WEBVTT 00:00:00.090 --> 00:00:02.430 The following content is provided under a Creative 00:00:02.430 --> 00:00:03.820 Commons license. 00:00:03.820 --> 00:00:06.030 Your support will help MIT OpenCourseWare 00:00:06.030 --> 00:00:10.150 continue to offer high quality educational resources for free. 00:00:10.150 --> 00:00:12.690 To make a donation, or to view additional materials 00:00:12.690 --> 00:00:16.620 from hundreds of MIT courses, visit MIT OpenCourseWare 00:00:16.620 --> 00:00:17.830 at ocw.mit.edu. 00:00:26.354 --> 00:00:27.770 ANDREW LO: What I want to do today 00:00:27.770 --> 00:00:31.910 is to continue where we left off last time in talking 00:00:31.910 --> 00:00:34.400 about the capital asset pricing model, 00:00:34.400 --> 00:00:36.050 and we're going to finish that off 00:00:36.050 --> 00:00:37.770 in the next 15 or 20 minutes. 00:00:37.770 --> 00:00:41.120 And then, I'm going to turn to applications of the capital 00:00:41.120 --> 00:00:42.170 asset pricing model. 00:00:42.170 --> 00:00:45.350 In particular, I want to focus on capital budgeting. 00:00:45.350 --> 00:00:48.380 That's going to be the last major topic we take on 00:00:48.380 --> 00:00:49.740 for this course. 00:00:49.740 --> 00:00:52.589 So let me finish the capital asset pricing model 00:00:52.589 --> 00:00:54.380 and then I'll talk a little bit about where 00:00:54.380 --> 00:00:58.670 we're going to go for the remainder of the lectures. 00:00:58.670 --> 00:01:01.820 You remember last time where we left off was, 00:01:01.820 --> 00:01:05.600 I decided to estimate the CAPM relationship for a couple 00:01:05.600 --> 00:01:08.660 of stocks, Biogen and Motorola. 00:01:08.660 --> 00:01:14.720 And we found that the estimated alphas, the deviations 00:01:14.720 --> 00:01:16.790 from the CAPM, were pretty sizable 00:01:16.790 --> 00:01:18.780 for both of these companies. 00:01:18.780 --> 00:01:20.990 And the interpretation is either, 00:01:20.990 --> 00:01:25.460 wow these companies are really exceptional values, 00:01:25.460 --> 00:01:27.920 they offer investors much, much larger 00:01:27.920 --> 00:01:32.360 expected return than justified by the appropriate market 00:01:32.360 --> 00:01:33.260 betas. 00:01:33.260 --> 00:01:36.050 That's one interpretation, or the other interpretation 00:01:36.050 --> 00:01:39.380 is there something missing with the CAPM. 00:01:39.380 --> 00:01:42.650 The CAPM doesn't quite capture all 00:01:42.650 --> 00:01:45.830 of the risks that are giving you these kinds of expected 00:01:45.830 --> 00:01:47.130 rates of return. 00:01:47.130 --> 00:01:49.970 So I'm going to come back to that debate 00:01:49.970 --> 00:01:51.480 in just a few minutes. 00:01:51.480 --> 00:01:55.040 But I thought, that to continue along these lines, let's 00:01:55.040 --> 00:01:59.120 explore a little bit about the goodness of fit 00:01:59.120 --> 00:02:00.080 of these measures. 00:02:00.080 --> 00:02:03.230 Now, I mentioned last time that the R-squareds, 00:02:03.230 --> 00:02:08.990 as a measure of goodness of fit, was 17.5 percent for Biogen 00:02:08.990 --> 00:02:12.950 and 33% for Motorola. 00:02:12.950 --> 00:02:15.980 Both of which are reasonably representative 00:02:15.980 --> 00:02:18.740 of the kind of goodness of fit measures 00:02:18.740 --> 00:02:21.050 that you're going to see with financial data, 00:02:21.050 --> 00:02:24.470 for the simple reason that financial data is very noisy. 00:02:24.470 --> 00:02:26.990 And so you're not going to get any single theory that 00:02:26.990 --> 00:02:31.640 can explain 99.9 percent of the fluctuations 00:02:31.640 --> 00:02:33.440 in any kind of financial series. 00:02:33.440 --> 00:02:38.120 So here's a plot of Biogen versus the market. 00:02:38.120 --> 00:02:41.000 Now the market, as I reminded you last time, 00:02:41.000 --> 00:02:43.580 is the valuated return, including 00:02:43.580 --> 00:02:47.390 dividends, of all stocks on the NYSE, Amex, and NASDAQ. 00:02:47.390 --> 00:02:50.480 So this market portfolio, you can 00:02:50.480 --> 00:02:55.430 think of as being a broader version than the S&P 500, 00:02:55.430 --> 00:02:57.510 but it's meant to capture the market. 00:02:57.510 --> 00:03:01.370 So this is a plot of Biogen versus the market. 00:03:01.370 --> 00:03:05.690 And you can see that there is some slope that 00:03:05.690 --> 00:03:08.930 fits this scatter of points, and of course the equation 00:03:08.930 --> 00:03:14.750 is 1.42 times the market, minus a particular value 00:03:14.750 --> 00:03:18.440 for the alpha, and then R-squared of about 33% 00:03:18.440 --> 00:03:21.350 over this particular sample period. 00:03:21.350 --> 00:03:25.380 So there is a line that goes through these points, 00:03:25.380 --> 00:03:28.280 but it's not a perfect straight line by any means. 00:03:28.280 --> 00:03:30.620 You can see there's a scatter. 00:03:30.620 --> 00:03:34.460 And so there's a tendency for Biogen 00:03:34.460 --> 00:03:36.470 to move together with the market, 00:03:36.470 --> 00:03:40.610 but it's not a perfect linear relationship by any means. 00:03:40.610 --> 00:03:43.700 That's why the R-squared is not 100%. 00:03:43.700 --> 00:03:47.480 It's because we're not able to explain all of the fluctuations 00:03:47.480 --> 00:03:49.220 with a simple linear relationship. 00:03:49.220 --> 00:03:51.420 Life is more complicated than that, 00:03:51.420 --> 00:03:54.800 and so the CAPM is really just an approximation 00:03:54.800 --> 00:03:57.000 to a much more complex reality. 00:03:57.000 --> 00:04:02.780 Now, a particular stock has a lot of idiosyncratic risk. 00:04:02.780 --> 00:04:06.350 That's what we talked about last time as the dancing 00:04:06.350 --> 00:04:10.070 the Irish jig on that catwalk when you're window 00:04:10.070 --> 00:04:12.020 washing on these skyscrapers. 00:04:12.020 --> 00:04:15.590 So you can see that that idiosyncratic risk is really 00:04:15.590 --> 00:04:17.370 quite significant. 00:04:17.370 --> 00:04:21.680 What happens if we plot, not Biogen against the market, 00:04:21.680 --> 00:04:25.550 but another market portfolio against the market. 00:04:25.550 --> 00:04:27.010 like let's say NASDAQ. 00:04:27.010 --> 00:04:30.180 Well, the next plot shows you. 00:04:30.180 --> 00:04:33.430 Look at NASDAQ versus the market as a whole. 00:04:33.430 --> 00:04:37.410 Now NASDAQ, as you know, tends to have smaller stocks, stocks 00:04:37.410 --> 00:04:41.970 that seem to be technology oriented, and as a result 00:04:41.970 --> 00:04:44.380 NASDAQ might be more volatile. 00:04:44.380 --> 00:04:48.480 But nevertheless, there is a very strong common relationship 00:04:48.480 --> 00:04:52.630 between these two market indexes. 00:04:52.630 --> 00:04:54.360 And so now, look at this. 00:04:54.360 --> 00:04:56.160 Scatter of points is a lot tighter. 00:04:56.160 --> 00:04:57.510 Right? 00:04:57.510 --> 00:05:01.816 Still, it's not exactly linear, but comparing this to that, 00:05:01.816 --> 00:05:02.940 you can see the difference. 00:05:02.940 --> 00:05:03.439 Right? 00:05:03.439 --> 00:05:05.550 There was a stronger relationship here. 00:05:05.550 --> 00:05:08.520 And not surprisingly, when you put securities 00:05:08.520 --> 00:05:13.559 into a portfolio, what gets averaged out? 00:05:13.559 --> 00:05:14.350 AUDIENCE: Outliers. 00:05:14.350 --> 00:05:17.590 ANDREW LO: Exactly, the outliers, and what else? 00:05:17.590 --> 00:05:18.830 What other component? 00:05:18.830 --> 00:05:19.330 Leland. 00:05:19.330 --> 00:05:20.500 AUDIENCE: The idiosyncratic risk. 00:05:20.500 --> 00:05:21.291 ANDREW LO: Exactly. 00:05:21.291 --> 00:05:25.090 The Idiosyncratic risk, The unusual stock 00:05:25.090 --> 00:05:28.974 specific kinds of randomness that gets averaged out. 00:05:28.974 --> 00:05:30.640 So not surprisingly, when you put things 00:05:30.640 --> 00:05:35.830 into portfolios the noise, or the idiosyncratic risks average 00:05:35.830 --> 00:05:43.020 out and what you're left with is whatever common factors remain. 00:05:43.020 --> 00:05:46.090 So I'm going to show you some evidence for how well, 00:05:46.090 --> 00:05:48.970 or how poorly the CAPM works by looking 00:05:48.970 --> 00:05:50.590 not at individual stocks, because we 00:05:50.590 --> 00:05:52.715 know there's a lot of noise with individual stocks. 00:05:52.715 --> 00:05:55.060 I want to show you what happens when you put stocks 00:05:55.060 --> 00:05:59.680 into portfolios and you look at how those portfolios do. 00:05:59.680 --> 00:06:03.280 So let's do one simple example, market cap portfolios. 00:06:03.280 --> 00:06:06.940 Let's take a look at small stocks and big stocks. 00:06:06.940 --> 00:06:10.340 Remember at the introduction of this series of lectures, 00:06:10.340 --> 00:06:12.400 I showed you some empirical evidence 00:06:12.400 --> 00:06:16.330 that illustrated the fact that small stocks seem 00:06:16.330 --> 00:06:21.940 to do really well relative to large stocks, the size anomaly. 00:06:21.940 --> 00:06:24.610 So let's now take the size anomaly 00:06:24.610 --> 00:06:26.530 and look at it through the lens of the CAPM 00:06:26.530 --> 00:06:28.540 and ask the question, with the CAPM 00:06:28.540 --> 00:06:33.071 can we explain the difference between small and large? 00:06:33.071 --> 00:06:33.570 OK. 00:06:33.570 --> 00:06:35.640 Well, let's take a look. 00:06:35.640 --> 00:06:41.220 Over the 40 years from 1960 to 2000, 00:06:41.220 --> 00:06:45.990 approximately, we see that the small stock portfolio, 00:06:45.990 --> 00:06:50.280 the smallest decile, the smallest tenth of stocks, 00:06:50.280 --> 00:06:54.030 in terms of market cap, as a group, as a portfolio, 00:06:54.030 --> 00:06:59.790 had an average monthly return of 1.33% and a beta of 1.4. 00:06:59.790 --> 00:07:02.400 On the other hand, the large stock portfolio 00:07:02.400 --> 00:07:08.890 had an average monthly return of 0.9% and a beta of 0.94. 00:07:08.890 --> 00:07:11.530 So that seems like it's sort of consistent. 00:07:11.530 --> 00:07:15.520 Lower risk, lower expected return, but let's plug it in 00:07:15.520 --> 00:07:19.990 and see if the CAPM relationship actually can tell us something. 00:07:19.990 --> 00:07:25.630 So the expected return of the stock, according to the CAPM, 00:07:25.630 --> 00:07:28.510 is going to be given by the risk free rate, plus beta, 00:07:28.510 --> 00:07:31.607 multiplied by the market risk premium over the sample period 00:07:31.607 --> 00:07:32.440 that I'm looking at. 00:07:32.440 --> 00:07:34.939 The market risk premium is about a half a percent per month. 00:07:34.939 --> 00:07:38.500 So roughly 6% a year. 00:07:38.500 --> 00:07:42.640 And the risk free rate is also about a half a percent 00:07:42.640 --> 00:07:45.970 per month during this time period. 00:07:45.970 --> 00:07:49.960 So now, let's ask the question, what 00:07:49.960 --> 00:07:53.140 is the expected return of a large stock portfolio? 00:07:53.140 --> 00:07:55.390 Well according to this, it should 00:07:55.390 --> 00:07:59.760 be 93 basis points per month. 00:07:59.760 --> 00:08:01.380 What about the small stock portfolio? 00:08:01.380 --> 00:08:06.880 According to this, it should be 1.16% per month. 00:08:06.880 --> 00:08:10.140 Now, this is an amazingly good fit, 00:08:10.140 --> 00:08:15.090 so I wouldn't take this as typical in the finance 00:08:15.090 --> 00:08:15.990 literature. 00:08:15.990 --> 00:08:19.230 But it just so happens that over this 40 year period, 00:08:19.230 --> 00:08:21.870 the CAPM actually works pretty darn well. 00:08:21.870 --> 00:08:27.540 0.99 is the average realize return and 0.93 is 00:08:27.540 --> 00:08:29.070 what was predicted. 00:08:29.070 --> 00:08:34.080 For the small cap portfolio, 1.33 is what was realized 00:08:34.080 --> 00:08:37.320 and 1.16 was what was predicted. 00:08:37.320 --> 00:08:38.809 So that's pretty good. 00:08:38.809 --> 00:08:41.240 Now, I want to emphasize the point 00:08:41.240 --> 00:08:43.669 that this is really good because, let's take 00:08:43.669 --> 00:08:47.630 a look at other ways of dividing up the universe 00:08:47.630 --> 00:08:50.390 and seeing whether or not we can get a better explanation 00:08:50.390 --> 00:08:53.280 of risk and expected return. 00:08:53.280 --> 00:08:57.410 Here's a picture of size sorted portfolios along the security 00:08:57.410 --> 00:08:57.960 market line. 00:08:57.960 --> 00:08:59.660 So remember, security market line 00:08:59.660 --> 00:09:03.110 is a graph of beta and expected return. 00:09:03.110 --> 00:09:03.890 Right? 00:09:03.890 --> 00:09:07.010 The security market line applies to all portfolios 00:09:07.010 --> 00:09:09.140 and securities, unlike the capital market 00:09:09.140 --> 00:09:12.500 line that applies only to efficient portfolios 00:09:12.500 --> 00:09:13.640 and securities. 00:09:13.640 --> 00:09:16.500 So in this case, we expect a linear relationship. 00:09:16.500 --> 00:09:20.300 And with the exception of this little outlier up here. 00:09:20.300 --> 00:09:23.510 From 1960 to 2001 there was actually 00:09:23.510 --> 00:09:28.580 a pretty reasonable relationship between beta and expected 00:09:28.580 --> 00:09:29.120 return. 00:09:29.120 --> 00:09:33.140 In other words, the CAPM looks like it's actually doing OK 00:09:33.140 --> 00:09:35.030 for size sorted portfolios. 00:09:35.030 --> 00:09:38.300 The higher the beta, the higher the expected return. 00:09:38.300 --> 00:09:41.270 The lower the beta, the lower the expected return 00:09:41.270 --> 00:09:43.550 for size sorted portfolios. 00:09:43.550 --> 00:09:45.770 Now, what about for beta sorted portfolios? 00:09:45.770 --> 00:09:47.390 Suppose you took a bunch of portfolio 00:09:47.390 --> 00:09:50.240 and grouped them into beta's and asked the question, 00:09:50.240 --> 00:09:53.440 do the high beta portfolios have higher expected return? 00:09:53.440 --> 00:09:55.740 Low betas have low expected return? 00:09:55.740 --> 00:09:58.880 It turns out that, again you get a reasonable relationship. 00:09:58.880 --> 00:10:02.420 Not exactly what ' would expect according to the CAPM. 00:10:02.420 --> 00:10:04.220 So the slope of this line, remember, 00:10:04.220 --> 00:10:08.060 is going to be given by the risk premium, the market risk 00:10:08.060 --> 00:10:09.350 premium. 00:10:09.350 --> 00:10:13.040 In fact, the realized relationship looks linear, 00:10:13.040 --> 00:10:15.080 but it's at a slightly different slope. 00:10:15.080 --> 00:10:18.189 It doesn't look like the risk premium is the right slope, 00:10:18.189 --> 00:10:19.730 something a little bit less than that 00:10:19.730 --> 00:10:21.390 seems to be the right slope. 00:10:21.390 --> 00:10:24.680 And it turns out that in 15.433, you're 00:10:24.680 --> 00:10:27.020 going to learn a new theory of the CAPM 00:10:27.020 --> 00:10:30.980 that was developed by Fisher Black called the Balck CAPM. 00:10:30.980 --> 00:10:35.750 And the Black CAPM says that there is no risk-free rate. 00:10:35.750 --> 00:10:37.790 In fact, what you ought to be using 00:10:37.790 --> 00:10:40.490 is the rate of return of something called a zero beta 00:10:40.490 --> 00:10:41.390 portfolio. 00:10:41.390 --> 00:10:43.970 Well it turns out that if you do that, you would actually 00:10:43.970 --> 00:10:47.630 get a line that fits this line almost exactly. 00:10:47.630 --> 00:10:50.300 So the Black Zero-Beta CAPM seems 00:10:50.300 --> 00:10:53.900 to be a better approximation, but for now the CAPM 00:10:53.900 --> 00:10:56.660 is actually a pretty reasonable first approximation, 00:10:56.660 --> 00:10:59.980 so let's finish off that first and I'll come back to the Black 00:10:59.980 --> 00:11:02.010 Zero-Beta CAPM in a minute. 00:11:02.010 --> 00:11:02.600 OK. 00:11:02.600 --> 00:11:05.390 So this is a plot of the expected return 00:11:05.390 --> 00:11:07.460 of beta sorted portfolios. 