What do I mean by this?
Well, let's compare two projects.
Again, I will put some numbers as an example, this is project A,
for which cash flows are minus 5,000,
plus 10,000 and that's it.
And then project B,
has cash flows of minus 10,000 and then plus 17,000,
and let's say that we analyze them at the rate of return of 10 percent.
So, let's see what we have here.
The internal rate of return for this project,
so this will be IRR,
and this will be, NPV at 10 percent.
Here, we have 100 percent,
for project B, we have 70 percent.
However, when it comes to NPV at 10 percent,
here this is plus 4,091,
and here it's plus 5,454.
The numbers exactly are sort of immaterial,
but see what happens.
Based on the criterion of the internal rate of return,
we have to take project A,
because it has a higher internal rate of return.
Now, beware that these projects are one period.
So, if we go back a couple of episodes,
we expect to have the same conclusion from the use of NPV and the use of IRR,
but it's not quite because indeed the IRR criterion tells us take A.
But then, if we study that at the rate of 10 percent,
we can see that the NPV of B is higher.
Well, we know that the general criterion of NPV maximization will force us to take B.
Now, we can go further and say here for the first time,
we introduced the idea of incremental projects.
What if both projects A and B require let's say,
a piece of land,
then we can take either A or B,
but we can say well,
we can start with taking an A,
because it requires not only this piece of land but a much smaller amount of money.
Let's say that we have $10,000,
then we can easily take A that promises the internal rate of return of100 percent,
and then the NPV at 10 at 4,000 plus.
And then, we still have close to the spare $5,000.
If we could find another project that would not require the same piece of land,
but that would produce an incremental cash,
incremental PV, which is the difference between those which is about,
a little bit less than $1,400,
then we could be better off by taking these two,
A plus another project C,
that is not on the slip chart.
And that is key.
So, oftentimes the idea of NPV here again becomes a little bit but still better thing.
So, we have to be really careful about these mutually exclusive projects and I
specifically said that this whole approach of using incremental projects,
and take into account incremental cash flows,
this is actually extremely fruitful and important in the real use of the NPV approach.
Now, what else?
I would specify just one more problem to IRR or challenge.
What if Rs change?
As was the case with ones.
So we can see that to this end,
the use of IRR becomes much less fruitful,
because you can hardly use one and the same R,
for all these periods of time and you have to analyze the project deeper.
However, you can see that the NPV approach still holds perfectly.
You just have to feed the NPV formula with different Rs.
So, we can see that here again,
NPV is better.
Now you can say, "Well,
you are sort of pushing us towards say,
well NPV is always better."
Well, it indeed is,
and we will in the next episode,
where we'll put things together,
we will repeat once again why.
But now, I just wanted to emphasize that the difference and the areas in which
the NPV is a little bit or
sometimes much better criterion when compared to some other ones.
And, the big question occurs,
why is that that everyone knows that NPV is better?
And why not drop all others?
Well, as oftentimes happens,
that is because people,
especially people in corporations where they have to make many decisions,
they feel tempted to use a simpler proxy,
something that is basically not that much worse but
really allows them not to worry about many things,
not to worry about proper treatments of inputs,
not to worry about proper calculations,
and not to worry about thinking the way we did in this episode than in the previous one.
So, now you can see that oftentimes
this push towards decisions that are easier to implement,
that we once in the first week put as there, double quoted ignorance.
That plays an important role in corporate management and that is why we have to
pay attention to that because it's not worthwhile saying that this is all just wrong.
It's more important to explain when these proxies can be safely used,
because that saves time and saves managerial resources.
But when this is actually potentially damaging,
and you are better off if you really worried about the inputs to the NPV,
and if you really spend time and resources to calculate that
and sort of would make your decision based on a more advanced criterion.
In what follows, I will briefly wrap this up
and then we will move to the other more important piece.
How exactly we will use the NPV criterion.
