Hi, I hope you had some time to think about and reflect on what we had done in the past. In some senses, we did a brief review of all three weeks. But I want to be very focused on decision criteria. And as I said today, I'm going to talk a little bit more about decision criteria. And then move on to the one ingredient common to all of them which is cash flow. And I'll talk about that in pieces that are digestible. But remember, you always have the option of pausing, right. My goal is to try to show you the essence of things and why things work. And your goal is to learn at the pace that's good for you, and that's what I like about this whole program. So let's get started. Suppose you have mutually exclusive projects. So till now, the examples we did with IRR were, you have one project to look at, but really many times what you do have is several projects and for whatever reason, you want to see which one to move at first, or at least rank them in some way. And this happens all the time. Turns out, if you fall back on NPV and think about it, which project would you take? And there the answer was pretty obvious, the one with the highest value, because NPV is creating value and measuring value directly. And Dollars or Yen and so on is our fundamental way of measuring value. Again it could be called. But as long as we all agree what it is, it could be a currency in your local economy. It's doesn't matter. What matters is, the more acceptable the measured unit and if that's the stuff that you use for a decision criteria, it's good. So first of all remember IRRs is in percentage terms which should already make you feel a little wary. So suppose you have two projects and you are more. Which one would you choose? An actual instinct to most people is to go to the high IRR, makes sense, right? Ranked based on returns, the highest project is 15% and the next is 10, which one most people would say choose, 15. I'm going to show you that this unfortunately is not right. And there's systematic biases in IRR, and I'm not going to spend the entire time talking about IRR. So I'll give you two examples which are obviously a little bit constructed for the purposes of conveying the idea to you. But the same pattern is there in life. So I would look at cartons not necessarily the exam books. So let me show you some, couple of examples which show you biases of IRR. So the first bias is IRRs like short term projects. Now you see very clearly what the problem with that is. It reminds you of another criterion actually, and it should, which is pay back. But remember, payback is a little bit blatant about its bias, right. How soon am I getting my money back? [LAUGH] IRR is much more seductive and devious in some sense. So if IRR was a person who was purposely trying to deceive us, it'll be very tough to figure out what's going on. So I'm going to spend some time. Now look at Projects A and B, they're right in front. I'll let you just kind of reflect on that. And I will recommend very strongly that even if I don't take a specific pause or clip is not broken up video for certain examples, this example take a break after this, think about it. Next example, take a break after that and think about it. So here are your cashflows, Project A 0, 1, 2, -2,400, 2400. Remember, the timing of it is very simple. At time 0, spend some money. End of period 1, you get some money, 400 and 2,400. Similarly for Project B. Now, what I'm going to do is, I'm going to calculate the IRR using Excel with you. However, remember, what is the IRR? IRR is that rate of return, which makes the NPV of this project 0. For example, if there was only one Peter, do you know what you would do? But here, there are two Peter's, so it's kind of compounding. [LAUGH] Make your life a little bit difficult. So we go to a calculator. So are you ready? We are going to calculate it using Excel. You can use calculators still. So let's go to Excel. And if you notice, I have already put in the numbers for cash flows. If you go up to row number 1, what you'll notice is, in cell A1 I have -2000, in cell B1 I have 400, and in cell C1 I have 2400. And this is Project A. Project B is -2000, 2000, 625. So let's just try and do the IRRs. So IRR function. Remember, you have to put equal sign, open up parenthesis. Let's do project 1. Remember it's in row one where A1 through C1. Okay. I think I got it. Did I get the colon? Yep, I'm not going to put in a guess and see if it works. Turns out, it does. So what is 20%, 20% is the IRR of which project? Project number 1. Which means what? Just very slowly, it means the rate of return you earn per year over two years. Let's do project B. Irr( a2 Colon, 'C2'. I'm just telling it where their numbers are, 25. So think about this, I would choose which project first. Almost everybody would say, go for project number 2 because it gives you a higher rate of return. And this is where problems start. So, I'm