00:11:07.460 --> 00:11:10.190 Higher beta, higher average return. 00:11:10.190 --> 00:11:12.050 Lower beta, lower average return. 00:11:12.050 --> 00:11:15.960 So it seems like a CAPM is actually pretty reasonable. 00:11:15.960 --> 00:11:21.050 I'm not perfect, but it gets at the heart 00:11:21.050 --> 00:11:23.851 of what risk really means. 00:11:23.851 --> 00:11:25.350 Now in order to emphasize the point, 00:11:25.350 --> 00:11:27.570 let me show you a couple of other graphs. 00:11:27.570 --> 00:11:30.930 This is volatility sorted portfolios. 00:11:30.930 --> 00:11:35.160 So now, I'm sorting stocks based upon their total volatility, 00:11:35.160 --> 00:11:36.630 not just their beta. 00:11:36.630 --> 00:11:41.220 Remember, the beta measures a part of their total volatility. 00:11:41.220 --> 00:11:42.150 Right? 00:11:42.150 --> 00:11:45.510 The beta is the systematic component of the risk. 00:11:45.510 --> 00:11:50.590 Volatility is the entire amount of risk of a security. 00:11:50.590 --> 00:11:54.640 If you use volatility as a way of sorting stocks, 00:11:54.640 --> 00:11:58.160 then look at the expected rate of return. 00:11:58.160 --> 00:12:00.820 There is no systematic relationship 00:12:00.820 --> 00:12:04.120 between volatility and return. 00:12:04.120 --> 00:12:08.900 The higher the volatility, you don't get necessarily the 00:12:08.900 --> 00:12:10.890 higher the return. 00:12:10.890 --> 00:12:15.800 So in other words, volatility is not the right measure 00:12:15.800 --> 00:12:17.900 of the risk reward trade-off. 00:12:17.900 --> 00:12:20.660 One of the first things I talked to you about in this course 00:12:20.660 --> 00:12:23.180 is that, if we've learned anything in modern finance 00:12:23.180 --> 00:12:26.010 we've learned that you don't get something for nothing, 00:12:26.010 --> 00:12:29.000 and in particular, if you are gonna bear more risk, 00:12:29.000 --> 00:12:32.180 you have to be paid to bear more risk, 00:12:32.180 --> 00:12:34.430 but you have to define risk appropriately. 00:12:34.430 --> 00:12:38.510 In this case this diagram shows that volatility is not 00:12:38.510 --> 00:12:39.710 the right measure of risk. 00:12:39.710 --> 00:12:43.640 You might have to bear more volatility for whatever reason, 00:12:43.640 --> 00:12:45.990 but you won't always get rewarded. 00:12:45.990 --> 00:12:46.490 Right? 00:12:46.490 --> 00:12:49.760 Because volatility is not the relevant measure 00:12:49.760 --> 00:12:52.920 of risk from the capital markets point of view. 00:12:52.920 --> 00:12:55.640 What you get rewarded for is the risk that you cannot get rid 00:12:55.640 --> 00:13:00.500 of by diversification and that kind of risk is not sigma, 00:13:00.500 --> 00:13:01.755 it's beta. 00:13:01.755 --> 00:13:05.620 So beta, you do get rewarded. 00:13:05.620 --> 00:13:09.130 Sigma, you do not get rewarded necessarily. 00:13:09.130 --> 00:13:10.150 Right? 00:13:10.150 --> 00:13:13.360 Higher risk does not mean necessarily higher 00:13:13.360 --> 00:13:16.150 expected rates of return when you measure risk 00:13:16.150 --> 00:13:17.620 with volatility. 00:13:17.620 --> 00:13:20.710 Higher risk in the form of beta does 00:13:20.710 --> 00:13:23.770 seem to be associated with higher 00:13:23.770 --> 00:13:25.680 expected rates of return. 00:13:25.680 --> 00:13:26.610 OK. 00:13:26.610 --> 00:13:29.260 Now, in the most recent literature 00:13:29.260 --> 00:13:31.153 there have been-- oh, question? 00:13:31.153 --> 00:13:33.880 AUDIENCE: So if I remember the definition of volatiility-- 00:13:33.880 --> 00:13:36.375 or based [INAUDIBLE],, it's a ratio of two 00:13:36.375 --> 00:13:37.600 standard deviations, right? 00:13:37.600 --> 00:13:42.050 ANDREW LO: Beta is the ratio of a covariance to the variance. 00:13:42.050 --> 00:13:43.900 It's not the ratio of standard deviations. 00:13:43.900 --> 00:13:46.780 In the case of an efficient portfolio, 00:13:46.780 --> 00:13:48.715 it's the ratio of two standard deviations. 00:13:52.180 --> 00:13:55.150 Other questions? 00:13:55.150 --> 00:13:55.890 OK. 00:13:55.890 --> 00:13:58.050 So what I'm going to tell you now 00:13:58.050 --> 00:14:00.600 is about the most current research. 00:14:00.600 --> 00:14:02.730 The most current research suggests 00:14:02.730 --> 00:14:08.160 that, while beta does seem to have some impact on explaining 00:14:08.160 --> 00:14:12.120 expected returns, there are other factors out there 00:14:12.120 --> 00:14:14.820 that seem to contribute to that explanation. 00:14:14.820 --> 00:14:16.920 In other words, the CAPM, while it's 00:14:16.920 --> 00:14:22.300 a very interesting and compelling first approximation, 00:14:22.300 --> 00:14:24.880 it is only an approximation. 00:14:24.880 --> 00:14:28.480 There are other factors, like book to market, 00:14:28.480 --> 00:14:31.660 like liquidity, like trading volume, 00:14:31.660 --> 00:14:35.980 that seems to also add to the explanatory power 00:14:35.980 --> 00:14:37.990 of these kinds of relationships. 00:14:37.990 --> 00:14:41.020 So what we're at today is that we 00:14:41.020 --> 00:14:44.050 think there are multiple betas out there, not just 00:14:44.050 --> 00:14:45.770 one market beta. 00:14:45.770 --> 00:14:49.480 So the basic vanilla flavored theory of finance, 00:14:49.480 --> 00:14:51.760 and what you're going to be learning how to use over 00:14:51.760 --> 00:14:54.490 the next few lectures remaining in this course, 00:14:54.490 --> 00:14:58.420 is the single beta CAPM. 00:14:58.420 --> 00:15:00.660 But where we are at the cutting edge of research, 00:15:00.660 --> 00:15:03.460 or some would argue the bleeding edge of research, 00:15:03.460 --> 00:15:07.240 is that there are multiple betas out there, multiple sources 00:15:07.240 --> 00:15:09.830 of common risk. 00:15:09.830 --> 00:15:11.290 So it's not just the market risk, 00:15:11.290 --> 00:15:15.550 that is by far the biggest, but there is liquidity risk, 00:15:15.550 --> 00:15:19.400 there is currency risk, there is term structure risk, 00:15:19.400 --> 00:15:23.560 there is a variety of risks that cannot be diversified away with 00:15:23.560 --> 00:15:28.090 a large portfolio of very, very different kinds of assets. 00:15:28.090 --> 00:15:31.720 And So a better version of the CAPM, one 00:15:31.720 --> 00:15:35.800 that you might use if you are becoming an expert in finance 00:15:35.800 --> 00:15:39.760 theory, is to try to identify other sources of betas, 00:15:39.760 --> 00:15:43.360 other sources of expected return that have risks attached 00:15:43.360 --> 00:15:46.390 to them and to use these multiple factors 00:15:46.390 --> 00:15:49.050 in your analysis. 00:15:49.050 --> 00:15:52.660 So these are some references that you can take a look at, 00:15:52.660 --> 00:15:57.510 but the fact is that the CAPM is used, almost universally, 00:15:57.510 --> 00:16:03.900 among portfolio managers, among venture capitalist, and project 00:16:03.900 --> 00:16:06.670 managers, and chief financial officers. 00:16:06.670 --> 00:16:10.230 So the CAPM is a very, very powerful framework 00:16:10.230 --> 00:16:13.260 for thinking about risk and return. 00:16:13.260 --> 00:16:16.230 And so it's important to understand it, but just 00:16:16.230 --> 00:16:19.800 keep in mind that like any other finance theory 00:16:19.800 --> 00:16:23.010 it's just a theory, its just meant to be an approximation 00:16:23.010 --> 00:16:25.399 to a much more complex reality. 00:16:25.399 --> 00:16:26.690 So what we're going to do now-- 00:16:26.690 --> 00:16:29.385 Yeah, question. 00:16:29.385 --> 00:16:31.176 AUDIENCE: Would the other betas always have 00:16:31.176 --> 00:16:33.636 to be associated with like some kind of market 00:16:33.636 --> 00:16:35.604 portfolio or some representative portfolio, 00:16:35.604 --> 00:16:38.556 or do they just track a defaulted [INAUDIBLE] 00:16:38.556 --> 00:16:40.040 or something like that. 00:16:40.040 --> 00:16:42.456 ANDREW LO: So that's a great question, let me repeat that. 00:16:42.456 --> 00:16:46.820 The question is, does factors that are useful for the CAPM 00:16:46.820 --> 00:16:49.160 always have to be associated with some kind 00:16:49.160 --> 00:16:52.490 of a tradable market portfolio, or index, 00:16:52.490 --> 00:16:55.580 or can it be some other factor, like macroeconomic like 00:16:55.580 --> 00:16:56.900 unemployment? 00:16:56.900 --> 00:17:00.950 Well, there's a big difference between factors 00:17:00.950 --> 00:17:03.770 that are economically relevant and factors 00:17:03.770 --> 00:17:05.540 that are financially relevant, and let 00:17:05.540 --> 00:17:07.069 me explain the difference. 00:17:07.069 --> 00:17:08.869 Factors that are economically relevant 00:17:08.869 --> 00:17:12.950 may well explain the returns of certain securities. 00:17:12.950 --> 00:17:15.319 A good case in point is unemployment. 00:17:15.319 --> 00:17:17.270 Unemployment is a factor that does 00:17:17.270 --> 00:17:21.470 seem to have some explanatory power for stock market returns. 00:17:21.470 --> 00:17:24.260 The reason that we don't focus on those kinds of factors 00:17:24.260 --> 00:17:26.690 from a financial decision making point of view 00:17:26.690 --> 00:17:30.890 is that while they may identify interesting economic 00:17:30.890 --> 00:17:34.250 relationships between certain parts of one 00:17:34.250 --> 00:17:37.070 part of the economy and other, it doesn't really 00:17:37.070 --> 00:17:39.870 allow you to make any kind of market decisions. 00:17:39.870 --> 00:17:42.510 In other words, if you can't trade it, 00:17:42.510 --> 00:17:44.190 then you can't manage it. 00:17:44.190 --> 00:17:46.880 So from the perspective of financial applications, 00:17:46.880 --> 00:17:49.580 most of the factor models that you will see 00:17:49.580 --> 00:17:52.130 are factor models where the risk factors 00:17:52.130 --> 00:17:57.140 are portfolios of securities, or in some other sense tradable 00:17:57.140 --> 00:18:01.640 So for example, if I had a particular beta exposure-- 00:18:01.640 --> 00:18:04.550 For example, if I'm holding a portfolio over here 00:18:04.550 --> 00:18:06.830 and this is more beta than I want, 00:18:06.830 --> 00:18:10.070 I can get rid of that beta by trading in S&P futures 00:18:10.070 --> 00:18:13.940 contracts to decrease the beta. 00:18:13.940 --> 00:18:16.220 You can't trade unemployment. 00:18:16.220 --> 00:18:17.240 All right? 00:18:17.240 --> 00:18:20.930 At least not as easily as you could market beta's. 00:18:20.930 --> 00:18:23.840 So while there are many research papers out there that 00:18:23.840 --> 00:18:26.210 try to document the relationship between all sorts 00:18:26.210 --> 00:18:29.090 of economic indicators and financial markets 00:18:29.090 --> 00:18:31.700 from the applications perspective the kind of models 00:18:31.700 --> 00:18:33.080 that we will be dealing with will 00:18:33.080 --> 00:18:35.810 be factors that are associated with portfolios 00:18:35.810 --> 00:18:38.210 of marketable securities that you can trade, 00:18:38.210 --> 00:18:42.015 purely from a practical perspective. 00:18:42.015 --> 00:18:43.380 OK. 00:18:43.380 --> 00:18:46.470 So the key points for these series of lectures, 00:18:46.470 --> 00:18:50.670 lectures 15 through 17, what I want you to take with you 00:18:50.670 --> 00:18:53.460 is that there are two critical relationships 00:18:53.460 --> 00:18:55.050 that you must understand. 00:18:55.050 --> 00:18:59.070 The first, is the risk reward trade for efficient portfolios, 00:18:59.070 --> 00:19:01.320 that's the capital market line. 00:19:01.320 --> 00:19:04.560 And the second, is the risk reward relationship 00:19:04.560 --> 00:19:08.460 for all other kinds of portfolios, that's the security 00:19:08.460 --> 00:19:10.920 market line of the CAPM. 00:19:10.920 --> 00:19:12.360 The CAPM. 00:19:12.360 --> 00:19:15.660 requires equilibrium. 00:19:15.660 --> 00:19:18.030 That's a departure from everything 00:19:18.030 --> 00:19:20.720 we've done in this course up until now. 00:19:20.720 --> 00:19:23.790 All of the pricing relationships that I've argued 00:19:23.790 --> 00:19:29.370 have to hold things like present values of bonds, 00:19:29.370 --> 00:19:35.070 of stocks, of futures, of forwards, of options, 00:19:35.070 --> 00:19:38.040 all of those pricing models, all of them, 00:19:38.040 --> 00:19:41.910 rely just on this notion of no free lunch, 00:19:41.910 --> 00:19:45.270 that people prefer more money to less money. 00:19:45.270 --> 00:19:47.700 But with the CAPM, I actually had 00:19:47.700 --> 00:19:50.670 to invoke a much stronger condition. 00:19:50.670 --> 00:19:54.510 I actually had to require that supply equals demand. 00:19:54.510 --> 00:19:56.220 It was through supply equaling demand 00:19:56.220 --> 00:19:59.760 that I was able to identify that the tangency portfolio is 00:19:59.760 --> 00:20:01.830 equal to the market portfolio. 00:20:01.830 --> 00:20:02.910 OK? 00:20:02.910 --> 00:20:08.040 So what we've done is to look into the heart of the market 00:20:08.040 --> 00:20:11.760 and try to infer from that what the market is actually 00:20:11.760 --> 00:20:16.050 doing by coming up with a particular discount rate that 00:20:16.050 --> 00:20:19.620 is consistent with those market views. 00:20:19.620 --> 00:20:23.790 And that now provides us with a complete theory of finance 00:20:23.790 --> 00:20:25.800 from your perspectives. 00:20:25.800 --> 00:20:31.140 You now know how to value 99.9% of anything that's out there, 00:20:31.140 --> 00:20:33.100 you've got the tools to do that. 00:20:33.100 --> 00:20:36.014 So what I want to do with the remainder of the course 00:20:36.014 --> 00:20:37.430 is I'm going to force you to apply 00:20:37.430 --> 00:20:40.490 those tools In several different contexts 00:20:40.490 --> 00:20:44.540 until you understand how the tools work. 00:20:44.540 --> 00:20:45.230 OK? 00:20:45.230 --> 00:20:50.050 So that's a we're going to do for the rest of the course. 00:20:50.050 --> 00:20:53.170 Let me just pull up the syllabus. 00:20:53.170 --> 00:20:58.750 Amazingly, we're actually on schedule despite the crisis 00:20:58.750 --> 00:21:02.570 and all our discussions thereof. 00:21:02.570 --> 00:21:06.730 We are to be focusing on capital budgeting today, next lecture, 00:21:06.730 --> 00:21:09.340 and the third lecture, where we take 00:21:09.340 --> 00:21:12.160 the tools of net present value calculations and risk 00:21:12.160 --> 00:21:13.876 adjustments and then just apply them 00:21:13.876 --> 00:21:15.250 to a bunch of different contexts. 00:21:15.250 --> 00:21:18.080 We're going apply them left and right. 00:21:18.080 --> 00:21:22.240 And what I'd like to do after that is to put it all together. 00:21:22.240 --> 00:21:24.640 In the very last lecture I'm going 00:21:24.640 --> 00:21:28.000 to try to give you a sense of where we stand 00:21:28.000 --> 00:21:31.780 today in terms of how to apply these tools more broadly given 00:21:31.780 --> 00:21:34.600 the market conditions that prevail. 00:21:34.600 --> 00:21:37.150 So I'm going to talk about market efficiency 00:21:37.150 --> 00:21:39.370 versus behavioral finance, psychology 00:21:39.370 --> 00:21:41.470 and I'm going to bring in some evidence 00:21:41.470 --> 00:21:43.720 from the cognitive neurosciences that 00:21:43.720 --> 00:21:47.510 will integrate all of the different parts of the course. 00:21:47.510 --> 00:21:49.780 So make sure if you're going to come for one lecture, 00:21:49.780 --> 00:21:50.770 you're going to come to that one, 00:21:50.770 --> 00:21:53.353 because that's where I'm going to put it all together for you. 00:21:53.353 --> 00:21:54.490 OK. 00:21:54.490 --> 00:21:57.970 So we're going to turn now to this notion of capital 00:21:57.970 --> 00:21:59.380 budgeting. 