Economists make a lot of assumptions when they make their models. One of the biggest and most common assumptions they make is that people are rational. We’d like to think that people, capable of building cities and atomic bombs...of building a global civilization...and of destroying it in under a minute...are rational creatures.
The dollar auction runs where two people are bidding on a dollar. The winner will get the dollar, and the loser will have to pay up whatever their last bid was. So players aren’t only trying to win, they’re also trying to minimize what they might lose. Once the bidding goes above $1, it makes sense to keep bidding. For instance, if your last bid was $0.95, and the other player’s bid was $1, then it would make sense for you to bid $1.01 to avoid losing $0.95. If this kept going, with infinite bidding, then each player would bid one cent through eternity.
Like the Prisoner’s Dilemma, this game shows that the rational choice doesn’t always lead to what appears to be the most rational outcome, especially when people aren’t working together, and instead are working in their own self-interest. For instance, it’s not rational to bid more than $1 to earn $1, but each player in the dollar auction is incentivized to keep bidding one cent more when it passes the $1 mark. If they worked together and said “okay, this is silly, let’s stop” it would lead to a more “rational outcome,” but how would they decide who's the last person to bid, i.e. the winner?
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Finance: What is Discounted Cash Flow?9 Views
Finance allah shmoop What is discounted Cash flow money air
gets your money on sale discounted money Yeah kind of
sort of like that but how can cash be discounted
and what is flowing anyway Is this like a scene
from huck finn goes to wall street so the cash
we're talking about here is cash in the future Got
it Your company the spice in ator ink sells a
product that takes any item of food and runs it
through a processor which makes it pumpkin spice flavor You
are hated by starbucks everywhere So spice in aitor is
going to make ten grand by the end of this
year Fifty grand by the end of next year and
for five hundred grand by the end of the following
year and a million bucks by the end of the
next All right that's not revenues that's profit Or at
least so you you think it's going to earn a
million bucks you estimate you guess you hope All right
Well the value of a company in professional wall street
he circles is the sum of the parts of its
future cash flows or cash profits than discounted back for
risk Meaning it might not actually earn that million dollars
in four years and time What if those forty years
or ten years or two years Alright all this means
that spice in ator ink earning half a million bucks
in three years is an estimated number It's not certain
it's hope for begged for prayed for even at least
in the red states but there is risk It doesn't
happen Maybe there's thirty percent on that produces three hundred
grand in profits instead of five hundred grand but ten
percent odds It produces a million dollars instead of that
five hundred grand and years out So calculating that risk
and then discounting it in the value of the company
Today is a big part of valuing a business parts
that's the risk side But then there's the time side
you have to think about as well If you had
a company you were certain would make half a million
dollars in profit thirty years from now you know like
shmoop well that wouldn't be as impressive or valuable as
a company You were equally certain would make half a
million dollars in profit next year So that's the time
component let's add up the notional value of this company
just as an illustration here Alright Your company's spice in
ater at the moment has no cash your debt and
is for illustrative purposes on lee So don't get all
technical on us and wine about details Try to glean
a concept here okay So spicy nature will make ten
thousand Dollars this year in profits it's january now in
twelve months were eighty percent certain it'll make ten grand
in profit All right now if we bought the safest
bond in the world a one year u s treasury
bond we get three percent interest We fight a discount
on a thousand bucks Okay that number's serves as kind
of a bassline whenever we do these kind of analyses
the u s treasury paper is in generally riskless question
how much riskier is our company Above and beyond the
t bill I even company makes that ten thousand dollars
like could it only make five thousand sure couldn't make
nothing couldn't lose money Sure couldn't make way more than
ten grand maybe twenty thirty forty grand Regardless there is
risk here So the value of that ten thousand dollars
a year from now carries what is called a risk
premium tacked onto that three percent figure We're gonna divide
by it So adding risk premium makes the present value
less All right let's say that extra risk is pretty
high like twelve percent That company produces meaningfully less than
ten grand and profits All right well we discount back
that One year from now figure of ten thousand dollars
to be less right Well here's the math you take
the amount expected to be earned Yes that is the
cash flow ding ding ding and you divide by one
plus the quantity of the risk free rate that t
bill three percent thing plus the risk premium which we've
guest is in twelve percent So what is the risk
adjusted and discounted cash flow of ten thousand dollars expected
or estimated a year from now worth today Well it's
ten grand divided by the quantity one plus point zero
three plus point one teo or divided by one point
one five to the first power for this one year
away and it looks like that which equals a bit
under eighty seven hundred bucks So wow Interesting It means
that the risk of getting that ten grand a year
from now is high In fact it is worth roughly
thirteen hundred bucks less today Because of that risk or
set another way our analysis would suggest that you'd be
risk neutral if you took a cashier's cheque today for
eighty seven hundred bucks versus waiting a year and getting
that Ten grand pay then But if you did wait
well you'd have a very nice fifteen percent ish return
on your invested money All right Welcome to risk people
This is investing Wanna one's order and no extra charge
from the kindly loving people it's mum inside All right
And as you'd guess you can get to the total
value of the company by adding up and then discounting
future years cash flows of this company in the same
way when we have the ten grand number already What
about the fifty k two years from now Well since
we are comp pounding investment returns we make a call
too Exponents land with e ticket there all day passed
And to discount the odds of that fifty k coming
to us two years from now we apply a similar
calculation on lee Now we think that the odds of
fifty k in two years are even riskier than they
were before Will attach a seventeen percent risk premium toe
actually getting out fifty grand a profit out of our
product And we have to discount it back on top
of the safe or risk free rate of three percent
Well how's that work well we have fifty thousand bucks
coming to us We think and hope and pray two
years from now We then divided by one plus point
zero three plus the risk premium of point one seven
squared or to the second power Why Because it's two
years of compounding away not one Remember I kind of
mumbled that one year to the first power thing was
clever on Alright that's Fifty grand over the quantity One
point two square or fifty grand over one point four
four or carrying a present discounted value of fifty k
divided by that one point four four which is a
little under thirty five grand Well if we carry this
forward a year and there's even more risk for the
fur five hundred thousand bucks we expect in three years
Well then we get something like a risk premium of
say twenty two percent tacked onto the safe rate of
three percent or twenty five percent total And we discounted
back three years or cubed if it looks like this
Five hundred thousand dollars divided by the quantity one plus
point oh three plus point two two to the third
power Or that's five hundred thousand dollars over one point
two five cubes Which is almost to telling us that
the present value of that highly suspect five hundred k
in profits supposedly coming in from spice in ator was
about five hundred thousand over too or just over two
hundred fifty grand in present value today Got it Well
same holds true for that million dollar year and calculate
the discounted cash value of that million bucks four years
from now you follow the same pattern and add in
the million bucks divided by the quantity one Plus you
know all the other crap in there Yeah So if
we're getting the total discounted cash flow valuation of the
company we just add everything up including a sale of
the company at the end Like if we sold it
for two and million dollars six years from now we
discount that back with some you know premiums and someone
loaded in so that ten million's not a sure thing
at all We have to assume our guests or dark
board with blindfolds on the value of the company overall
will hold for five years from now And yeah that's
How This kind of cash flow works at least the
one point overs you're learning here So just be careful
when you throw that dart You don't want to force
your business partners to rock and ipad shit no matter 00:07:57.755 --> [endTime] how much that looked cool Oh
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