going to now go back to our presentation and it's very obvious that I've calculated the IRRs and the IRRs, I'll just write them down here is 20%, 25%. Let me just reiterate one thing. What is the IRR? IRR is that rate of return which makes the NPV 0, but that's a rule of thumb for calculating the number because with compounding the number is very tough to calculate. So at 20% NPV is 0, at 25% NPV is 0. But now the question I'm asking you is, which of these two products do you think most people would choose? They choose Project B. And the answer to this is even though you choose Project B, it may not be the right choice. And why do we call it a short term bias? Just stare at it. Which project is. Are they similar in length? Yes. Physical life is two years on both projects. So what short-term bias am I talking about? Just stare at these two numbers for the time being. What do you see? You see that Project A is giving a lot of the cash flows later, whereas Project B is giving cash flows early. Which one does IRR favor? It favors B because of that earlier cash flow. Now, I'm not necessarily saying, therefore Project B shouldn't be taken. I'm just saying that comparing 25% with 20 is not the right way to do things, and I'll show you why not in a second. However, let me ask you, what's missing when I compare 25 with 20? And this is so common in the real world. What's missing is, I'm comparing things internally. What is my real benchmark, even for IRR? What is the cost of capital outside? So I am not even looking at r. So, this is key to decision making. Remember, all value is relative. So if I just compare internally, my investor's not interested in my internal project even if you are investing in the company, you're interested in how well I'm going to do relative to the competition. Where is the competition? It's nowhere there, right? So there is a fundamental problem. Let me just show you now what I mean by the bias. So in order to that, we have to do a couple of things. So let me ask you to do NPV calculations based on 5%, 20%, or 11%. Why am I giving you three numbers? Because you can do the analysis of your competitors, or your investor will see, and we don't know what the discount rate or little r is. So little r could be 5%, it could be 20%, or it could be 11%. There's a reason why I'm choosing all three, and you'll see it in a second. But it should be pretty simple for you to calculate the NPV of both projects using 5, 20, or 11. And I'm going to go to Excel to do this, but only for a second, because I think you should know how to calculate the NPV of these, and then I'll just put up the numbers for you. But I'd encourage you when you take a break to calculate the numbers. Fair enough? You know how to the NPV of project A, what do you do? Minus 2,000 plus what? 400 divided by 1 plus r in parentheses, plus 2,400, divided by 1 plus r squared. I’m just saying, you don’t know your discount rate, figure out what the value of your project is, okay? So what I'm going to do is I'm going to go back and I'm going to use 5% to calculate. So let's do this. Let's do the NPV, NPV. And remember, NPV has some problems with it. So just remember that for a second. Let's use 0.05, which is the rate of return. Now, what is this 0.05? This is not your IRR. What is it? It's that rate of return your investor will look at to compare you to them. And we are doing Project A. So what after that? After that, it's asking for values. Now, remember, don't give value zero for npv. That's a little quirk. So what do you do? You do, b1:c1, right? Everybody okay? b1:c1, no a1, but then you have to remember that you need a1 to do this project, and I said plus because a1 is already a negative thing. So where does the net come from? From adding back a1, which is almost always a negative. You need effort to create something of value. So let's see what the answer is. You get 557.8, so about 558 bucks. Okay? Let's do the same thing for Project B. So let's, I'm going slow here so that we kind of recap calculations. As I said, I promise I'll recap, but I won't spend time on doing for all interest rates, okay? So what do you do? You do 0.05. Now where are my cash flows? Remember, starting with year one. So b2:c2 plus, what do I add back? a2. Everybody okay? 471.66. So what I'm going to do now is I’m going to go back and write out all these numbers, okay? And confirm that we are all on the same page, okay? So just give me a second here and we'll get going. So remember the two numbers we just did. We did 558 and 472. And let's go back, and let's work with this now. So NPV, I'm going to start writing here, at 5% was what? 558 and 472. So, the first question I'll ask you is, so suppose you do your analysis on your projects A and B, you're responsible for the cash flows, but now you go and judge them at 5%, which one will you choose? Suppose this is millions of dollars, which one will you