00:21:59.380 --> 00:22:02.830 I'm going to take the perspective that we now 00:22:02.830 --> 00:22:05.230 understand how markets work. 00:22:05.230 --> 00:22:07.600 We understand how pricing works, we 00:22:07.600 --> 00:22:09.340 know how to make risk adjustments, 00:22:09.340 --> 00:22:11.170 and we're going to take those ideas 00:22:11.170 --> 00:22:14.200 and apply them to very practical settings. 00:22:14.200 --> 00:22:17.179 And so in that respect I'm going to ask 00:22:17.179 --> 00:22:18.220 you to change your focus. 00:22:18.220 --> 00:22:20.770 Up until now we've been looking at markets 00:22:20.770 --> 00:22:23.710 from the perspective of an investor, either Warren 00:22:23.710 --> 00:22:29.530 Buffett, or the investor that's steeped in portfolio theory. 00:22:29.530 --> 00:22:31.780 Now, I want you to change your perspective 00:22:31.780 --> 00:22:36.070 and say that you are a corporate financial officer, 00:22:36.070 --> 00:22:38.500 or you're a project manager and you're 00:22:38.500 --> 00:22:40.360 trying to make financial decisions 00:22:40.360 --> 00:22:42.310 about various different alternatives. 00:22:42.310 --> 00:22:45.160 You're not principally trying to beat the market, 00:22:45.160 --> 00:22:47.740 or you're not principally trying to invest you're wealth, 00:22:47.740 --> 00:22:49.656 you're trying to make a decision about whether 00:22:49.656 --> 00:22:51.850 or not to take on certain projects. 00:22:51.850 --> 00:22:54.760 And the question is, how do we use the tools that we've 00:22:54.760 --> 00:22:56.540 developed to do that? 00:22:56.540 --> 00:22:59.410 So we're going to start with the NPV rule, which 00:22:59.410 --> 00:23:01.960 is the rule that we've developed at the very beginning 00:23:01.960 --> 00:23:03.110 of this course. 00:23:03.110 --> 00:23:06.430 It's very appropriate that we end the course 00:23:06.430 --> 00:23:08.350 with a discussion on this rule, but now 00:23:08.350 --> 00:23:10.480 with a much more sophisticated understanding of how 00:23:10.480 --> 00:23:11.590 to apply it. 00:23:11.590 --> 00:23:13.600 I'm going to talk about cash flow computations 00:23:13.600 --> 00:23:16.600 because it will turn out that cash flows are what you need 00:23:16.600 --> 00:23:20.830 to discount with NPV, not accounting earnings which 00:23:20.830 --> 00:23:23.710 have all sorts of conventions that are not necessarily 00:23:23.710 --> 00:23:27.190 realistic, or relevant for economic decision making, 00:23:27.190 --> 00:23:30.730 but rather I want you to focus on actual dollars and cents 00:23:30.730 --> 00:23:33.700 that you're going to be getting period by period. 00:23:33.700 --> 00:23:35.990 I'm going to talk about discount rates 00:23:35.990 --> 00:23:40.000 and applying them over time, project interactions, 00:23:40.000 --> 00:23:43.840 alternatives to the NPV role, and how capital budgeting is 00:23:43.840 --> 00:23:45.910 currently done. 00:23:45.910 --> 00:23:50.060 There are going to be three different main points 00:23:50.060 --> 00:23:52.070 to this sequence of lectures. 00:23:52.070 --> 00:23:57.360 The first main point is to use proper risk adjustments 00:23:57.360 --> 00:23:58.940 in doing NPV calculations. 00:23:58.940 --> 00:24:00.980 That's something that I think by now 00:24:00.980 --> 00:24:03.980 should be already ingrained in your way of thinking, 00:24:03.980 --> 00:24:06.570 but I want to make sure that that's true. 00:24:06.570 --> 00:24:08.450 The second main point I want to get across 00:24:08.450 --> 00:24:13.490 is that, there are lots of different ways of doing capital 00:24:13.490 --> 00:24:18.200 budgeting, but in this case there's 00:24:18.200 --> 00:24:20.840 only one right way to do it from the perspective 00:24:20.840 --> 00:24:22.180 of economic analysis. 00:24:22.180 --> 00:24:25.940 Now, economic analysis may not be the only consideration. 00:24:25.940 --> 00:24:29.490 When you make a decision about whether to take on a project, 00:24:29.490 --> 00:24:31.160 there are economic considerations, 00:24:31.160 --> 00:24:35.510 but there are also political, social, practical, cultural, 00:24:35.510 --> 00:24:37.550 all sorts of other considerations. 00:24:37.550 --> 00:24:39.883 I'm not going to say anything about those because that's 00:24:39.883 --> 00:24:42.470 outside the purview of this finance course, 00:24:42.470 --> 00:24:45.050 but from the business and financial decision 00:24:45.050 --> 00:24:48.560 making perspective, NPV is always the right thing to do 00:24:48.560 --> 00:24:52.940 and I want to emphasize that by showing you three wrong ways 00:24:52.940 --> 00:24:54.440 of doing capital budgeting. 00:24:54.440 --> 00:24:57.770 These are ways that people still will make use of today. 00:24:57.770 --> 00:25:02.060 So things like using IRR, or using payback, 00:25:02.060 --> 00:25:04.479 or using profitability indexes. 00:25:04.479 --> 00:25:06.020 I'm going to go through each of those 00:25:06.020 --> 00:25:09.740 and argue why those are not the correct way of making 00:25:09.740 --> 00:25:11.600 financial decisions, but because they're 00:25:11.600 --> 00:25:14.870 so prevalent I want you to at least be aware of them 00:25:14.870 --> 00:25:19.170 and understand how they relate to NPV. 00:25:19.170 --> 00:25:21.140 And the last thing I want to do is 00:25:21.140 --> 00:25:23.090 to tell you about the complexities 00:25:23.090 --> 00:25:25.790 of financial decision making by talking 00:25:25.790 --> 00:25:28.620 about time as an element. 00:25:28.620 --> 00:25:31.580 In other words, the fact that decisions 00:25:31.580 --> 00:25:35.150 are being made over time makes these kinds 00:25:35.150 --> 00:25:38.919 of interactions among projects very, very complicated. 00:25:38.919 --> 00:25:40.460 And I'm not going to be able to solve 00:25:40.460 --> 00:25:42.170 all of those for you, that's what 00:25:42.170 --> 00:25:44.780 15.434 of this course on capital budgeting 00:25:44.780 --> 00:25:47.150 and corporate financing will do, but I want to give you 00:25:47.150 --> 00:25:49.670 a taste of it so you are aware that there 00:25:49.670 --> 00:25:51.470 is a whole other world out there where 00:25:51.470 --> 00:25:53.690 you've got to take these tools and understand 00:25:53.690 --> 00:25:55.270 how to apply them. 00:25:55.270 --> 00:25:56.030 OK. 00:25:56.030 --> 00:25:59.020 So let's talk about the NPV role. 00:25:59.020 --> 00:26:02.140 We started this course with a statement 00:26:02.140 --> 00:26:08.360 that all assets are nothing more than a sequence of cash flows. 00:26:08.360 --> 00:26:09.940 That's what I call an asset. 00:26:09.940 --> 00:26:13.450 Every single asset can be reduced, essentially, 00:26:13.450 --> 00:26:15.560 to a sequence of task flows. 00:26:15.560 --> 00:26:19.240 So this is a sequence of cash flows for a particular project, 00:26:19.240 --> 00:26:20.620 or asset. 00:26:20.620 --> 00:26:22.870 And the current market value is simply 00:26:22.870 --> 00:26:26.050 the NPV where now you've got a discount 00:26:26.050 --> 00:26:29.020 by the appropriate cost of capital that 00:26:29.020 --> 00:26:32.620 is an appropriate risk adjusted cost of capital 00:26:32.620 --> 00:26:36.250 where you are adjusting the risk relevant to that particular 00:26:36.250 --> 00:26:38.110 cash flow. 00:26:38.110 --> 00:26:41.800 So you'll notice that I use r1 for cash flow one, 00:26:41.800 --> 00:26:46.210 and I use rT for cash T. What that means is that you can have 00:26:46.210 --> 00:26:49.060 two different discount rates for two different cash 00:26:49.060 --> 00:26:52.120 flows of the same project because those two 00:26:52.120 --> 00:26:54.190 different cash flows may actually 00:26:54.190 --> 00:26:57.770 have two different risks. 00:26:57.770 --> 00:27:01.610 So now when you see this expression, which is exactly 00:27:01.610 --> 00:27:04.070 the same expression I showed you at the very beginning 00:27:04.070 --> 00:27:07.100 of this course, it should have much more meaning to you 00:27:07.100 --> 00:27:10.010 because now you understand what amount of effort 00:27:10.010 --> 00:27:15.140 goes in to coming up with that appropriate discount rate. 00:27:15.140 --> 00:27:17.930 It turns out that because of something called value 00:27:17.930 --> 00:27:21.980 additivity we can make decisions about how 00:27:21.980 --> 00:27:27.290 to allocate our resources simply by picking those projects 00:27:27.290 --> 00:27:30.930 with big positive NPVs. 00:27:30.930 --> 00:27:34.290 In other words, you don't have to worry about project 00:27:34.290 --> 00:27:37.830 interactions unless there are interactions 00:27:37.830 --> 00:27:44.060 that are explicitly involving your decisions. 00:27:44.060 --> 00:27:47.390 Having a firm and combining high NPV projects 00:27:47.390 --> 00:27:50.600 is the best way to increase the value of that firm. 00:27:50.600 --> 00:27:53.330 So you look at each project on a standalone basis 00:27:53.330 --> 00:27:55.160 and if there are project interactions 00:27:55.160 --> 00:27:57.560 you then evaluate those interactions separately, 00:27:57.560 --> 00:27:59.460 and I'll give you examples of that. 00:27:59.460 --> 00:27:59.960 OK. 00:27:59.960 --> 00:28:01.450 So we're all familiar with this. 00:28:01.450 --> 00:28:03.110 This is just the standard approach 00:28:03.110 --> 00:28:05.990 to calculating market value. 00:28:05.990 --> 00:28:09.666 Now, the investment criteria that I'm 00:28:09.666 --> 00:28:11.290 going to propose for capital budgeting, 00:28:11.290 --> 00:28:14.870 for project selection is this. 00:28:14.870 --> 00:28:16.460 For a single project, if you've got 00:28:16.460 --> 00:28:18.560 one project you're trying to decide upon, 00:28:18.560 --> 00:28:23.510 take it if and only if the NPV is positive. 00:28:23.510 --> 00:28:25.810 If it's positive take it, if it's negative 00:28:25.810 --> 00:28:27.340 do not take it, or sell it. 00:28:27.340 --> 00:28:28.521 Short it, if you can. 00:28:28.521 --> 00:28:29.020 [LAUGHTER] 00:28:29.020 --> 00:28:29.710 OK? 00:28:29.710 --> 00:28:31.660 It's hard to short projects it's not 00:28:31.660 --> 00:28:35.400 that hard to short securities. 00:28:35.400 --> 00:28:39.300 For many independent projects, take all of them 00:28:39.300 --> 00:28:40.440 with positive NPV. 00:28:40.440 --> 00:28:43.740 If they're independent, meaning that taking one 00:28:43.740 --> 00:28:45.480 doesn't preclude you from doing another, 00:28:45.480 --> 00:28:47.580 or there's no project interactions, 00:28:47.580 --> 00:28:51.930 take them all as long as they have positive NPV. 00:28:51.930 --> 00:28:55.410 If there are project interactions, 00:28:55.410 --> 00:28:58.510 then you have to take that into account. 00:28:58.510 --> 00:29:00.780 So one simple example of a project interaction 00:29:00.780 --> 00:29:04.530 is you can only take one of many. 00:29:04.530 --> 00:29:06.480 And if that's the case, then you pick the one 00:29:06.480 --> 00:29:10.530 that's got the highest NPV. 00:29:10.530 --> 00:29:13.950 Where you have to use the proper risk adjustment 00:29:13.950 --> 00:29:16.980 for that particular project. 00:29:16.980 --> 00:29:20.130 So in order to compute NPV you need three things, 00:29:20.130 --> 00:29:23.550 you need cash flows, obviously, you need the discount rates, 00:29:23.550 --> 00:29:26.310 and you need to consider strategic options. 00:29:26.310 --> 00:29:29.690 The first and the third I'm not going to help you with, 00:29:29.690 --> 00:29:30.660 that's your business. 00:29:30.660 --> 00:29:32.160 That's the business of business. 00:29:32.160 --> 00:29:35.340 You've got to identify what those cash flows are 00:29:35.340 --> 00:29:38.100 and you've got to identify what your options are. 00:29:38.100 --> 00:29:42.270 What I could help you with, in the context of this course, 00:29:42.270 --> 00:29:47.220 is evaluating the market value of those possibilities. 00:29:47.220 --> 00:29:49.230 Those strategic options, you now understand 00:29:49.230 --> 00:29:51.420 how to use option pricing analysis 00:29:51.420 --> 00:29:53.010 and for discount rates, you now know 00:29:53.010 --> 00:29:54.750 how to use risk adjustments to calculate 00:29:54.750 --> 00:29:57.210 the appropriate discount rates. 00:29:57.210 --> 00:30:00.150 But the other stuff is domain specific expertise 00:30:00.150 --> 00:30:01.962 that you bring to the table. 00:30:01.962 --> 00:30:04.170 And so I told you at the very beginning of the course 00:30:04.170 --> 00:30:07.590 that finance is the language of business, this is what I mean. 00:30:07.590 --> 00:30:10.350 You can't even talk about making a decision 00:30:10.350 --> 00:30:12.240 unless you speak the language of finance, 00:30:12.240 --> 00:30:16.080 unless you evaluate projects in this kind of a framework. 00:30:16.080 --> 00:30:16.860 OK. 00:30:16.860 --> 00:30:19.740 So in terms of cash flow calculations, 00:30:19.740 --> 00:30:22.110 I'm going to give you some examples in a few minutes, 00:30:22.110 --> 00:30:24.550 but let me summarize what I'm going to tell you 00:30:24.550 --> 00:30:27.720 and then we can talk about the specifics through that example. 00:30:27.720 --> 00:30:30.780 The first point, is you should use cash flows, not 00:30:30.780 --> 00:30:33.870 accounting earnings because again, accounting earnings 00:30:33.870 --> 00:30:38.250 are meant for purposes other than decision making. 00:30:38.250 --> 00:30:41.700 Accounting is really meant as a kind of a checkup 00:30:41.700 --> 00:30:43.920 to see how you've done. 00:30:43.920 --> 00:30:45.480 How you've done is not the same thing 00:30:45.480 --> 00:30:47.490 as how you're going to do. 00:30:47.490 --> 00:30:51.870 One of the things that I think is apparently not 00:30:51.870 --> 00:30:54.090 emphasized enough is that when you 00:30:54.090 --> 00:30:57.400 look at accounting data you're looking 00:30:57.400 --> 00:31:00.820 at numbers that are not random variables, 00:31:00.820 --> 00:31:01.990 they have been realized. 00:31:01.990 --> 00:31:06.400 There's no uncertainty in what a balance sheet, or an income 00:31:06.400 --> 00:31:07.840 statement says. 00:31:07.840 --> 00:31:09.550 It's about the past. 00:31:09.550 --> 00:31:11.737 And accountants hate uncertainties. 00:31:11.737 --> 00:31:13.820 I don't know how many people are accountants here, 00:31:13.820 --> 00:31:15.850 or how many accountants you know, but if you know them 00:31:15.850 --> 00:31:18.058 you know there's a certain personality type that gets 00:31:18.058 --> 00:31:20.320 drawn into that profession. 00:31:20.320 --> 00:31:23.690 And these are not big risk takers, 00:31:23.690 --> 00:31:27.111 they want to see order and certainty in what they're 00:31:27.111 --> 00:31:27.610 doing. 00:31:27.610 --> 00:31:29.193 That's what a good accountant will do, 00:31:29.193 --> 00:31:32.500 is to try to understand where to put all the expenses 00:31:32.500 --> 00:31:37.170 and revenues into the proper boxes so that it all adds up. 00:31:37.170 --> 00:31:39.330 Accounting is incapable. 00:31:39.330 --> 00:31:44.900 It is not designed to manage and reflect uncertainty. 00:31:44.900 --> 00:31:47.330 You've heard the term off-balance sheet item, right? 00:31:47.330 --> 00:31:49.640 For example, I've spoken before about a credit default 00:31:49.640 --> 00:31:51.620 swap, or a futures contract. 00:31:51.620 --> 00:31:55.450 If you engage in a futures transaction, the moment 00:31:55.450 --> 00:31:58.150 you engage in that transaction what's 00:31:58.150 --> 00:32:00.640 the NPV of a futures contract? 00:32:00.640 --> 00:32:01.544 AUDIENCE: Zero. 00:32:01.544 --> 00:32:02.210 ANDREW LO: Zero. 00:32:02.210 --> 00:32:03.560 Exactly. 00:32:03.560 --> 00:32:07.580 And as a result, that does not go on the balance sheet 00:32:07.580 --> 00:32:10.700 because it is neither an asset nor is it a liability. 