0:03

Suppose you have Mutually Exclusive Projects, so

until 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 is pretty obvious, the one with the highest value

because NPV is creating value, and measuring value directly.

And dollars, or yen, and so on, are fundamental way of measuring value.

Again, it could be carved.

But as long as we all agree what it is, it could be a currency in your local economy.

It doesn't matter.

What matters is, the more acceptable the measurement unit and

if that's the stuff that you use for a decision criteria, it's good.

So first of all, remember,

IRR 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.

1:39

And there is systematic biases in IRR.

And I'm going to not 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.

2:18

Now, you see very clearly what the problem with that is.

It reminds you of another criteria, criterion, actually.

And it should, which is payback.

But remember, payback is a little bit blatant about its bias, right?

How soon am I getting my money back?

2:36

IRR is much more seductive and devious in some sense.

So if IRR was a person, who was purposely trying to deceive us,

it would 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 would recommend very strongly that even if I don't take specific pause or

there is, the 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 cash flows, Project A, 0, 1, 2.

-2,000, 400, 2,400.

Remember, the timing of it is very simple.

At time 0 spend some money and repeat it while you get some money, 400 and 2,400.

Similarly for Project B.

3:33

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 featured you know what you would do.

But here, there is two [INAUDIBLE], so it's kind of compounding,

make your life a little more difficult.

So we go to calculator.

So are you ready?

We are going to calculate it using Excel.

You can use calculators still.

So lets go to Excel and if you notice,

I have already put in the numbers for cash flows.

If you go up to row number one,

what do 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.

4:41

So, IRR Function.

Remember, you have to put equals sign.

Open up parentheses.

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?

5:29

IRR, a2:c2.

I'm just telling it where the numbers are.

25.

So think about this.

I will choose which project first.

Almost everybody would say, go for

project number two 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?

The IRR is that rate of return which makes the NPV 0, but

that's the 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 projects do you think most people would choose?

They would choose Project B.

6:51

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 of both projects.

So what short-term bias am I talking about?

Just stare at these two numbers from the time being.

7:10

What do you see?

You see that Project A is giving a lot of the cash flows later,

whereas Project B is giving the cash flows early.

Which one does IRR favor?

It favors B because of that earlier cashflow.

Now I'm not necessarily saying, therefore, Project B shouldn't 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.

7:53

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

is not interested in my internal projects even if you are investing in the company.

You're interested in how well you're going to do relative to the competition.

Where is the competition?

It's over there.

Right?

So there is a fundamental problem.

Let me just show you now what I mean by the bias.

8:32

So in order to do 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 the little r could 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 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.

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 do the NPV of project A, what do you do?

Minus two thousand, plus one.

400 divided by 1 plus r in parentheses

plus 2400 divided by 1 plus r squared.

I'm just saying you don't know your discount rate.

9:48

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, and

NPV, and remember NPV has some problems with it,

so just remember that for a second.

Let's use .05, which is the rate of return, now what is this .05,

it 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.

10:43

Everybody okay, B1, C1, no A1.

But, then you have to remember that you need A1 to do this project,

and I've said plus, because A1 is already a negative thing.

So, where does the net come from?

From adding back A1, which is almost always 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.

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 .05.

Now, where are my cash flows?

Remember, starting with year one.

So B2 colon 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 in 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 and

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?

12:47

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 choose?

13:10

Now let's do, what is the second percentage?

20%.

So now you 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?

I just flipped.

I made a 20% rate of return, I now choose Project B.

So you see what's going on.

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?

Turns out the numbers are 308, 309.

What's going on here?

14:22

I've chosen these numbers to show you three things.

One, at the 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 a break even analysis.

So this is, 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

15:14

NPV vs 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.

15:43

So if the IRR is zero, can I do the two?

Very straightforward.

If IRR is zero, I could easily figure out the NPV's of both projects.

The first project's NPV is 800.

Why?

Because the cash flows, if you go back, are minus 2,000, 400, and 2,400.

And at r of zero, which is usually not the case,

16:12

this is trying to guess, the calculator is trying to guess what it is.

So what is the NPV of Project B at r zero?

Turns out to be it is minus 2,000, 2,625 so it's 625.

Right?

17:04

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.

17:35

So the 11% tells you kind of a benchmark or kind of a cut off point.

And the point here is very simple.

You will choose 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?

18:08

It's very simple.

Look, stare at this graph, when would you not choose either one?

Well, at what rates of return that the competition is operating at,

are both projects negative NPV?

The 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 neither.

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 rate is more than 25%, you won't choose either.

So I have just shown you the very simple example

that the problem with IRR is, it's not clean.

It's biased in favor of short-term projects.

19:05

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 are learning, or you already know these issues.

But the second set of people who know they shoot at IRR,

it's very smart, very seemingly of calculating things.

It's very natural, but there's a built-in bias.

And the bias in favor of myopia, short-term, like pay back.

Right? But it's a 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'll tend to favor IRR as a decision making groove.