Hi, my name is Bob Holthausen, I am a professor of accounting in finance here at the Wharton school. And we're talking about decision making and scenarios as you know. And this first module is about or first lecture is about why is net present value appropriate for evaluating projects. So I want to give you some sense for why that is the case before we go on and actually talk about net present value analysis. So there is many different ways one could consider choosing amongst different investment projects. So what might some of those be? Well, you could calculate something called return on investment and we'll talk more formally about that in a little bit. You could calculate whether your earnings were going up or whether your earnings per share was going up or whether your sales were growing. You could calculate your share of the market, so you could calculate, if I look at all the companies that are selling that particular product, what is my share of those sales? And I could evaluate projects based upon whether my market share was increasing or not. Another alternative that people sometimes talk about is something called the Internal Rate of Return. That may not be something you know but it's something that we'll be discussing as we go through this material. Another criteria that some companies use is called payback, which just basically ask how many years does it take me to get my investment back. Another criteria that I hear companies talk about is customer satisfaction, did we increase customer satisfaction through the actions that we took. Now, all those are potential criteria, but it turns out that the criteria that really is the most appropriate for selecting investment projects is to calculate the net present value of the projects and to use what I call the net present value criterion. And so, let's get a sense of why that might be the case. So to understand that, you have to think about what is it you're trying to accomplish with the projects you select. What we're trying to do is we're trying to maximize the value of the firm. And finance takes that as it's objective function and deciding what is the appropriate criterion to use for choosing amongst alternatives projects and as it turns out as we'll see the net present value of a project is actually a point estimate of how much value creation there is associated with taking a project. And as it turns out, if you use the other criteria like increasing earnings or your earnings per share, or increasing market share, or increasing customer satisfaction for example, it's possible that those will lead to increases in value. But it's also conceivable that if you focus on that and don't think about whether or not the decisions you're making are increasing value, that you could actually destroy value in the firm. So what would be an example of that? So let's supposed that I decided to increase my market share by reducing my product prices by 20%. Well, that clearly would lead to increases in sales and so my market share would go up. But of course, what would happen because I've reduce my product prices so much is that my profits would go down and I would likely be destroying value suppose to increasing value. So well, as a manager, I'm worried about customer satisfaction and increasing market share, and things of that nature. I'll only do that with respect to increasing the value of the firm. So a one will increase customer satisfaction. But I have to do it in such a way that the value of the firm is increased when I do that. So there are three key ingredients that you need to understand for evaluating projects. The first is understand the time value of money. And this is to calculate present values. And so, we're going to be talking about how to calculate present values and to understand exactly what the time value of money is. The second thing you really need to understand is to understand what we'll call incremental analysis. And that is how do the after-tax cash flows of the organization change because of the potential project that you're going to take. And so, this entails forecasting what you think is going to happen to these after tax cash flows of the organization if you take a project on. And we'll spend a fair amount of time talking about that as well. And the third key ingredient for understanding that present value is to understand something about a company's cost of capital. When we calculate present values, we're going to discount the cash flows that we forecasted associated with the project at the company's cost of capital. As it turns out, calculating the cost of capital is very esoteric endeavor. And we're not going to try to actually walk you through a cost of capital calculation. But rather what we're going to do is we're going to give you intuition for what the cost of capital is. And also give you a sense of where that cost of capital number comes from within an organization. And then, you'll be able to understand totally why calculating net present values is consistent with increasing the value of the firm.