00:32:10.700 --> 00:32:13.920 It's both, or neither, depending on how you look at it. 00:32:13.920 --> 00:32:16.490 It's an off-balance sheet item because it doesn't-- 00:32:16.490 --> 00:32:18.140 Where do you put it? 00:32:18.140 --> 00:32:20.590 It has zero value. 00:32:20.590 --> 00:32:23.200 But the point is that entering into one of those agreements 00:32:23.200 --> 00:32:27.030 has a big impact on your future risk. 00:32:27.030 --> 00:32:28.930 So accounting, the language of accounting 00:32:28.930 --> 00:32:32.530 is not ideally suited for thinking about the future. 00:32:32.530 --> 00:32:35.056 It's a wonderful method for understanding 00:32:35.056 --> 00:32:36.430 what happened in the past and you 00:32:36.430 --> 00:32:38.980 need to understand that in order to plan for the future, 00:32:38.980 --> 00:32:41.320 you need to know what your current assets are 00:32:41.320 --> 00:32:43.150 and what your current liabilities are, 00:32:43.150 --> 00:32:46.070 but that doesn't tell you where your risks are going to be 00:32:46.070 --> 00:32:47.560 and it doesn't allow you to speak 00:32:47.560 --> 00:32:50.680 about the dynamics of cash flows because that's not 00:32:50.680 --> 00:32:52.930 what an accountants job is. 00:32:52.930 --> 00:32:54.806 That's not what accounting is designed to do. 00:32:54.806 --> 00:32:55.305 Right? 00:32:55.305 --> 00:32:57.400 This is not meant to be a critique of accounting, 00:32:57.400 --> 00:33:00.670 but simply that you can't use it for purposes that it wasn't 00:33:00.670 --> 00:33:03.640 ideally designed to serve. 00:33:03.640 --> 00:33:06.190 So the first point is, you've got to use cash flows, 00:33:06.190 --> 00:33:07.510 not accounting earnings. 00:33:07.510 --> 00:33:10.290 Second point, you've got to use after-tax cash flows. 00:33:10.290 --> 00:33:10.790 Why? 00:33:10.790 --> 00:33:12.640 Because you have to pay taxes. 00:33:12.640 --> 00:33:14.440 That's one of the, along with death 00:33:14.440 --> 00:33:18.610 and some other unavoidable aspects of life, 00:33:18.610 --> 00:33:19.900 you have to pay taxes. 00:33:19.900 --> 00:33:22.720 So if you have to pay taxes, then you may as well 00:33:22.720 --> 00:33:25.750 look at after-tax cash flows. 00:33:25.750 --> 00:33:27.670 The reason this is important is because there 00:33:27.670 --> 00:33:32.300 are certain things that show up as cash flows that you wouldn't 00:33:32.300 --> 00:33:35.550 ordinarily think of as cash flows because of the tax code. 00:33:35.550 --> 00:33:38.770 For example, depreciation. 00:33:38.770 --> 00:33:41.670 Depreciation is an accounting technique 00:33:41.670 --> 00:33:46.680 for attributing the decline of capital assets. 00:33:46.680 --> 00:33:50.640 When you buy a machine it's new on day one, but after 50 years 00:33:50.640 --> 00:33:53.100 it's not new anymore and it's not worth the same 00:33:53.100 --> 00:33:55.960 after 15 years as it is on day one. 00:33:55.960 --> 00:34:00.990 Now, how you account for the loss in value of that machine, 00:34:00.990 --> 00:34:03.150 how you account for how the machine gets used up 00:34:03.150 --> 00:34:07.950 over 15 years, that's a matter of accounting practice 00:34:07.950 --> 00:34:11.489 that may have no bearing on the actual economics 00:34:11.489 --> 00:34:14.730 of the machine, but it has absolute bearing 00:34:14.730 --> 00:34:17.070 on the cash flows that you are going 00:34:17.070 --> 00:34:20.159 to receive because you get to deduct depreciation 00:34:20.159 --> 00:34:22.590 expenses off of your taxes. 00:34:22.590 --> 00:34:25.480 So after tax cash flow is as important. 00:34:25.480 --> 00:34:29.670 And finally, this third point sounds simple, 00:34:29.670 --> 00:34:33.420 but it's anything but simple unless you practice with it 00:34:33.420 --> 00:34:36.070 and do a lot of examples. 00:34:36.070 --> 00:34:40.199 Use cash flows attributable to the project. 00:34:40.199 --> 00:34:42.250 In other words, you've got to compare 00:34:42.250 --> 00:34:44.750 the firm with and without the project 00:34:44.750 --> 00:34:46.570 and look at the cash flows. 00:34:46.570 --> 00:34:47.770 OK? 00:34:47.770 --> 00:34:52.480 It's very, very easy to forget certain cash flows that either 00:34:52.480 --> 00:34:54.820 come along with the project, or have 00:34:54.820 --> 00:34:58.630 to be spent if you take on the project 00:34:58.630 --> 00:35:01.720 and you'll end up missing one element or another. 00:35:01.720 --> 00:35:05.830 And in many cases those kinds of omissions 00:35:05.830 --> 00:35:08.440 can have a huge impact on whether or not 00:35:08.440 --> 00:35:11.200 you decide to take on the project. 00:35:11.200 --> 00:35:13.150 So there are lots of examples about how 00:35:13.150 --> 00:35:17.050 you might do that here, but in the end practice, practice, 00:35:17.050 --> 00:35:19.780 practice is going to get you to understand 00:35:19.780 --> 00:35:23.130 how to take into account each of the features. 00:35:23.130 --> 00:35:25.620 So I want to just go through a few of these now 00:35:25.620 --> 00:35:27.864 and then I'm going to talk about the point 00:35:27.864 --> 00:35:29.280 that I started with earlier, which 00:35:29.280 --> 00:35:32.070 is I want to show you some techniques for capital 00:35:32.070 --> 00:35:34.650 budgeting that are incorrect and how 00:35:34.650 --> 00:35:37.290 they relate to the NPV rule. 00:35:37.290 --> 00:35:39.990 So let me just tell you a little bit more 00:35:39.990 --> 00:35:44.170 about accounting earnings versus cash flows. 00:35:44.170 --> 00:35:48.120 Cash flows are what you need to use for calculating NPV 00:35:48.120 --> 00:35:50.940 because in the end what matters is the cash that you get, 00:35:50.940 --> 00:35:56.040 not the accounting profits that may or may not be realizable. 00:35:56.040 --> 00:36:01.710 So cash flows are simply equal to cash cash inflows minus cash 00:36:01.710 --> 00:36:02.760 outflows. 00:36:02.760 --> 00:36:04.590 That sounds simple, right? 00:36:04.590 --> 00:36:06.600 It's not simple because you've got 00:36:06.600 --> 00:36:09.630 to figure out what those cash inflows or outflows are 00:36:09.630 --> 00:36:12.541 from, in many cases, accounting data. 00:36:12.541 --> 00:36:14.040 And so you need to know a little bit 00:36:14.040 --> 00:36:16.110 about how the accounting interacts 00:36:16.110 --> 00:36:18.250 with these kinds of calculations. 00:36:18.250 --> 00:36:20.560 So I'll just give you a little bit more detail, 00:36:20.560 --> 00:36:25.020 and I'll leave it up to you to focus on specific applications 00:36:25.020 --> 00:36:26.640 because the accounting rules, first 00:36:26.640 --> 00:36:29.730 of all they change fairly often and actually right now 00:36:29.730 --> 00:36:33.420 at the heart of the debate in the financial crisis 00:36:33.420 --> 00:36:37.680 is this notion of fair value accounting, FAS 157, which 00:36:37.680 --> 00:36:40.590 says that you've got to use market values for updating 00:36:40.590 --> 00:36:42.480 your assets and liabilities. 00:36:42.480 --> 00:36:45.270 And that's a new ruling that has created some problems 00:36:45.270 --> 00:36:48.450 because market values, during times of stress, 00:36:48.450 --> 00:36:50.310 can drop precipitously. 00:36:50.310 --> 00:36:53.160 And this is why I told you early on that accounting 00:36:53.160 --> 00:36:56.040 is not ideally suited to deal with a lot of issues 00:36:56.040 --> 00:36:59.640 having to do with risky assets because risk is not 00:36:59.640 --> 00:37:03.060 an element that the accounting framework is 00:37:03.060 --> 00:37:06.480 well-suited to deal with. 00:37:06.480 --> 00:37:09.720 So how do we get cash inflows minus cash outflows. 00:37:09.720 --> 00:37:12.060 Well, operating revenues is typically 00:37:12.060 --> 00:37:16.890 what cash inflows involve for a given project, operating 00:37:16.890 --> 00:37:18.030 revenues. 00:37:18.030 --> 00:37:21.690 And then, you subtract from that operating expenses 00:37:21.690 --> 00:37:24.150 without depreciation. 00:37:24.150 --> 00:37:26.430 The reason you don't take into account depreciation 00:37:26.430 --> 00:37:28.140 is, as I told you, depreciation is 00:37:28.140 --> 00:37:32.100 one of these magic accounting concepts that 00:37:32.100 --> 00:37:34.710 has no bearing on reality. 00:37:34.710 --> 00:37:37.800 It's a mechanism for simply accounting 00:37:37.800 --> 00:37:41.910 for a decline in the market value of a particular kind 00:37:41.910 --> 00:37:43.980 of equipment, or asset. 00:37:43.980 --> 00:37:46.350 And there are a lot of different accounting conventions 00:37:46.350 --> 00:37:49.110 that are a function of tax code changes. 00:37:49.110 --> 00:37:52.440 For example, in some cases you can accelerate 00:37:52.440 --> 00:37:53.760 the depreciation of an asset. 00:37:53.760 --> 00:37:55.584 Even though a machine is working fine, 00:37:55.584 --> 00:37:57.000 there are certain situations where 00:37:57.000 --> 00:37:59.190 you can assume that half of the machine 00:37:59.190 --> 00:38:01.770 evaporated after one year. 00:38:01.770 --> 00:38:03.160 Now how does that happen? 00:38:03.160 --> 00:38:07.080 Well it's an accounting tool that Congress passed years 00:38:07.080 --> 00:38:10.920 ago to allow companies, businesses, to accelerate 00:38:10.920 --> 00:38:14.351 the depreciation and therefore get a tax advantage. 00:38:14.351 --> 00:38:14.850 Question? 00:38:14.850 --> 00:38:19.690 AUDIENCE: Aren't income taxes linked to the accounting 00:38:19.690 --> 00:38:20.658 nuances? 00:38:20.658 --> 00:38:22.836 So if we're using taxes, I'm saying, 00:38:22.836 --> 00:38:25.014 sort of, we can't use accounting [INAUDIBLE] 00:38:25.014 --> 00:38:26.466 because it's a depreciation-- 00:38:26.466 --> 00:38:27.966 Depending what depreciation that you 00:38:27.966 --> 00:38:29.505 used, do income taxes change? 00:38:29.505 --> 00:38:30.130 ANDREW LO: Yes. 00:38:30.130 --> 00:38:30.590 That's right. 00:38:30.590 --> 00:38:32.464 And so we're going to take that into account, 00:38:32.464 --> 00:38:35.270 but the point is that for the purposes of cash flow, 00:38:35.270 --> 00:38:37.510 the depreciation schedule will impact the cash 00:38:37.510 --> 00:38:42.220 flow only in terms of the actual tax shields that it generates. 00:38:42.220 --> 00:38:45.580 Not that it will decrease the value of the machine 00:38:45.580 --> 00:38:48.370 when the accountants tell you that it will. 00:38:48.370 --> 00:38:49.790 OK? 00:38:49.790 --> 00:38:52.430 So the idea is that your operating expenses 00:38:52.430 --> 00:38:55.490 are expenses you have to pay irrespective of what 00:38:55.490 --> 00:38:58.220 the depreciation schedule is. 00:38:58.220 --> 00:39:02.000 So accounting expenses without depreciation 00:39:02.000 --> 00:39:04.040 is what you're paying out in cash. 00:39:04.040 --> 00:39:08.520 It's the actual cash outflow every single year. 00:39:08.520 --> 00:39:12.660 Capital expenditures is what you spend on new equipment, 00:39:12.660 --> 00:39:14.670 and then income taxes. 00:39:14.670 --> 00:39:16.050 So this is your point, Louis. 00:39:16.050 --> 00:39:19.770 All of the effect of depreciation on your income tax 00:39:19.770 --> 00:39:21.510 gets included in here. 00:39:21.510 --> 00:39:23.590 Income taxes you have to pay every year, 00:39:23.590 --> 00:39:25.080 so that's a cash outflow. 00:39:25.080 --> 00:39:25.830 Right? 00:39:25.830 --> 00:39:28.350 So if there's something that can reduce your cash outflow, 00:39:28.350 --> 00:39:30.486 you better take that into account. 00:39:30.486 --> 00:39:32.110 And that's where depreciation comes in. 00:39:32.110 --> 00:39:36.030 It's a tax shield that allows you not to pay as much taxes, 00:39:36.030 --> 00:39:39.810 so it reduces your tax burden, it reduces your income taxes. 00:39:39.810 --> 00:39:42.870 But again, the focus is on cash flows. 00:39:42.870 --> 00:39:45.450 Money in versus money out. 00:39:45.450 --> 00:39:47.730 That's what you're trying to measure. 00:39:47.730 --> 00:39:52.540 And once you get the measure of money in minus money out, 00:39:52.540 --> 00:39:54.720 then you can start discounting using 00:39:54.720 --> 00:39:56.770 your appropriate cost of capital, 00:39:56.770 --> 00:39:59.090 but you got to get the cash flows right. 00:39:59.090 --> 00:40:02.910 And so there are a number of other subtleties. 00:40:02.910 --> 00:40:06.540 For example, the project income taxes 00:40:06.540 --> 00:40:09.960 that you pay for your project is going to be the corporate tax 00:40:09.960 --> 00:40:14.760 rate, times the operating profit, minus the tax rate, 00:40:14.760 --> 00:40:17.400 times your depreciation. 00:40:17.400 --> 00:40:20.880 So your depreciation doesn't actually 00:40:20.880 --> 00:40:25.140 affect the profitability of the particular piece of equipment, 00:40:25.140 --> 00:40:29.130 or the project, except in so far as it affects 00:40:29.130 --> 00:40:31.760 the taxes you have to pay. 00:40:31.760 --> 00:40:35.660 So project income taxes, that income taxes associated 00:40:35.660 --> 00:40:37.910 with your particular project, are 00:40:37.910 --> 00:40:40.850 going to simply be the tax rate multiplied by the operating 00:40:40.850 --> 00:40:44.960 profit, minus the tax rate, times whatever depreciation 00:40:44.960 --> 00:40:48.500 you can claim, and so this is how you can get depreciation 00:40:48.500 --> 00:40:50.000 into your cash flows. 00:40:50.000 --> 00:40:52.250 It affects the amount of income taxes you're paying 00:40:52.250 --> 00:40:54.670 and that's it. 00:40:54.670 --> 00:40:57.650 So the bottom line, what's your task flow? 00:40:57.650 --> 00:41:01.090 It's going to be one, minus your tax rate, 00:41:01.090 --> 00:41:04.070 times the operating profits. 00:41:04.070 --> 00:41:07.940 Operating profits is operating revenues, minus operating 00:41:07.940 --> 00:41:11.720 expenses without depreciation. 00:41:11.720 --> 00:41:13.850 Without depreciation. 00:41:13.850 --> 00:41:18.260 Depreciation comes in later when you're talking about the taxes. 00:41:18.260 --> 00:41:20.840 So here is where the depreciation comes in. 00:41:20.840 --> 00:41:23.930 So your cash flow is operating profits, 00:41:23.930 --> 00:41:27.470 multiplied by one, minus the tax rate, 00:41:27.470 --> 00:41:30.979 minus your capital expenditures, and by the way, 00:41:30.979 --> 00:41:33.020 your capital expenditures, notice that you're not 00:41:33.020 --> 00:41:35.180 getting taxed on that. 00:41:35.180 --> 00:41:37.250 Nor do you get a deduction for that. 00:41:37.250 --> 00:41:40.520 You don't get to deduct capital expenditures the way 00:41:40.520 --> 00:41:44.420 you get to deduct ordinary expenses from running a company 00:41:44.420 --> 00:41:47.060 because capital expenditures are treated differently 00:41:47.060 --> 00:41:48.890 by the tax code. 00:41:48.890 --> 00:41:50.250 Does that make sense? 00:41:50.250 --> 00:41:50.930 Who knows. 00:41:50.930 --> 00:41:53.760 That's for the tax experts to decide upon. 00:41:53.760 --> 00:41:55.986 The fact is that capital expenditures have 00:41:55.986 --> 00:41:57.360 a different tax treatment and you 00:41:57.360 --> 00:41:59.776 have to know that, that's why you need accountants to tell 00:41:59.776 --> 00:42:01.530 you how they get treated. 00:42:01.530 --> 00:42:06.660 The way they get treated is you get to depreciate the capital 00:42:06.660 --> 00:42:12.000 expenditures as the accountants tell you you're using them up. 00:42:12.000 --> 00:42:15.030 So if you buy a piece of equipment for $25 million, 00:42:15.030 --> 00:42:18.570 you don't get to deduct it right away because you're not 00:42:18.570 --> 00:42:21.050 using all of it right away. 00:42:21.050 --> 00:42:23.780 You're using part of it every year. 00:42:23.780 --> 00:42:25.130 How much are you using? 