel, and

Excel will give you the NPV in the blink of an eye.

So, so that's not really the problem.

The problem in real life, once again, and that is something important for

you to keep in mind, is foreseeing what those cash flows are going to be.

That is the key of determining properly what the NPV actually is.

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