choose? Because if it's just dollars, you would say, come on, you're wasting my time. It's not worth my time to put in the effort to calculate. Suppose this is millions, and believe me, corporations use millions of dollars to make decisions, which one will you chose? You'll choose A. Now let's do, what is the second percentage, 20%. So now you'll go and say, suppose my best alternative for the investor and for me, my competition, is earning 20%. At 20%, I know this is zero because I just calculated the IRR. And it turns out the answer to this is 101. What's happening now? [LAUGH] I just flipped. I made a 20% rate of return, I'll now choose Project B. So you see what's going on? My IRR rule always said, if you were using it blindly, choose B over A. But now I'm giving you two scenarios where it depends. So at 5% go with A, at 20% go with B. Finally, I gave you an 11% rate of return. What was the scenario there? It turns out the numbers are 308, 309. What's going on here? I've chosen these numbers to show you three things. One, at a rate of return that's relatively low for the competition, I should choose project A. At very high rates of return, for this kind of project, I would choose B. But at about 11%, what's true? I'm roughly the same, so I'm indifferent between A or B, so I'll put this or this. This is also one way of thinking about what we call in the real world is a kind of break-even analysis. So 11% is the point at which you're indifferent between the two. And I would really like you to draw graphs to emphasize this. I'm going to now draw graphs, but remember, the graph will be IRR, I mean NPV which is rate of return, and I’ll show you all the numbers. Okay, so let’s get started, this is very cool stuff actually, and it’s not that difficult to do. We have done this before, so I’m plotting NPV here which is value. 0 and returns, r. So let's start off trying to plot the two projects. So if the IRR is 0, can I do the two? Very straight-forward. If IRR is 0, I could easily figure out the NPVs of both projects. The first project's NPV is 800. Why? Because the cash flows if you go back are minus 2000, 400 and 2400. And that r of 0 which is usually not the case, this is just trying to guess, the calculator is trying to guess what it is. So what is the NPV of project b and r0? Turns out to be it is minus 2000, 2625. So it's 625, right? You know the second point. What is this and what is this? These are the points at which the two projects have what, 0 NPV. So these are the points at which the two projects will give you the IRRs. Right? So this graph is a way of figuring out what the IRR is. And what is this point? Remember, what's true at this point? The NPVs are the same. And they were about what? 309, so what is this graph telling you? That at 11%, you don't care between the two projects. But at 5%, which one would you choose? A. And at 20%, which one would you choose? P. So the 11% tells you kind of a benchmark or kind of a cutoff point and the point here is very simple. You will chose project A if the competitors are earning anything up to 11%. After that, you will choose B, if then other competition is earning more than 11%. Let me ask you a simple question and then we'll take a break. When would you choose neither? It's very simple, you look, stare at this graph, when would you not choose either one? Well, when is at what rates of return that the competition is operating at? Are both projects negative NPV? Answer is more than 25%. Because if the discount rate is more than 25% and remember the discount rate little r is what the competition is earning. It's not easy to calculate, we'll spend a whole bunch of time on that when we do risk and return. But the point I'm saying is that it's the most important ingredient to decision making. So if the discount is more than 25%, you won't choose either. So I have just shown you with a very simple example. That the problem with IRR is, it's not clean. It's biased in favor of short term projects. It's biased in favor of projects that show you early cash flows. Let's take a break now. Think about this. Take even a few hours thinking about it. Because it's extremely important. I genuinely believe that there are two kinds of people out there. Those who do not understand IRR and can, therefore, learn and I learned. Hopefully, you're learning or you already know these issues. But a second set of people who know they should with IRR. It's very smart, very seemingly way of calculating things. It's very natural, but there's a built-in bias. And the bias in favor of myopia, short-term like payback. Right? But it's very sophisticated kind of bias. If you want things in the short-term for whatever reason and I'll talk about that in a second. What will you tend to do? You will tend to favor IRR as a decision making rule. Okay, so take a break, we'll do one more example and then we'll move on to cash flows. See you soon, bye.