00:42:25.130 --> 00:42:29.340 That's where the depreciation schedule becomes relevant. 00:42:29.340 --> 00:42:33.350 So here what you're getting, in terms of cash flows, 00:42:33.350 --> 00:42:36.380 what you're getting is the depreciation 00:42:36.380 --> 00:42:40.880 that you report every year, multiplied by the tax rate. 00:42:40.880 --> 00:42:45.000 You're getting that as a positive cash flow. 00:42:45.000 --> 00:42:45.954 Why is that? 00:42:45.954 --> 00:42:47.120 Who can tell me why that is? 00:42:52.540 --> 00:42:53.251 Yeah. 00:42:53.251 --> 00:42:56.860 AUDIENCE: Because you're not paying any expenses. 00:42:56.860 --> 00:43:00.900 ANDREW LO: That's not quite right. 00:43:00.900 --> 00:43:04.830 It's along those lines, but not exactly, that's not exactly 00:43:04.830 --> 00:43:05.640 the mechanism. 00:43:05.640 --> 00:43:06.172 [INAUDIBLE]? 00:43:06.172 --> 00:43:07.630 AUDIENCE: This position is expense, 00:43:07.630 --> 00:43:09.942 but it's not out of cash flow. 00:43:09.942 --> 00:43:10.650 ANDREW LO: Right. 00:43:10.650 --> 00:43:13.530 Depreciation is an expense you get to deduct, 00:43:13.530 --> 00:43:15.330 so you're right about that, but you're 00:43:15.330 --> 00:43:18.340 getting to deduct it purely because of the tax code. 00:43:18.340 --> 00:43:20.070 And because you get to deduct it you 00:43:20.070 --> 00:43:22.260 don't have to pay this much tax. 00:43:22.260 --> 00:43:24.780 In other words, without the depreciation 00:43:24.780 --> 00:43:26.780 you would be out this much money. 00:43:26.780 --> 00:43:28.800 But because you have that deduction, 00:43:28.800 --> 00:43:30.469 it's like a get out of jail free card, 00:43:30.469 --> 00:43:32.010 you basically take this card and say, 00:43:32.010 --> 00:43:34.740 here I don't have to pay this much tax, how much is that card 00:43:34.740 --> 00:43:35.610 worth? 00:43:35.610 --> 00:43:37.500 Well, it's worth this. 00:43:37.500 --> 00:43:39.330 So this is actually the amount of cash 00:43:39.330 --> 00:43:41.130 you're going to get to keep in your pocket 00:43:41.130 --> 00:43:44.377 if you have this depreciation tax shield. 00:43:44.377 --> 00:43:45.960 That's what it's called, a tax shield. 00:43:45.960 --> 00:43:48.990 It prevents you from paying a certain amount of taxes. 00:43:48.990 --> 00:43:51.790 You actually get to keep that money in your company. 00:43:51.790 --> 00:43:53.280 So it's actual cash flows to you. 00:43:55.790 --> 00:44:00.050 So the accounting impact of depreciation is here. 00:44:00.050 --> 00:44:03.440 And it's important, I know it seems like it's a waste of time 00:44:03.440 --> 00:44:05.870 for us to spend time for my telling you 00:44:05.870 --> 00:44:09.470 how to do accounting, but this is an important enough point 00:44:09.470 --> 00:44:12.860 that people forget when you're doing NPV calculations that I 00:44:12.860 --> 00:44:14.540 want to hammer this home. 00:44:14.540 --> 00:44:17.390 What matters, from an economic perspective, 00:44:17.390 --> 00:44:19.580 is the cash that you're getting for your project 00:44:19.580 --> 00:44:21.260 year in and year out. 00:44:21.260 --> 00:44:22.970 Keep your eyes on the cash. 00:44:22.970 --> 00:44:26.600 Don't keep it on the accounting numbers, keep it on the cash. 00:44:26.600 --> 00:44:29.800 And if you do that, you'll never go wrong. 00:44:29.800 --> 00:44:30.880 OK. 00:44:30.880 --> 00:44:35.050 Here's an example just to make the point. 00:44:35.050 --> 00:44:39.100 A machine is purchased for a $1 million with a life of 10 years 00:44:39.100 --> 00:44:41.440 and it generates annual revenues of 300,000 00:44:41.440 --> 00:44:44.092 and operating expenses of 100,000. 00:44:44.092 --> 00:44:45.550 If you assume that the machine gets 00:44:45.550 --> 00:44:50.200 depreciated over 10 years using straight line depreciation. 00:44:50.200 --> 00:44:52.086 What does that mean, straight line? 00:44:52.086 --> 00:44:52.585 Yeah. 00:44:52.585 --> 00:44:53.920 AUDIENCE: Equal amounts every year. 00:44:53.920 --> 00:44:54.670 AUDIENCE: Exactly. 00:44:54.670 --> 00:44:57.220 So if the machine is worth a million bucks 00:44:57.220 --> 00:45:00.290 and you're depreciating it over 10 years straight line, 00:45:00.290 --> 00:45:01.803 what do you deduct every year? 00:45:01.803 --> 00:45:02.928 AUDIENCE: 1,000 [INAUDIBLE] 00:45:02.928 --> 00:45:03.750 ANDREW LO: 100,000. 00:45:03.750 --> 00:45:04.249 Yeah. 00:45:04.249 --> 00:45:05.140 Yeah, that's right. 00:45:05.140 --> 00:45:06.990 It'd be 100 years if you did 10,000. 00:45:06.990 --> 00:45:09.570 That would be a long life of the machine. 00:45:09.570 --> 00:45:12.500 That's right $10,000-- $100,000 a year 00:45:12.500 --> 00:45:16.010 for 10 years, that's how much the accountants are telling you 00:45:16.010 --> 00:45:17.990 you're using up the machine. 00:45:17.990 --> 00:45:21.350 And so every year you get to deduct $100,000 00:45:21.350 --> 00:45:23.820 from that kind of depreciation. 00:45:23.820 --> 00:45:25.630 So what is your after-tax cash flow? 00:45:25.630 --> 00:45:28.250 Now, you're accounting earnings, the way 00:45:28.250 --> 00:45:32.930 that an accountant would accrue the earnings would be this. 00:45:32.930 --> 00:45:39.450 It's 3 million, minus 100k, minus a 300k, 00:45:39.450 --> 00:45:44.680 minus 100k, minus 100k, that's 100k of earnings. 00:45:44.680 --> 00:45:48.570 So an accountant would tell you that your earnings 00:45:48.570 --> 00:45:51.600 for this situation is $100,000 a year. 00:45:51.600 --> 00:45:53.140 Right? 00:45:53.140 --> 00:45:56.200 However, that's not the cash flows. 00:45:56.200 --> 00:45:57.760 Let's look at the task flows. 00:45:57.760 --> 00:46:00.580 The cash flows on an after tax basis, 00:46:00.580 --> 00:46:07.780 assuming a 40% corporate tax rate is 1 minus 0.4, 00:46:07.780 --> 00:46:12.430 times revenue of 300, minus operating expenses of 100. 00:46:12.430 --> 00:46:17.350 So you're making $200 cash every year before tax, 00:46:17.350 --> 00:46:21.670 but then you've got to pay tax, but then you're 00:46:21.670 --> 00:46:25.760 getting a depreciation deduction of $100,000 a year. 00:46:25.760 --> 00:46:31.170 So you're actually getting $160,000 of cash every year. 00:46:31.170 --> 00:46:35.340 Not a 100, but 160. 00:46:35.340 --> 00:46:37.230 So when you do an NPV calculation 00:46:37.230 --> 00:46:40.500 it makes a world of difference whether your NPVing this guy, 00:46:40.500 --> 00:46:42.320 or your NPVing this guy. 00:46:42.320 --> 00:46:43.800 They're not the same. 00:46:43.800 --> 00:46:44.460 Right? 00:46:44.460 --> 00:46:46.620 And from an economic decision perspective, 00:46:46.620 --> 00:46:49.600 this is what you ought to focus on, not on this. 00:46:49.600 --> 00:46:50.924 Yeah, Edward? 00:46:50.924 --> 00:46:51.507 AUDIENCE: Yes. 00:46:51.507 --> 00:46:53.423 Probably through the accounting calculation, 00:46:53.423 --> 00:46:55.339 you will have the million up front. 00:46:55.339 --> 00:46:58.692 While here you will have a cash flow and a cash in flow 00:46:58.692 --> 00:47:00.130 from here [INAUDIBLE], right? 00:47:00.130 --> 00:47:00.270 ANDREW LO: Yeah. 00:47:00.270 --> 00:47:01.200 AUDIENCE: In the accounting. 00:47:01.200 --> 00:47:02.200 ANDREW LO: That's right. 00:47:02.200 --> 00:47:03.660 So there are other considerations 00:47:03.660 --> 00:47:05.800 that you might want to bring into the analysis, 00:47:05.800 --> 00:47:07.929 but my point is simply using accounting earnings 00:47:07.929 --> 00:47:10.470 versus after tax cash flows will give you a different number. 00:47:10.470 --> 00:47:13.520 In both cases, I'm not I'm not taking into account 00:47:13.520 --> 00:47:16.050 the upfront outlay of a million. 00:47:16.050 --> 00:47:16.550 Right? 00:47:16.550 --> 00:47:17.800 AUDIENCE: But in the accounting you would never. 00:47:17.800 --> 00:47:18.040 ANDREW LO: Right. 00:47:18.040 --> 00:47:18.664 AUDIENCE: Yeah. 00:47:18.664 --> 00:47:19.290 [INAUDIBLE] 00:47:19.290 --> 00:47:20.040 ANDREW LO: Agreed. 00:47:20.040 --> 00:47:21.000 That's right. 00:47:21.000 --> 00:47:22.687 And that's part of the problem. 00:47:22.687 --> 00:47:24.270 That's one of the reasons, by the way, 00:47:24.270 --> 00:47:27.210 why certain companies are incentivized 00:47:27.210 --> 00:47:29.220 to acquire other companies. 00:47:29.220 --> 00:47:30.930 It's because the acquisition costs 00:47:30.930 --> 00:47:34.086 aren't accounted for in the same way that the operating costs. 00:47:34.086 --> 00:47:35.460 So if you've got a company that's 00:47:35.460 --> 00:47:38.430 generating a lot of profits, it's very profitable, 00:47:38.430 --> 00:47:41.010 but it cost you a lot of money to acquire, from the counting 00:47:41.010 --> 00:47:42.390 perspective it can make you look really 00:47:42.390 --> 00:47:44.723 good because your earnings are going to get a big boost, 00:47:44.723 --> 00:47:47.130 but in fact the NPV of the situation 00:47:47.130 --> 00:47:49.250 may not be as attractive. 00:47:49.250 --> 00:47:51.780 The bottom line from shareholder wealth, 00:47:51.780 --> 00:47:54.715 if you are doing this for your own personal account 00:47:54.715 --> 00:47:56.090 you'd want to be making decisions 00:47:56.090 --> 00:47:59.660 not on accounting earnings alone, but rather on cash 00:47:59.660 --> 00:48:00.270 flows. 00:48:00.270 --> 00:48:00.530 All right? 00:48:00.530 --> 00:48:01.140 NPVs. 00:48:01.140 --> 00:48:02.950 Yeah, [INAUDIBLE]. 00:48:02.950 --> 00:48:05.560 AUDIENCE: What about if you can give a working capital? 00:48:05.560 --> 00:48:09.440 Aren't you supposed to take it also in to consideration? 00:48:09.440 --> 00:48:10.660 ANDREW LO: In what sense? 00:48:10.660 --> 00:48:13.110 You're looking at the net incremental impact 00:48:13.110 --> 00:48:16.440 on your working capital and this take that into account. 00:48:16.440 --> 00:48:19.410 Wokring capital is the change-- 00:48:19.410 --> 00:48:21.885 is demanding opportunity to invest in the business 00:48:21.885 --> 00:48:23.800 in order to make the business to grow. 00:48:23.800 --> 00:48:25.050 ANDREW LO: Yeah, that's right. 00:48:25.050 --> 00:48:26.760 So I haven't talked about what the NPV. 00:48:26.760 --> 00:48:29.710 Is if you want to do the NPV you've got to ask the question, 00:48:29.710 --> 00:48:33.180 does the after tax cash flow justify a million dollars? 00:48:33.180 --> 00:48:36.420 I haven't talked about that yet. 00:48:36.420 --> 00:48:38.970 So I'm not I'm not suggesting that we've 00:48:38.970 --> 00:48:40.350 got an answer for what you should 00:48:40.350 --> 00:48:42.344 do with this particular situation, 00:48:42.344 --> 00:48:44.010 I'm simply using this as an illustration 00:48:44.010 --> 00:48:45.930 to point out that accounting earnings is not 00:48:45.930 --> 00:48:50.277 the same thing as after tax net cash task flows. 00:48:50.277 --> 00:48:50.776 Yeah. 00:48:50.776 --> 00:48:53.242 AUDIENCE: So from a finance [INAUDIBLE] point, 00:48:53.242 --> 00:48:57.098 we don't care about this [INAUDIBLE] company, as well as 00:48:57.098 --> 00:49:00.480 this ability to generate future cash flows? 00:49:00.480 --> 00:49:03.846 ANDREW LO: Well, no I didn't I did not say that. 00:49:03.846 --> 00:49:05.220 The question about whether or not 00:49:05.220 --> 00:49:08.250 you care about the solvency of the company 00:49:08.250 --> 00:49:11.460 is a question about what the ultimate costs of bankruptcy 00:49:11.460 --> 00:49:14.970 are, but from a shareholder's perspective, 00:49:14.970 --> 00:49:17.730 if you ask the question what does the shareholder want 00:49:17.730 --> 00:49:21.070 you, the corporate manager, to do, the answer is simple. 00:49:21.070 --> 00:49:24.060 The shareholder wants you to maximize the net present value 00:49:24.060 --> 00:49:26.580 of the business. 00:49:26.580 --> 00:49:27.410 OK? 00:49:27.410 --> 00:49:29.780 If there are dramatic costs of bankruptcy, 00:49:29.780 --> 00:49:31.730 or financial stress, then you're going 00:49:31.730 --> 00:49:34.340 to have to incorporate that into your calculation for what 00:49:34.340 --> 00:49:35.060 you should do. 00:49:35.060 --> 00:49:36.320 Absolutely. 00:49:36.320 --> 00:49:37.700 But the point is that when you're 00:49:37.700 --> 00:49:41.120 looking at net present value, net present value gives you 00:49:41.120 --> 00:49:43.280 the appropriate data to make that trade off. 00:49:46.090 --> 00:49:49.150 Always use net present value to at least calculate 00:49:49.150 --> 00:49:51.820 the implications of the various different investments. 00:49:51.820 --> 00:49:53.800 In the case of bankruptcy costs, if there 00:49:53.800 --> 00:49:56.156 are dramatic costs of financial distress, 00:49:56.156 --> 00:49:58.280 then you don't want to go there because then you're 00:49:58.280 --> 00:50:01.580 not going to be serving the best interest of the shareholders. 00:50:01.580 --> 00:50:04.700 But if on the other hand, there are very little risks 00:50:04.700 --> 00:50:06.650 of financial distress and there's 00:50:06.650 --> 00:50:08.420 an incredibly good opportunity for you 00:50:08.420 --> 00:50:12.290 to take on certain risk that looks more than worthwhile 00:50:12.290 --> 00:50:14.480 relative to the compensation you're getting, 00:50:14.480 --> 00:50:17.660 then I would argue that it makes sense to do so. 00:50:17.660 --> 00:50:21.130 So the question is one about magnitude. 00:50:21.130 --> 00:50:24.190 What are the bankruptcy costs versus the value 00:50:24.190 --> 00:50:27.700 of the upside for the particular project at hand? 00:50:27.700 --> 00:50:29.200 And you've got to make that decision 00:50:29.200 --> 00:50:33.059 with all the various different data properly computed. 00:50:33.059 --> 00:50:35.350 What I'm telling you how to do is to compute that data. 00:50:39.290 --> 00:50:40.130 All right. 00:50:40.130 --> 00:50:44.540 Here are some other calculations that describe 00:50:44.540 --> 00:50:46.340 what went on in the previous. 00:50:46.340 --> 00:50:49.640 This is a case of accounting earnings after tax, cash flow 00:50:49.640 --> 00:50:50.990 after tax. 00:50:50.990 --> 00:50:53.510 The bottom line is that they're different. 00:50:53.510 --> 00:50:57.200 So for the perspective of NPV calculations 00:50:57.200 --> 00:51:00.500 you ought to focus on the particular calculation that 00:51:00.500 --> 00:51:02.420 gives you net cash flows. 00:51:05.450 --> 00:51:10.130 So now I'm going to turn to focusing on the denominator, 00:51:10.130 --> 00:51:12.530 discount rates. 00:51:12.530 --> 00:51:15.680 We already went through an analysis about how 00:51:15.680 --> 00:51:17.640 to pick the discount rate. 00:51:17.640 --> 00:51:20.030 The discount rate that you use is the one 00:51:20.030 --> 00:51:22.910 that adjusts for the risk of the project, 00:51:22.910 --> 00:51:25.580 but keep in mind that a project's discount 00:51:25.580 --> 00:51:27.620 rate, the required rate of return 00:51:27.620 --> 00:51:32.300 is the expected return demanded by investors for the project. 00:51:32.300 --> 00:51:35.240 The way you ought to think about it is the project, 00:51:35.240 --> 00:51:40.160 think of it like a stock and ask the question, for people who 00:51:40.160 --> 00:51:41.840 are going to buy that project, they're 00:51:41.840 --> 00:51:44.960 going to buy the stock, what kind of a discount rate 00:51:44.960 --> 00:51:49.310 are they going to place on the riskiness of that stock. 00:51:49.310 --> 00:51:52.250 It's just like Gillette versus General Motors, 00:51:52.250 --> 00:51:54.600 we talked about that last time. 00:51:54.600 --> 00:51:59.600 Depending on how risk averse the population is, 00:51:59.600 --> 00:52:02.450 that will determine a particular market risk premium. 