because if for example there are two projects,

and one project has a payback period of

three years and the other has a payback period of five years,

then people are tempted to say,

Well, the first one is better.

However, the NPV of the second project may well be higher,

and in this case, we are likely to commit a mistake.

Not only that, remember that all these ideas,

they are not just the ideas on this flip chart.

They are taken as measures that people

actually apply in corporate processes and in making decisions,

and then in governing corporations.

So basically, you have a lot of people who are adherents of the payback period.

They are very much likely to first of all,

prefer short term projects and ignore projects that have longer term but with higher NPV,

which is a value-damaging thing.

Well, this is not only that,

there is another great challenge here.

I would put it like,

wrong treatment of,

I'll put a quote, of after.

What do you mean by that metaphorically?

Well, you know basically,

what happens beyond the payback period here, becomes less important.

And we already learned in our analysis of the tale in a corporation that oftentimes,

the value that arrives from this tale may be the largest component of value.

So basically, the payback period is a poor measure of fixing good or bad labels.

Well, let's go further.

And another set of criteria is the criteria based on return on total assets,

return on capital employed,

and some other things that deal with some parameters of corporate efficiency.

We take the net income of the company or profit.

And then, we compare that with the amount of

resources that have been used in order to arrive at this profit.

Well, here, there are a couple of things that are problems.

Again, time value of money is ignored and this is,

as we know, this is a huge problem.

Then also, here, the main component is net income, not cash flow.

And that again is a huge thing.

So basically, these are widely used in corporate efficiency measurements.

And oftentimes, human behavior is directed against that.

Sometimes people say, Well,

we have to reach whatever 20 percent return on

total assets and if we fail to reach this goal then,

we are managing poorly and so on and so forth.

But in terms of value creations,

this group of criteria is poor to.

The third group, this is called profitability index,

and this is sort of one of the best proxies for NPV if you wanted it basically says that,

what's profitability in this PV of cash flows,

divided by the initial investment.

So if this index is greater than one,

this is a good project.

So, it seems to be very,

very much similar to NPV because basically,

if this is a one period project,

that's exactly the same.

So if the profitable the index is greater than the one,

that's the same as the positive NPV.

But, first of all, and again,

this is a good criteria but because it's so close to NPV,

it, as you can see,

deals with PV here.

So it does require some advanced calculations of PV.

That is why it's not so simplistic as the first two groups.

So we are coming out with a better criteria,

but it also employs a lot more resources to arrive at the result.

And not only that,

we will see very quickly that oftentimes,

there is a contradiction here that may occur when we are comparing projects.

We have different profitability indices that are mutually exclusive,

and these projects may oftentimes result in the situation in which

you may take the project that will not maximize your NPV.

So this is somewhat more fine tuned here but this is a better thing.

Now, I'm coming to the end of this episode with the introduction of the by

far most widely used criterion that oftentimes is treated as the same as NPV.

This is the criterion of internal rate of return or IRR.

This is so widely used and so often,

is mistakenly taken as,

not as a proxy but as a perfect substitute for NPV,

that it requires a special episode.

Actually more than one to discuss,

why it's so important?

Why it's so close to NPV but not equivalent to that?

And how we have to make sure that you do not fall in

certain traps that are oftentimes associated with the use of IRR.