Welcome back. We're going to talk about risk. And I have kind of held myself. I put myself under control not to get into this, because it would have bean too much to take it, unless you're familiar with the concept. And if you're already familiar with the concept application, you probably shouldn't be taking this class. So here's the big picture again. You know this formal. Please stare at it one more time. What are the ingredients of measuring value creation. We call value creation and PV I not is a cash flow in period one. Remember capital invested C1, C2, CC3 are your profits in the future? Are we also call the cash flows? Do they necessarily have to be profits? No. Can they be negative for a long period of time? Yes, that's what's happened to almost every company. Why? Because you initially do lose money, and you remember this is cash flows and you may actually encourage the company to invest more than another company that's not doing very well or doesn't have great ideas. So you may want to investors an investor through the company aggressively and therefore don't worry about cash was being negative in the long run, they have to be positive. Otherwise, why the heck would value be positive? One quick question. Can the value of a company every ever stock or a bond? We ever negative answers? No. And the reason is limited liability. So we almost always assumed that. So this is the formula. What are the basic two ingredients for conducting any kind of value creation assessment? And by the way, it's the same tools that you use to figure out NPV, is the stools you used to figure out PV, right? So if you want to evaluate an existing company like a lot of analysts do, the only missing piece of the Net piece. You just still are looking at future cash flows and figuring out the value. What are the two ingredients? Cash flows? Quick question. Who do they belong to? By the way, they don't belong to anybody. They belong to all of us in the sense of how the cash flows are created. But they belong to the project, the idea, the company. If the company, the projects in the idea, cannot reflect its cash flows, it's like saying I can't tell you who I am. What's my name? Where I'm coming from? How will anybody else be able to figure who I am out? So Castro's are the signature of the project? The valuation, however, depends very critically on the cost of capital, and all are examples. What did I do? Including the one last week? I gave you the cost of capital and if I remember correctly, it was, I believe, 12% when we were thinking about value creation. Where did you get that from? And who does it? Does it belong to? Let's answer the who does it belong to first and then pretty much the next two weeks, or actually even the week beyond that is about cost of capital. Who does this belong? Toe the market place are the competition. Therefore, all value creation is relative to the assessment of the competition. We assume that the law on price holds that are, if two things walked the same way, talk the same talk, have to have the same value, right? Approximately at least, we have spent some time on cash flows. I think we have spent a fair amount of time with one caveat. That accounting was the one thing I would encourage you to either learn on your own, and I've given you resources in the syllabus and so on. Or take a class. Take a class that will help you sort through making accounting statements into financial cash flows. But deeply understanding accounting in the same way like it's called financial statement analysis. And it can be very, very useful to you in their lives. We have also spent some time on two main sources of financing. Bond i.e debt, shares, i.e equity. And the reason we went there is not necessarily to understand financing, but for two reasons. One, you have a direct connection to this. You take loans, you may invest in stocks. As I keep saying, I wish more people had access to the resources in the world and the markets would be more phenomenon. However, the reason we did it in this class in the introductory class focused on value creation, you could have a introductory class focused on debt inequity. This class is based on value creation. We went there for one simple reason. We wanted to figure out the cost of capital. And the only way in the real world to actually figure it out practically is if you know how to value bonds and stocks. And one more piece risk. And I will understand what I mean as we go through this. So why risk in return? So we are after the cost of capital. The little are that's our goal. Why risk and return. So the first thing let me propose is that different ideas projects have different risks. I don't think this is anything new. I have discovered. How are you? This is life, right? Different things have different risks. Different returns. Let me ask you this. Have you looked at the Treasury Bill? Yep. Have you looked at the stop? Yes. Have you looked at the bond? They all have different returns. Let's just talk about what we just did in bond pricing, which is riskier. A long term bond by the government or shorter term? By the same government, long term. Because it's price fluctuates more, Which is more riskier Corporate bond or the government bond. Identical corporate. Why? Because the company promises to pay but may not be able to. Not because they're devious, but because there's just times do change, like has been happening last few years. Most people are risk averse, and hence returns on idea should be different, depending on their risks. This is very, very key towards we're going to talk about. I hope you agree with this that most people are discovers. In fact, it's been shown in experiments, and in reality I'll prove to you that that has to be the case. A fear risk covers. What's the problem? We don't like risk means in order to take on risk? What do I have to? Do I have to give you something that you like And that's something that you like. It's called Wrister. Okay? We therefore need to understand very critically because we're after return. We have to understand risk. Not only do we have to understand risk because that's the one thing that determines return. We also want to know how to measure it. That's why I love finance. It is so awesome that it just doesn't talk about a concept. There's a practical way of measuring it as long as their market. And that's what's so cool about it, is that it's so intuitive. Get measurable, get riel not perfect. Nothing is perfect. Only love is perfect. That's why finances number two okay? We then need to understand and measure the relationship between risk and return on different ideas to be able to figure out what the heck is that little are. Remember, you have your cash flows belonging to you. Your project. You've done your analysis, but the return that you need to discount those cash flows or evaluate your project comes from the competition. But the competition has different risks, right? So your competition should have a similar risk to you. That's the key element, right? Otherwise, apples and oranges. So we need to understand how to measure that risk. But then, what's most challenging in some senses after you understood that you should be able to translate it into a return that you can use to evaluate your project. It's called discounting because the return is usually positive. Got it? That's our goal valuing orange. So let's set it up in the context off a company and idea of whatever. We want to evaluate an idea/project/ firm that's launching a you phone you pad, And given its exceptional originality, we will call it orange and this is what the goal is. Okay? I hope you like this because my sense of humor is so bad that I tend to laugh at my own jokes. But then I'm a happy guy. And that's one thing you want to know in life. If you're happy with yourself, the world will take care of itself. Okay, so be cool. We have projected our cash flows. So you haven't learned enough in this class to say okay, I need to know my future revenues. I need to know my cost of goods sold. I need to know SGN s sales, selling, administration, costs, depreciation. Even though it's not a cash flow. Then I have to add it back. And then I have to worry about capital expenditures and working capital. Look, it's not that difficult. Captured most of it, except one thing I conveniently forgot. You have to pay taxes along the way. That's why you subtract appreciation and then added back. It helps reduce your taxes. How do you determine the cost of capital? Remember, the reason you're going to figure out the cost of capital and you're going to figure it out from comparable same risk, same business. Same risk is because of the law on price and because all valuation is relative, nothing is absolute. All value creation is incremental and on all values relative. Okay? A fundamental problem. By the way, I'm going to I think it's best you take a break right now because you understand what we're trying to achieve one more time. We're trying to figure out the cost of capital off a company that has just started or planned to start called Orange. And we now need to figure out How do I discount my cash flows to figure out whether than NPV is positive or not? Is this a value creating entity or not? So before we try to solve a fundamental problem that's posed by the real world, let's take a break and we'll come back because the beginning of this class is a little bit intense. This class, structurally is more intense. By that, I mean pure opportunities to do number crunching for two reasons. One, I'm setting up the problem. Why the heck are we worried about risk in return? And you need to relate to that? The second reason is, that I'm going to jump into statistics because I have to. And I cannot assume that statistics. I will not. However, I cannot teach you all of statistics that even the statistics that we need I cannot. It's a class on its own, but I feel unlike accounting, which is a language which you have to learn and understand. Statistics is a conceptually driven thing. I'll teach you enough, and with Excel and some practice problems, you can keep up to pace. But the class itself is going to be thinking concept. I will, because slowly, but it's very important you get it before you do it. Okay, let's take parts. Come back in a minute.