00:52:02.450 --> 00:52:04.370 The market risk premium and the beta 00:52:04.370 --> 00:52:07.310 is going to determine what the appropriate discount rate is 00:52:07.310 --> 00:52:10.820 for that particular stock, and the idiosyncratic risk 00:52:10.820 --> 00:52:13.280 is going to be assumed away because nobody 00:52:13.280 --> 00:52:15.110 has to bear that risk. 00:52:15.110 --> 00:52:18.545 Everybody can be diversified if they want to be. 00:52:18.545 --> 00:52:21.780 The second thing is that the discount rate, in general, 00:52:21.780 --> 00:52:24.655 depends on the timing and the risks of the cash flows. 00:52:24.655 --> 00:52:27.030 I'm going to give you an example in a few minutes that'll 00:52:27.030 --> 00:52:28.530 throw you off a bit because there's 00:52:28.530 --> 00:52:30.197 going to be two different kinds of risks 00:52:30.197 --> 00:52:32.613 and you're going to have to differentiate between the two. 00:52:32.613 --> 00:52:34.050 So let me come back to that point 00:52:34.050 --> 00:52:37.080 with an example that will be much clearer. 00:52:37.080 --> 00:52:41.160 And the last couple of points is that, the discount rate 00:52:41.160 --> 00:52:43.300 is usually different for different projects. 00:52:43.300 --> 00:52:45.630 Now, this is something that, again, a lot 00:52:45.630 --> 00:52:47.340 of corporate managers miss. 00:52:47.340 --> 00:52:51.330 They feel that if they're in a particular division then 00:52:51.330 --> 00:52:54.044 that division has a particular cost of capital 00:52:54.044 --> 00:52:55.710 and from that point on you should always 00:52:55.710 --> 00:52:57.270 use the cost of capital for anything 00:52:57.270 --> 00:52:59.460 that the division does. 00:52:59.460 --> 00:53:01.500 What if it's the case that the division is 00:53:01.500 --> 00:53:04.440 doing something so different from what it originally 00:53:04.440 --> 00:53:06.390 started with? 00:53:06.390 --> 00:53:08.990 And I'm going to give you an example of that. 00:53:08.990 --> 00:53:12.060 An example is something that happened just a couple of years 00:53:12.060 --> 00:53:12.880 ago. 00:53:12.880 --> 00:53:14.421 I don't know how many of you realize, 00:53:14.421 --> 00:53:16.920 but Bloomberg, you know the maker of those nice terminals 00:53:16.920 --> 00:53:20.040 that everybody uses, Bloomberg has actually a publishing 00:53:20.040 --> 00:53:21.730 company. 00:53:21.730 --> 00:53:22.480 Yeah that's right. 00:53:22.480 --> 00:53:24.730 There's a Bloomberg Business press. 00:53:24.730 --> 00:53:29.350 They publish books and this particular business just 00:53:29.350 --> 00:53:32.382 got launched a couple of years ago. 00:53:32.382 --> 00:53:34.090 They already have a whole bunch of books. 00:53:34.090 --> 00:53:35.710 In fact, they're publishing a book 00:53:35.710 --> 00:53:38.950 that I've been working on with a former student of mine 00:53:38.950 --> 00:53:42.660 a series of interviews of technical analysts. 00:53:42.660 --> 00:53:48.100 And so as part of this idea of setting up a business press, 00:53:48.100 --> 00:53:51.700 they had to figure out what the appropriate cost of capital 00:53:51.700 --> 00:53:55.390 is for that activity, and then ask for money from the parent 00:53:55.390 --> 00:53:58.360 company to launch this. 00:53:58.360 --> 00:54:00.970 So the question is, how do they do that? 00:54:00.970 --> 00:54:04.660 Do they use the appropriate cost of capital for Bloomberg? 00:54:04.660 --> 00:54:07.540 Bloomberg's business is not publishing. 00:54:07.540 --> 00:54:08.320 All right? 00:54:08.320 --> 00:54:11.765 They're an information vendor, and they're 00:54:11.765 --> 00:54:13.280 a technology company. 00:54:13.280 --> 00:54:16.460 And as such, they have a certain multiple, right? 00:54:16.460 --> 00:54:19.130 Those of you who are in venture capital, project financing, 00:54:19.130 --> 00:54:20.750 you know about multiples, right? 00:54:20.750 --> 00:54:23.690 If you have a company with a particular kind of earnings, 00:54:23.690 --> 00:54:26.750 then the value of the company is typically 00:54:26.750 --> 00:54:31.380 stated as a multiple of those earnings. 00:54:31.380 --> 00:54:35.520 The multiple for an IT company, a technology company, 00:54:35.520 --> 00:54:38.240 a financial services company, a multiple 00:54:38.240 --> 00:54:40.010 there is not the same as the multiple 00:54:40.010 --> 00:54:42.240 for a publishing company. 00:54:42.240 --> 00:54:45.000 By the way, which multiple is higher? 00:54:45.000 --> 00:54:47.790 Does anybody know? 00:54:47.790 --> 00:54:49.665 AUDIENCE: IT? 00:54:49.665 --> 00:54:50.290 ANDREW LO: Yes? 00:54:50.290 --> 00:54:52.275 AUDIENCE: Actually, publishing is higher. 00:54:52.275 --> 00:54:54.150 ANDREW LO: Multiple for publishing is higher? 00:54:54.150 --> 00:54:57.040 AUDIENCE: [INAUDIBLE] I think it would be higher unless 00:54:57.040 --> 00:54:59.355 it's [INAUDIBLE] particular-- 00:54:59.355 --> 00:55:00.480 ANDREW LO: And why is that? 00:55:00.480 --> 00:55:02.640 What's the logic for IT being higher? 00:55:02.640 --> 00:55:04.372 AUDIENCE: Higher growth potential. 00:55:04.372 --> 00:55:06.330 ANDREW LO: Higher growth potential, that's one. 00:55:06.330 --> 00:55:08.760 Also, profit margins tend to be higher. 00:55:08.760 --> 00:55:10.620 Publishing is not a growing business. 00:55:10.620 --> 00:55:12.369 I don't know how many of you realize that. 00:55:12.369 --> 00:55:14.670 Because of the internet, because of text messaging, 00:55:14.670 --> 00:55:17.250 all sorts of innovations have really 00:55:17.250 --> 00:55:18.610 hurt the publishing business. 00:55:18.610 --> 00:55:20.717 And that's why a lot of publishers 00:55:20.717 --> 00:55:22.800 have either gone out of business or have combined, 00:55:22.800 --> 00:55:25.450 so that now we have a few mega publishers. 00:55:25.450 --> 00:55:26.460 Yeah. 00:55:26.460 --> 00:55:31.350 So if you're an entrepreneur that's 00:55:31.350 --> 00:55:34.140 looking to set up Bloomberg Press 00:55:34.140 --> 00:55:38.410 and now Bloomberg is using a particular cost of capital, 00:55:38.410 --> 00:55:40.350 you may say, "Well, hey, wait a minute, that's 00:55:40.350 --> 00:55:42.600 not the right cost of capital because publishing 00:55:42.600 --> 00:55:43.984 is a different multiple." 00:55:43.984 --> 00:55:45.150 How would you do that, then? 00:55:45.150 --> 00:55:49.750 How would you figure out what to use in order 00:55:49.750 --> 00:55:52.980 to calculate the value of a venture for Bloomberg Press? 00:55:52.980 --> 00:55:53.480 Courtney? 00:55:53.480 --> 00:55:55.438 AUDIENCE: Just look at the comparable companies 00:55:55.438 --> 00:55:57.728 and take, like, look at all the betas of all of them, 00:55:57.728 --> 00:55:59.049 and do analysis from them. 00:55:59.049 --> 00:55:59.840 ANDREW LO: Exactly. 00:55:59.840 --> 00:56:03.590 So let's look at other companies that are in the business 00:56:03.590 --> 00:56:07.767 that we want to get into and see what kind of beta they have, 00:56:07.767 --> 00:56:09.600 and what the appropriate cost of capital is. 00:56:09.600 --> 00:56:10.784 Anant? 00:56:10.784 --> 00:56:12.752 AUDIENCE: So I understand why they doing that. 00:56:12.752 --> 00:56:16.196 But at the end of the day, if Bloomberg, the company, has, 00:56:16.196 --> 00:56:19.640 you know, $1 million or whatever to invest, why would it 00:56:19.640 --> 00:56:23.248 look at going into an area like this with a lower 00:56:23.248 --> 00:56:26.282 rate of return than, you know, a product where it could 00:56:26.282 --> 00:56:28.004 get a high rate of return? 00:56:28.004 --> 00:56:31.563 Unless you have some facilities, in which case facilities plus 00:56:31.563 --> 00:56:34.132 rate of return should be at least equal to the rate 00:56:34.132 --> 00:56:36.000 of return for the economy. 00:56:36.000 --> 00:56:38.940 ANDREW LO: So let's hold off on that discussion for a moment. 00:56:38.940 --> 00:56:41.425 I'm not going to try to justify why they get into it, 00:56:41.425 --> 00:56:43.050 I just want to understand the mechanics 00:56:43.050 --> 00:56:45.970 of how they decide on whether or not to get into it. 00:56:45.970 --> 00:56:47.532 I'll come back to why later. 00:56:47.532 --> 00:56:49.740 Let's come back to that in just a few minutes though. 00:56:49.740 --> 00:56:51.810 Before we get to that, let's figure out 00:56:51.810 --> 00:56:53.370 how they even evaluate. 00:56:53.370 --> 00:56:53.970 All right? 00:56:53.970 --> 00:56:56.940 So I've suggested here that they might use 00:56:56.940 --> 00:56:59.940 the beta of John Wiley & Sons. 00:56:59.940 --> 00:57:01.800 That's a publicly-traded publishing company. 00:57:01.800 --> 00:57:06.290 But they could also use the beta of McGraw-Hill. 00:57:06.290 --> 00:57:07.250 Which should we pick? 00:57:07.250 --> 00:57:09.760 McGraw-Hill or John Wiley? 00:57:09.760 --> 00:57:10.260 Louis? 00:57:10.260 --> 00:57:11.220 AUDIENCE: John Wiley. 00:57:11.220 --> 00:57:11.700 ANDREW LO: Why? 00:57:11.700 --> 00:57:14.116 AUDIENCE: Because McGraw-Hill's not a pure play publisher. 00:57:14.116 --> 00:57:15.110 ANDREW LO: Exactly. 00:57:15.110 --> 00:57:18.760 McGraw-Hill has lots of other businesses besides publishing. 00:57:18.760 --> 00:57:21.100 So while they do do a lot of publishing, 00:57:21.100 --> 00:57:22.559 they also do a lot of other things. 00:57:22.559 --> 00:57:25.058 Give me another business that McGraw-Hill is involved in it. 00:57:25.058 --> 00:57:25.610 Anybody? 00:57:25.610 --> 00:57:26.110 Yeah? 00:57:26.110 --> 00:57:26.850 AUDIENCE: Standard & Poor's? 00:57:26.850 --> 00:57:27.641 ANDREW LO: Exactly. 00:57:27.641 --> 00:57:29.960 McGraw-Hill owns Standard & Poor's. 00:57:29.960 --> 00:57:33.530 And Standard & Poor's does a lot of things, including publishing 00:57:33.530 --> 00:57:36.200 ratings as well as indexes. 00:57:36.200 --> 00:57:40.290 So those businesses are not the same as publishing books. 00:57:40.290 --> 00:57:44.780 McGraw-Hill has lots of other subsidiaries, 00:57:44.780 --> 00:57:48.790 whereas John Wiley & Sons, all they do is publishing. 00:57:48.790 --> 00:57:51.890 They are what is known as a pure play company. 00:57:51.890 --> 00:57:53.660 So let's take a look. 00:57:53.660 --> 00:58:01.220 This is the revenues of John Wiley & Sons in 2007. 00:58:01.220 --> 00:58:04.430 If you look at the core business-- 00:58:04.430 --> 00:58:09.420 39% professional trade, 70% higher ed, 44% scientific, 00:58:09.420 --> 00:58:12.000 technical, and medical-- 00:58:12.000 --> 00:58:16.380 that's not a perfect match for Bloomberg, 00:58:16.380 --> 00:58:18.150 but that's not bad, right? 00:58:18.150 --> 00:58:21.540 That's within the same general area. 00:58:21.540 --> 00:58:25.080 What we would really prefer is if it were just this slice 00:58:25.080 --> 00:58:26.970 that we could carve out and figure out 00:58:26.970 --> 00:58:28.590 what that business looked like. 00:58:28.590 --> 00:58:31.786 But that's not so easy to do because of the fact 00:58:31.786 --> 00:58:33.660 that it's one company that's doing all of it. 00:58:33.660 --> 00:58:33.840 Ken? 00:58:33.840 --> 00:58:35.274 AUDIENCE: How much does size matter? 00:58:35.274 --> 00:58:37.186 How much should Bloomberg take into consideration 00:58:37.186 --> 00:58:39.186 the fact that John Wyley is [INAUDIBLE] doing it 00:58:39.186 --> 00:58:40.420 at a different scale? 00:58:40.420 --> 00:58:43.990 ANDREW LO: Well, so I guess I would be lying if I told you 00:58:43.990 --> 00:58:46.030 that size didn't matter. 00:58:46.030 --> 00:58:47.620 That's usually the case. 00:58:47.620 --> 00:58:50.320 Size matters in the sense that you 00:58:50.320 --> 00:58:52.210 want to have a company that's representative 00:58:52.210 --> 00:58:53.710 of what you're trying to do. 00:58:53.710 --> 00:58:56.470 And smaller companies bear certain risks that larger 00:58:56.470 --> 00:58:57.640 companies don't. 00:58:57.640 --> 00:59:00.700 And vice versa, larger companies have access to certain benefits 00:59:00.700 --> 00:59:03.010 and technologies that smaller companies don't. 00:59:03.010 --> 00:59:05.380 So the point is that we don't always 00:59:05.380 --> 00:59:07.277 get to choose what's available. 00:59:07.277 --> 00:59:09.610 You've got to look at the various different alternatives 00:59:09.610 --> 00:59:12.980 out there and the best way to approach it is to get a range. 00:59:12.980 --> 00:59:14.590 So if you're going to be doing this 00:59:14.590 --> 00:59:16.450 in a more serious fashion, what you do 00:59:16.450 --> 00:59:18.850 is to make a study of the publishing business. 00:59:18.850 --> 00:59:21.370 Find companies at both ends of the spectrum. 00:59:21.370 --> 00:59:24.160 The small ones and the big ones, the pure plays 00:59:24.160 --> 00:59:26.830 and the conglomerates, and estimate 00:59:26.830 --> 00:59:28.720 the cost of capital for all of them. 00:59:28.720 --> 00:59:32.140 And then say, given this spectrum of results, 00:59:32.140 --> 00:59:36.430 we think that the appropriate cost of capital should be here. 00:59:36.430 --> 00:59:39.130 And basically make a choice after having 00:59:39.130 --> 00:59:40.390 looked at the evidence. 00:59:40.390 --> 00:59:43.390 So what I'm giving you is not a simple recipe 00:59:43.390 --> 00:59:45.100 that will work in every circumstance 00:59:45.100 --> 00:59:48.550 but rather an approach that, with sufficient study 00:59:48.550 --> 00:59:51.571 and analysis, will yield an intelligent answer. 00:59:51.571 --> 00:59:54.070 So let's actually take a look at the answer here, all right? 00:59:54.070 --> 00:59:56.170 So we've got John Wiley & Sons, we've 00:59:56.170 --> 01:00:00.040 got their performance over a period of time, the share price 01:00:00.040 --> 01:00:01.210 and so on. 01:00:01.210 --> 01:00:06.910 If you take the beta of John Wiley & Sons series A shares, 01:00:06.910 --> 01:00:10.210 and you can get that from Yahoo, it's a beta of 1.29 as 01:00:10.210 --> 01:00:11.560 of last year. 01:00:11.560 --> 01:00:15.940 Then, with a risk-free rate of 5% and a market-risk premium 01:00:15.940 --> 01:00:16.654 of 6%-- 01:00:16.654 --> 01:00:18.070 which is when Bloomberg was trying 01:00:18.070 --> 01:00:21.640 to decide when to go into the business, about two years ago-- 01:00:21.640 --> 01:00:26.770 it turns out that the cost of capital is 12.7%. 01:00:26.770 --> 01:00:28.990 So that's actually a pretty reasonable cost 01:00:28.990 --> 01:00:31.510 of capital, which says that that's 01:00:31.510 --> 01:00:36.430 the number you use in figuring out whether or not 01:00:36.430 --> 01:00:40.180 the cash flows from a publishing business make sense. 01:00:40.180 --> 01:00:41.140 OK? 01:00:41.140 --> 01:00:43.270 Now to Anant's question, why on earth 01:00:43.270 --> 01:00:45.040 would you do that when you could invest 01:00:45.040 --> 01:00:47.950 in a business that may have a higher cost of capital 01:00:47.950 --> 01:00:49.540 or a higher rate of return? 01:00:49.540 --> 01:00:50.770 We don't know that they do. 01:00:50.770 --> 01:00:52.630 In other words, at this point, Bloomberg 01:00:52.630 --> 01:00:55.030 may not have any ability to invest 01:00:55.030 --> 01:00:57.970 in its current business or others that 01:00:57.970 --> 01:00:59.750 have a higher rate of return. 01:00:59.750 --> 01:01:04.120 So one could argue that a cost of capital of about 12.7% 01:01:04.120 --> 01:01:07.120 is actually a pretty reasonable hurdle rate for a new business. 01:01:07.120 --> 01:01:09.940 So in other words, I would only invest in this business 01:01:09.940 --> 01:01:12.710 if it yielded a positive NPV. 01:01:12.710 --> 01:01:16.330 Now a positive NPV means it's earning more than 12.7% 01:01:16.330 --> 01:01:18.210 on average, right? 01:01:18.210 --> 01:01:21.340 That's a pretty good rate of return for a new business. 01:01:21.340 --> 01:01:24.320 Now, there is another business that Bloomberg 01:01:24.320 --> 01:01:27.774 could get into which is the hedge fund business, right? 01:01:27.774 --> 01:01:28.440 I mean, why not? 01:01:28.440 --> 01:01:30.856 They've got all this data, they may as well make use of it 01:01:30.856 --> 01:01:32.420 and turn into a hedge fund. 01:01:32.420 --> 01:01:35.420 Now, that business, I suspect that the cost of capital 01:01:35.420 --> 01:01:36.800 is a lot higher. 01:01:36.800 --> 01:01:40.580 Higher because the riskiness is more substantial. 01:01:40.580 --> 01:01:43.280 And there, you have to start talking about the riskiness 01:01:43.280 --> 01:01:44.570 of bankruptcy. 01:01:44.570 --> 01:01:46.670 Would it really be a good idea to jeopardize 01:01:46.670 --> 01:01:49.580 Bloomberg's entire franchise on one mega hedge fund? 01:01:49.580 --> 01:01:50.830 I don't know, maybe? 01:01:50.830 --> 01:01:53.630 But probably not, if you really are 01:01:53.630 --> 01:01:56.870 serious about preserving the franchise value the company. 01:01:56.870 --> 01:01:57.370 Mike? 01:01:57.370 --> 01:01:58.486 AUDIENCE: So then, to that point, 01:01:58.486 --> 01:02:00.870 how do you consider the impact on the rest of Bloomberg, 01:02:00.870 --> 01:02:03.712 given this additonal-- if they go 01:02:03.712 --> 01:02:04.962 into this additional division? 01:02:04.962 --> 01:02:07.087 ANDREW LO: Well, so that's the project interactions 01:02:07.087 --> 01:02:08.510 that I haven't talked about. 01:02:08.510 --> 01:02:12.740 Up until now, I'm assuming this is a standalone subsidiary. 01:02:12.740 --> 01:02:16.540 And I'm evaluating it as positive NPV or not. 01:02:16.540 --> 01:02:17.300 OK? 01:02:17.300 --> 01:02:20.180 The next step in the capital budgeting process 01:02:20.180 --> 01:02:23.870 is to then ask the question, OK, as a standalone entity, 01:02:23.870 --> 01:02:25.190 I think I understand it. 01:02:25.190 --> 01:02:28.117 I got the cash flows down, I got the discount rate down. 01:02:28.117 --> 01:02:29.450 I know what the comparisons are. 01:02:29.450 --> 01:02:34.260 I've evaluated the NPV and it looks positive. 01:02:34.260 --> 01:02:38.900 Now let me ask, what does this do strategically for the firm? 01:02:38.900 --> 01:02:41.180 That's the third question, the strategic options. 01:02:41.180 --> 01:02:42.410 Is it good? 01:02:42.410 --> 01:02:43.940 Or is it not so good? 01:02:43.940 --> 01:02:47.720 And if so can I put a number on that? 01:02:47.720 --> 01:02:50.480 Now, from Bloomberg, I wasn't involved in any discussions 01:02:50.480 --> 01:02:53.180 internally so I can't tell you what Bloomberg came up with. 01:02:53.180 --> 01:02:55.400 But from what I gather, they decided 01:02:55.400 --> 01:02:58.250 that there are some positive synergies between a business 01:02:58.250 --> 01:03:03.949 press and their other media type of access. 01:03:03.949 --> 01:03:05.990 That they felt that there were some cross-selling 01:03:05.990 --> 01:03:08.152 opportunities so that, when there was a good book, 01:03:08.152 --> 01:03:09.860 they could put it on the Bloomberg screen 01:03:09.860 --> 01:03:12.390 and advertise free, basically. 01:03:12.390 --> 01:03:14.150 And then the print media would actually 01:03:14.150 --> 01:03:16.790 help to support attention to Bloomberg 01:03:16.790 --> 01:03:19.460 as an outlet for news. 01:03:19.460 --> 01:03:23.990 So in that case, they determined that this interaction was all 01:03:23.990 --> 01:03:26.642 good, that there wasn't a downside to it. 01:03:26.642 --> 01:03:28.100 And part of the reason, I think, is 01:03:28.100 --> 01:03:29.516 because they were able to assemble 01:03:29.516 --> 01:03:32.660 a team of very experienced publishers and editors. 01:03:32.660 --> 01:03:35.000 They pulled them out of other publishing firms 01:03:35.000 --> 01:03:37.010 to start this new venture, and they ended up 01:03:37.010 --> 01:03:38.840 getting some really good people involved. 01:03:38.840 --> 01:03:41.006 And I've had the pleasure to work with some of them. 01:03:41.006 --> 01:03:42.680 They are very, very professional. 01:03:42.680 --> 01:03:46.694 So Bloomberg actually made a pretty good decision, at least 01:03:46.694 --> 01:03:48.860 from the perspective of getting this thing launched. 01:03:48.860 --> 01:03:50.630 Whether or not it will be profitable, who knows? 01:03:50.630 --> 01:03:52.520 It's only been around for a couple of years, 01:03:52.520 --> 01:03:54.800 but so far they've developed a pretty impressive list 01:03:54.800 --> 01:03:56.310 of authors. 01:03:56.310 --> 01:03:56.895 Yeah? 01:03:56.895 --> 01:03:57.765 AUDIENCE: I guess what I'm saying-- 01:03:57.765 --> 01:03:59.264 Let's just say the rest of Bloomberg 01:03:59.264 --> 01:04:00.970 had a cost of capital of 10. 01:04:00.970 --> 01:04:04.110 They go to this, let's say it pulls everything up to 11. 01:04:04.110 --> 01:04:06.487 The rest of their business is now more expensive. 01:04:06.487 --> 01:04:07.570 That was more my question. 01:04:07.570 --> 01:04:10.029 Will we include the value of destruction 01:04:10.029 --> 01:04:12.570 on the rest of their business for raising their overall cost? 01:04:12.570 --> 01:04:13.650 ANDREW LO: Well, so-- 01:04:13.650 --> 01:04:16.620 If there's any kind of value creation or destruction, 01:04:16.620 --> 01:04:21.720 you're implicitly assuming some kind of market irrationality. 01:04:21.720 --> 01:04:22.290 Right? 01:04:22.290 --> 01:04:25.620 Because what you're assuming is that, if they pull this thing 01:04:25.620 --> 01:04:28.350 up, they pull up the cost of capital for the entire firm, 01:04:28.350 --> 01:04:30.660 they lower the valuation of the entire firm. 01:04:30.660 --> 01:04:32.850 You're assuming that people in the industry 01:04:32.850 --> 01:04:36.060 can't see through the fact that they've got a subsidiary. 01:04:36.060 --> 01:04:38.880 And in some cases, you may be right. 01:04:38.880 --> 01:04:41.520 But I would argue that a better perspective is 01:04:41.520 --> 01:04:44.490 to say that analysts are going to be 01:04:44.490 --> 01:04:47.190 able to do division-by-division valuation 01:04:47.190 --> 01:04:49.227 and say, OK, they got a publishing division. 01:04:49.227 --> 01:04:51.060 These are the revenues, these are the costs, 01:04:51.060 --> 01:04:53.197 they're segregated, and it makes sense for them, 01:04:53.197 --> 01:04:54.030 given the synergies. 01:04:54.030 --> 01:04:55.030 Blah, blah, blah. 01:04:55.030 --> 01:04:57.690 So I would expect that those considerations may not 01:04:57.690 --> 01:04:58.610 be as significant. 01:04:58.610 --> 01:05:03.180 Now if, on the other hand, this publishing operation 01:05:03.180 --> 01:05:05.254 were really big-- 01:05:05.254 --> 01:05:07.670 In other words, if it ended up that it grew so big that it 01:05:07.670 --> 01:05:11.810 accounted for half of the revenues of Bloomberg, 01:05:11.810 --> 01:05:15.636 the entity, then I think your point would be well taken, 01:05:15.636 --> 01:05:16.760 would be much more serious. 01:05:16.760 --> 01:05:19.454 Right now, it's a tiny, little blip 01:05:19.454 --> 01:05:20.870 in the grand scheme of things that 01:05:20.870 --> 01:05:22.460 may turn into something big. 01:05:22.460 --> 01:05:24.980 But for example, if you're an investment bank-- 01:05:24.980 --> 01:05:27.410 Nowadays, we don't have any more of those but at one point 01:05:27.410 --> 01:05:28.340 we did. 01:05:28.340 --> 01:05:32.450 If you're an investment bank and you've got a franchise based 01:05:32.450 --> 01:05:36.230 upon customer-driven business, very reliable, 01:05:36.230 --> 01:05:42.470 very high multiples, very, very valuable kind of franchise-- 01:05:42.470 --> 01:05:43.970 And then the question is, should you 01:05:43.970 --> 01:05:46.330 get involved in prop trading? 01:05:46.330 --> 01:05:48.160 Prop trading, proprietary trading, 01:05:48.160 --> 01:05:51.550 basically being a hedge fund, carries 01:05:51.550 --> 01:05:54.190 in the marketplace no multiple. 01:05:54.190 --> 01:05:57.460 Actually in some cases, the multiple is negative, 01:05:57.460 --> 01:05:59.240 I mean, that is, less than 1. 01:05:59.240 --> 01:05:59.770 Right? 01:05:59.770 --> 01:06:03.270 Because if you're thinking about acquiring a hedge fund, 01:06:03.270 --> 01:06:04.895 the typical hedge fund will provide you 01:06:04.895 --> 01:06:06.686 with whatever earnings they have this year, 01:06:06.686 --> 01:06:08.250 but next year they could blow up. 01:06:08.250 --> 01:06:12.000 So there is no multiple assigned to hedge funds, typically. 01:06:12.000 --> 01:06:12.872 Not always. 01:06:12.872 --> 01:06:15.330 I can give you examples over the last couple of years where 01:06:15.330 --> 01:06:17.430 hedge funds have sold for multiples, 01:06:17.430 --> 01:06:19.810 but there are not many of them. 01:06:19.810 --> 01:06:22.410 And typically, a hedge fund, when 01:06:22.410 --> 01:06:25.920 you look at the value of the future earnings, the multiple 01:06:25.920 --> 01:06:27.840 that is applied can be less than 1 01:06:27.840 --> 01:06:31.860 if there is a concern that the hedge fund can drag down 01:06:31.860 --> 01:06:34.680 the value of the parent company. 01:06:34.680 --> 01:06:37.370 So there are situations where, for a distress sale, 01:06:37.370 --> 01:06:41.960 people have paid $0.50 on the dollar of assets of a hedge 01:06:41.960 --> 01:06:42.890 fund. 01:06:42.890 --> 01:06:45.464 Of the actual cash that the hedge fund has generated 01:06:45.464 --> 01:06:46.880 for its shareholders, they've paid 01:06:46.880 --> 01:06:50.750 less than a dollar for dollar because of that kind of effect 01:06:50.750 --> 01:06:52.190 on the parent company. 01:06:52.190 --> 01:06:54.050 Goldman Sachs, after they went public, 01:06:54.050 --> 01:06:57.860 they really had a lot of difficulty internally, 01:06:57.860 --> 01:07:00.770 thinking about prop trading, because prop trading accounted 01:07:00.770 --> 01:07:04.100 during certain years for such a large fraction of the Goldman 01:07:04.100 --> 01:07:07.014 franchise that it ended up having the effect 01:07:07.014 --> 01:07:08.180 that Mike was talking about. 01:07:08.180 --> 01:07:10.460 That is, people said, gee, Goldman is nothing 01:07:10.460 --> 01:07:11.630 but a prop trading firm. 01:07:11.630 --> 01:07:13.505 I'm not going to give it a multiple of seven. 01:07:13.505 --> 01:07:15.350 Let's try a multiple of 2 and 1/2. 01:07:15.350 --> 01:07:17.240 That is value destruction. 01:07:17.240 --> 01:07:18.900 That's a concern. 01:07:18.900 --> 01:07:21.110 But for small projects that aren't 01:07:21.110 --> 01:07:23.150 about the entire corporation, that 01:07:23.150 --> 01:07:25.100 aren't likely to affect the perception 01:07:25.100 --> 01:07:28.010 of the entire corporation, you don't have to worry about that. 01:07:28.010 --> 01:07:30.540 So size does matter in another way. 01:07:30.540 --> 01:07:31.290 Yeah, [INAUDIBLE]? 01:07:31.290 --> 01:07:32.664 AUDIENCE: How did you with, like, 01:07:32.664 --> 01:07:33.990 [INAUDIBLE] and risk-free rate? 01:07:33.990 --> 01:07:35.686 So today what rate would be used? 01:07:35.686 --> 01:07:38.480 ANDREW LO: Today I'd use 1%. 01:07:38.480 --> 01:07:42.470 So this is the time element that I mentioned to you before. 01:07:42.470 --> 01:07:44.690 When you take on a project, you've 01:07:44.690 --> 01:07:46.700 got to have the right time. 01:07:46.700 --> 01:07:48.240 It's got to be the right time. 01:07:48.240 --> 01:07:49.670 And so things change. 01:07:49.670 --> 01:07:51.920 The cost of capital changes. 01:07:51.920 --> 01:07:55.556 So right now, I would use 1% for this particular project. 01:07:55.556 --> 01:07:56.930 So you might think it'd be easier 01:07:56.930 --> 01:07:59.780 to get it launched, but try getting cash 01:07:59.780 --> 01:08:02.000 in a setting like today. 01:08:02.000 --> 01:08:02.500 Yeah? 01:08:02.500 --> 01:08:03.125 AUDIENCE: If you start a project, 01:08:03.125 --> 01:08:05.330 say it's a two-year project and you start it at 1%, 01:08:05.330 --> 01:08:07.496 and then all of a sudden the risk-free rate goes up. 01:08:07.496 --> 01:08:09.330 Does that mean that you might, economically, 01:08:09.330 --> 01:08:11.162 need to cancel your project halfway through? 01:08:11.162 --> 01:08:12.370 ANDREW LO: Yeah, absolutely. 01:08:12.370 --> 01:08:13.220 Yeah. 01:08:13.220 --> 01:08:16.130 At one point, John Maynard Keynes 01:08:16.130 --> 01:08:19.380 was criticized for flip flopping on the gold standard 01:08:19.380 --> 01:08:22.591 and Keynes had a very, very sensible reply, which I think 01:08:22.591 --> 01:08:23.840 I may have mentioned in class. 01:08:23.840 --> 01:08:27.510 Which is that, when the facts change, sir, I change my mind. 01:08:27.510 --> 01:08:30.050 What do you do? 01:08:30.050 --> 01:08:31.189 So absolutely. 01:08:31.189 --> 01:08:33.501 If cost of capital changes a year from now, 01:08:33.501 --> 01:08:35.000 you may have to cancel your project. 01:08:35.000 --> 01:08:37.399 Or you may wish you had taken two of the projects, 01:08:37.399 --> 01:08:38.960 but you didn't get to. 01:08:38.960 --> 01:08:40.956 These kinds of project interactions over time 01:08:40.956 --> 01:08:42.080 make it really complicated. 01:08:42.080 --> 01:08:44.359 That's one of the reasons why we have a whole separate course 01:08:44.359 --> 01:08:45.817 on capital budgeting, is to come up 01:08:45.817 --> 01:08:48.200 with tools to deal with these kind of interactions. 01:08:48.200 --> 01:08:49.140 So absolutely. 01:08:49.140 --> 01:08:51.015 In fact, I'm going to give an example of that 01:08:51.015 --> 01:08:54.080 in just a minute where that time element actually 01:08:54.080 --> 01:08:56.240 is very important. 01:08:56.240 --> 01:08:59.359 Let's actually go over that right now. 01:08:59.359 --> 01:09:02.590 So here's an example that you don't know how to do yet. 01:09:02.590 --> 01:09:04.590 We're going to figure out how to do it together. 01:09:04.590 --> 01:09:05.240 All right? 01:09:05.240 --> 01:09:08.330 And it has to do with time and with risks. 01:09:08.330 --> 01:09:14.450 So a firm is investing in an oil exploration project. 01:09:14.450 --> 01:09:18.215 We're going to drill a bunch of holes in a particular area 01:09:18.215 --> 01:09:20.250 where I'm trying to find oil. 01:09:20.250 --> 01:09:23.100 And it's going to take time to drill these holes. 01:09:23.100 --> 01:09:26.500 So it's going to take at least a year. 01:09:26.500 --> 01:09:28.529 And at the end of the first year, 01:09:28.529 --> 01:09:31.260 there's going to be a probability of 1/3 01:09:31.260 --> 01:09:34.200 that we find three million barrels of oil. 01:09:34.200 --> 01:09:36.569 But there's a probability of 2/3 that we find nothing, 01:09:36.569 --> 01:09:39.950 we come up dry. 01:09:39.950 --> 01:09:43.000 1/3, 2/3 probability. 01:09:43.000 --> 01:09:48.100 Now, if we are successful with that 1/3 probability, then 01:09:48.100 --> 01:09:50.439 the 3 million barrels of oil will 01:09:50.439 --> 01:09:54.262 be pumped out of the ground by the end of the second year. 01:09:54.262 --> 01:09:56.470 So at the end of the first year, if we're successful, 01:09:56.470 --> 01:09:58.300 we'll find oil. 01:09:58.300 --> 01:10:01.330 And then it'll take a year to extract it and barrel it. 01:10:01.330 --> 01:10:02.920 Put it in barrels and sell it. 01:10:02.920 --> 01:10:05.140 And we'll have 3 million barrels to be 01:10:05.140 --> 01:10:07.540 able to do that, and then after that, 01:10:07.540 --> 01:10:11.000 the field will be depleted. 01:10:11.000 --> 01:10:15.080 Now the expected after-tax profit per barrel is $20. 01:10:15.080 --> 01:10:19.010 We're going to make $20 a barrel after-tax. 01:10:19.010 --> 01:10:22.390 Not now, but a year from now. 01:10:22.390 --> 01:10:24.940 The risk-free rate is 5%. 01:10:24.940 --> 01:10:27.730 The industry discount rate of oil production is 20%. 01:10:27.730 --> 01:10:30.130 That's a very high cost of capital. 01:10:30.130 --> 01:10:33.640 But oil production is a high beta activity, 01:10:33.640 --> 01:10:35.470 as you can sort of tell, right? 01:10:35.470 --> 01:10:37.450 Market prices are down. 01:10:37.450 --> 01:10:39.490 Oil prices down. 01:10:39.490 --> 01:10:43.210 When the market was up, oil prices were pretty high. 01:10:43.210 --> 01:10:45.130 Oil has a high beta, OK? 01:10:45.130 --> 01:10:49.480 So the discount rate is 20%, but the exploration risk-- 01:10:49.480 --> 01:10:52.630 this 1/3, 2/3 probability-- 01:10:52.630 --> 01:10:53.790 that has a beta of 0. 01:10:57.474 --> 01:10:58.765 What's the NPV of this project? 01:11:01.270 --> 01:11:03.050 How do you figure that out? 01:11:03.050 --> 01:11:05.810 Believe it or not, you actually have all the tools 01:11:05.810 --> 01:11:07.590 to solve this problem. 01:11:07.590 --> 01:11:09.140 But it's hard. 01:11:09.140 --> 01:11:11.900 And not only is it hard for all of you, 01:11:11.900 --> 01:11:14.325 it's actually hard for professionals. 01:11:14.325 --> 01:11:16.700 A couple of years ago, I taught the Sloan Fellows program 01:11:16.700 --> 01:11:18.230 during the summer. 01:11:18.230 --> 01:11:20.813 I don't know how much you know about the Sloan Fellows program 01:11:20.813 --> 01:11:23.810 but this is a program where we bring executives who've 01:11:23.810 --> 01:11:27.200 worked for 15, 20, 30 years, made their fortunes, 01:11:27.200 --> 01:11:30.680 and have decided to take a year off to get a degree. 01:11:30.680 --> 01:11:36.020 And so these are very seasoned, senior professionals, 01:11:36.020 --> 01:11:39.680 so teaching them is a whole other challenge. 01:11:39.680 --> 01:11:42.460 They're very-- they know a lot. 01:11:42.460 --> 01:11:44.300 And they know a lot about virtually anything 01:11:44.300 --> 01:11:46.620 and everything you ever care to talk about. 01:11:46.620 --> 01:11:49.220 To case in point, I gave this example 01:11:49.220 --> 01:11:51.817 to the Sloan Fellows class. 01:11:51.817 --> 01:11:53.900 Somebody in the back of the room said, "Excuse me. 01:11:53.900 --> 01:11:57.130 First, Lo, but I don't recall that we actually used 01:11:57.130 --> 01:12:02.092 this analysis when we were doing oil exploration." 01:12:02.092 --> 01:12:04.550 And I said, well, why don't you tell us about what you did, 01:12:04.550 --> 01:12:06.470 and who you are, and so on. 01:12:06.470 --> 01:12:10.610 And the fellow said, "Well, I'm the senior vice-president 01:12:10.610 --> 01:12:13.665 for oil exploration at Saudi Aramco." 01:12:13.665 --> 01:12:16.880 This is the biggest oil company in the world, 01:12:16.880 --> 01:12:20.990 and he was the man in charge of drilling those holes. 01:12:20.990 --> 01:12:24.110 And he actually said that they didn't do this analysis, 01:12:24.110 --> 01:12:26.390 but that he actually was going to try it out 01:12:26.390 --> 01:12:29.930 because he thought it made a lot of sense. 01:12:29.930 --> 01:12:32.685 So that was a little scary, I have to tell you. 01:12:32.685 --> 01:12:35.480 A very intimidating audience. 01:12:35.480 --> 01:12:39.176 But the point is that this is a very subtle idea. 01:12:39.176 --> 01:12:40.300 Let me tell you what it is. 01:12:40.300 --> 01:12:42.390 Let me tell you how it works, OK? 01:12:42.390 --> 01:12:45.210 There are two risks going on here. 01:12:45.210 --> 01:12:48.630 There is the market risk of pumping the oil out 01:12:48.630 --> 01:12:50.460 of the ground and selling it. 01:12:50.460 --> 01:12:52.890 And that we understand quite well. 01:12:52.890 --> 01:12:57.870 That has a beta given by this particular cost of capital, 01:12:57.870 --> 01:12:58.890 20%. 01:12:58.890 --> 01:13:01.380 So we already know what the discount rate 01:13:01.380 --> 01:13:05.057 is in that second year. 01:13:05.057 --> 01:13:07.640 But we need to figure out how to discount from the second year 01:13:07.640 --> 01:13:09.470 to the first year. 01:13:09.470 --> 01:13:13.820 What should the appropriate risk-adjusted discount rate 01:13:13.820 --> 01:13:17.960 is from the first year back to year zero. 01:13:17.960 --> 01:13:18.901 That's the key. 01:13:18.901 --> 01:13:19.400 Right? 01:13:19.400 --> 01:13:20.600 That's the hard part. 01:13:20.600 --> 01:13:22.280 At the end of the second year, we're 01:13:22.280 --> 01:13:24.500 going to have 3 million barrels of oil, 01:13:24.500 --> 01:13:31.460 each priced at $20 a barrel for a profit of $60 million, right? 01:13:31.460 --> 01:13:33.120 Or $6 million here. 01:13:33.120 --> 01:13:34.040 Yeah. 01:13:34.040 --> 01:13:37.982 So $60 million at the end of two years. 01:13:37.982 --> 01:13:39.440 Now we're going to discount it back 01:13:39.440 --> 01:13:44.125 to the beginning of that two year period. 01:13:44.125 --> 01:13:46.000 So in other words, we're going to discount it 01:13:46.000 --> 01:13:48.910 from the end of the second year to the beginning 01:13:48.910 --> 01:13:51.460 of that second year, or the end of the first year, 01:13:51.460 --> 01:13:54.030 and that's what we get as $50 million, right? 01:13:54.030 --> 01:13:58.180 $60 million discounted back by 20% discount rate, 01:13:58.180 --> 01:14:04.850 that's $50 million at year one, if we strike oil. 01:14:04.850 --> 01:14:08.690 But there's a 1/3 probability that we strike oil. 01:14:08.690 --> 01:14:11.240 There's a 2/3 probability that we don't. 01:14:11.240 --> 01:14:15.230 The question is, what do we discount this possibility back 01:14:15.230 --> 01:14:16.550 to year zero? 01:14:16.550 --> 01:14:22.070 And I'm going to argue you discount it back, not at 20% 01:14:22.070 --> 01:14:24.460 but at 5%. 01:14:24.460 --> 01:14:25.790 5%? 01:14:25.790 --> 01:14:28.370 That's the risk-free rate. 01:14:28.370 --> 01:14:30.420 Now, why on earth would you do that? 01:14:30.420 --> 01:14:33.430 This is the oil industry we're talking about. 01:14:33.430 --> 01:14:37.570 The reason you discount the first year back to year zero 01:14:37.570 --> 01:14:42.540 at risk-free rate is because the risk of coming up dry, 01:14:42.540 --> 01:14:47.310 that risk is completely diversifiable. 01:14:47.310 --> 01:14:49.870 That is complete, idiosyncratic risk. 01:14:49.870 --> 01:14:52.260 There is no beta, right? 01:14:52.260 --> 01:14:55.980 The oil deposits underground don't 01:14:55.980 --> 01:14:58.200 know whether it's a bull market or a bear market. 01:14:58.200 --> 01:14:59.460 They couldn't care less. 01:14:59.460 --> 01:15:01.690 They're either there or they're not there, 01:15:01.690 --> 01:15:03.360 and you're drilling for it. 01:15:03.360 --> 01:15:09.310 So your risk of not striking oil has no bearing on the market. 01:15:09.310 --> 01:15:12.300 If you are well diversified, then that risk 01:15:12.300 --> 01:15:14.010 is actually not something that you're 01:15:14.010 --> 01:15:15.780 going to get rewarded for. 01:15:15.780 --> 01:15:17.730 And therefore, you need to discount it 01:15:17.730 --> 01:15:19.240 at the risk-free rate. 01:15:19.240 --> 01:15:26.500 So in fact, the NPV of this project is $15.9 million, 01:15:26.500 --> 01:15:29.820 which is a lot bigger number than if you were to discount it 01:15:29.820 --> 01:15:32.095 by 20% both years. 01:15:32.095 --> 01:15:34.620 But it's because the risks are different. 01:15:34.620 --> 01:15:38.960 So to Brian's point, when risk changes over time, 01:15:38.960 --> 01:15:40.710 you've got to use the appropriate discount 01:15:40.710 --> 01:15:43.180 rate for that particular kind of risk. 01:15:43.180 --> 01:15:46.470 Now, it just so happens that here ahead of time, we actually 01:15:46.470 --> 01:15:49.200 understood where the risks were coming from. 01:15:49.200 --> 01:15:52.200 So we know the risks between year zero and year one 01:15:52.200 --> 01:15:55.430 are different from the risks between year one and year two. 01:15:55.430 --> 01:15:57.180 You've got to use the appropriate discount 01:15:57.180 --> 01:15:58.380 rate for that kind of risk. 01:15:58.380 --> 01:16:01.710 This is a very subtle problem that you 01:16:01.710 --> 01:16:06.270 have to think about carefully in order to understand it fully. 01:16:06.270 --> 01:16:10.080 But it's an important one so that's why I spent time on it. 01:16:10.080 --> 01:16:11.880 Any questions about this? 01:16:11.880 --> 01:16:12.690 Any debate? 01:16:12.690 --> 01:16:13.360 Any argument? 01:16:13.360 --> 01:16:14.800 Do you agree with this? 01:16:14.800 --> 01:16:16.020 Does this make sense to you? 01:16:16.020 --> 01:16:19.530 If it doesn't make sense, speak up now 01:16:19.530 --> 01:16:21.341 or forever hold your peace. 01:16:21.341 --> 01:16:21.840 Right? 01:16:21.840 --> 01:16:25.080 Because it's important that you absorb the lesson 01:16:25.080 --> 01:16:27.160 from this particular example. 01:16:27.160 --> 01:16:28.120 Yeah, Andy? 01:16:28.120 --> 01:16:32.070 AUDIENCE: So suppose that you know for a fact there's 01:16:32.070 --> 01:16:38.164 a third of 20 million barrels in the ground. 01:16:38.164 --> 01:16:39.602 You consider the same project? 01:16:39.602 --> 01:16:40.880 That has the exact same-- 01:16:40.880 --> 01:16:41.880 ANDREW LO: That's right. 01:16:41.880 --> 01:16:42.330 AUDIENCE: --value? 01:16:42.330 --> 01:16:43.330 ANDREW LO: That's right. 01:16:43.330 --> 01:16:43.860 Absolutely. 01:16:43.860 --> 01:16:47.280 Because there, you have no uncertainty. 01:16:47.280 --> 01:16:49.320 And you're just simply taking the expected value 01:16:49.320 --> 01:16:51.900 and assuming that you're getting the expected value. 01:16:51.900 --> 01:16:55.020 And it's because the uncertainty of this project 01:16:55.020 --> 01:16:57.330 in the first year is completely diversifiable. 01:16:57.330 --> 01:16:58.980 It's a coin flip. 01:16:58.980 --> 01:16:59.790 It's a coin flip. 01:16:59.790 --> 01:17:01.289 And you're not going to get rewarded 01:17:01.289 --> 01:17:03.840 for bearing that coin flip because, if you diversify-- 01:17:03.840 --> 01:17:04.800 Put it another way. 01:17:04.800 --> 01:17:07.650 Suppose you were Saudi Aramco and, instead of doing one 01:17:07.650 --> 01:17:11.490 of these fields, you did 100? 01:17:11.490 --> 01:17:13.980 Well, then you've diversified across all sorts 01:17:13.980 --> 01:17:18.120 of possible coin flips, and then the law of large numbers 01:17:18.120 --> 01:17:23.100 would actually reduce your payoff to something very, very 01:17:23.100 --> 01:17:25.240 riskless, or close to riskless. 01:17:25.240 --> 01:17:25.740 Right? 01:17:29.100 --> 01:17:29.746 Ted? 01:17:29.746 --> 01:17:32.740 AUDIENCE: Would you just restate again 01:17:32.740 --> 01:17:36.570 why the first year is at 5% as opposed to 20%? 01:17:36.570 --> 01:17:37.260 ANDREW LO: Sure. 01:17:37.260 --> 01:17:40.710 The first year is the 5% because I told you here 01:17:40.710 --> 01:17:45.220 that the exploration risk is completely non-systematic. 01:17:45.220 --> 01:17:46.920 It's zero beta. 01:17:46.920 --> 01:17:49.680 So when you're drilling for holes, whether or not 01:17:49.680 --> 01:17:51.600 you find oil or you don't find oil 01:17:51.600 --> 01:17:55.620 has absolutely no bearing on whether the market is 01:17:55.620 --> 01:17:56.520 up or down. 01:17:56.520 --> 01:17:58.970 There's no correlation. 01:17:58.970 --> 01:18:00.980 If there's no correlation, then that 01:18:00.980 --> 01:18:03.317 means that it's a kind of risk that you're not 01:18:03.317 --> 01:18:04.400 going to get rewarded for. 01:18:04.400 --> 01:18:06.830 This is the Irish jig dance-- you know, the dancing 01:18:06.830 --> 01:18:08.090 on that platform. 01:18:08.090 --> 01:18:10.310 You're not going to get paid extra for dancing 01:18:10.310 --> 01:18:13.410 an Irish jig on that platform when you're window washing. 01:18:13.410 --> 01:18:14.240 OK? 01:18:14.240 --> 01:18:17.330 So the key here is this statement right here. 01:18:17.330 --> 01:18:19.970 The exploration risk is non-systematic. 01:18:19.970 --> 01:18:23.895 If the exploration risk were systematic for any reason, then 01:18:23.895 --> 01:18:25.520 of course, you'd have to use a discount 01:18:25.520 --> 01:18:28.520 rate that would be commensurate with the appropriate beta. 01:18:28.520 --> 01:18:30.090 And there's no telling that that beta 01:18:30.090 --> 01:18:33.410 is going to be the same as pumping the oil out. 01:18:33.410 --> 01:18:36.170 Oil exploration is not the same thing as oil production. 01:18:36.170 --> 01:18:38.960 There are two different kinds of activities 01:18:38.960 --> 01:18:43.070 that carry with it different kinds of risks. 01:18:43.070 --> 01:18:45.800 OK? 01:18:45.800 --> 01:18:48.760 Other questions or comments? 01:18:48.760 --> 01:18:49.260 Yeah? 01:18:49.260 --> 01:18:49.964 [INAUDIBLE] 01:18:49.964 --> 01:18:52.005 AUDIENCE: How often does this happen in practice? 01:18:52.005 --> 01:18:54.480 I mean, most of the time during my experience, 01:18:54.480 --> 01:18:57.004 we would forecast that 15 or 20 years down the line. 01:18:57.004 --> 01:18:57.670 ANDREW LO: Yeah. 01:18:57.670 --> 01:19:00.010 AUDIENCE: Most of the time we would pick a discount 01:19:00.010 --> 01:19:01.440 rate that, you know, tries to-- 01:19:01.440 --> 01:19:02.982 It's a level discount rate. 01:19:02.982 --> 01:19:05.019 We're not going to, you know, try and change 01:19:05.019 --> 01:19:05.810 that discount rate. 01:19:05.810 --> 01:19:06.450 ANDREW LO: Right. 01:19:06.450 --> 01:19:07.290 AUDIENCE: It could be 10 year-- 01:19:07.290 --> 01:19:08.190 ANDREW LO: Yeah. 01:19:08.190 --> 01:19:10.560 So the answer is, it depends on the industry. 01:19:10.560 --> 01:19:14.520 For certain industries where you cannot identify discrete 01:19:14.520 --> 01:19:17.700 changes in the riskiness of the activities, 01:19:17.700 --> 01:19:19.260 then it makes sense. 01:19:19.260 --> 01:19:22.744 The only thing you can do is to come up with one discount rate. 01:19:22.744 --> 01:19:24.160 But for industries like this where 01:19:24.160 --> 01:19:27.370 there are discrete phases of these different projects, 01:19:27.370 --> 01:19:29.830 then you actually do use different discount rates. 01:19:29.830 --> 01:19:33.220 Because the uncertainty resolves in a different manner, 01:19:33.220 --> 01:19:35.090 depending on the industry. 01:19:35.090 --> 01:19:37.180 So if you keep in mind the lesson 01:19:37.180 --> 01:19:39.880 that the appropriate discount rate should 01:19:39.880 --> 01:19:43.510 be commensurate with the risks of that particular cash flow-- 01:19:43.510 --> 01:19:46.600 Think of each cash flow as a piece of paper 01:19:46.600 --> 01:19:49.720 that you're auctioning off to people in a marketplace. 01:19:49.720 --> 01:19:52.570 And ask the question, what would those folks in the marketplace 01:19:52.570 --> 01:19:55.690 demand in terms of the appropriate compensation 01:19:55.690 --> 01:19:57.040 for that kind of risk? 01:19:57.040 --> 01:19:59.390 You'll be able to make the right decisions. 01:19:59.390 --> 01:20:00.160 OK? 01:20:00.160 --> 01:20:02.320 And if you can't tell, then you may as well 01:20:02.320 --> 01:20:03.650 use one discount rate. 01:20:03.650 --> 01:20:05.620 If you can't tell one cash flow from another, 01:20:05.620 --> 01:20:08.009 then what you're telling me is that, effectively, it's 01:20:08.009 --> 01:20:09.050 the same kind of project. 01:20:12.090 --> 01:20:12.590 OK. 01:20:12.590 --> 01:20:13.520 We're out of time. 01:20:13.520 --> 01:20:15.122 I wish you all a Happy Thanksgiving. 01:20:15.122 --> 01:20:16.580 We'll see you on Monday where we're 01:20:16.580 --> 01:20:18.620 going to continue on with capital budgeting 01:20:18.620 --> 01:20:22.330 and do some more applications.