0:03

Suppose you have Mutually Exclusive Projects, so

Â until now the examples we did with IRR were you have one project to look at.

Â But really, many times what you do have is several projects and for whatever reason,

Â you want to see which one to move at first or at least rank them in some way.

Â And this happens all the time.

Â Turns out, if you fall back on NPV and

Â think about it, which project would you take?

Â And there the answer is pretty obvious, the one with the highest value

Â because NPV is creating value, and measuring value directly.

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

Â Again, it could be carved.

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

Â It doesn't matter.

Â What matters is, the more acceptable the measurement unit and

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

Â So first of all, remember,

Â IRR is in percentage terms which should already make you feel a little wary.

Â So suppose you have two projects and you are more.

Â Which one would you choose?

Â An actual instinct to most people is to go to the high IRR, makes sense right?

Â Ranked based on returns, the highest project is 15% and the next is 10,

Â which one most people would say, choose?

Â 15.

Â I'm going to show you that this, unfortunately, is not right.

Â 1:39

And there is systematic biases in IRR.

Â And I'm going to not spend the entire time talking about IRR.

Â So I'll give you two examples which are obviously a little bit constructed for

Â the purposes of conveying the idea to you, but the same pattern is there in life.

Â 2:18

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

Â It reminds you of another criteria, criterion, actually.

Â And it should, which is payback.

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

Â How soon am I getting my money back?

Â 2:36

IRR is much more seductive and devious in some sense.

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

Â it would be very tough to figure out what's going on.

Â So I'm going to spend some time.

Â Now look at projects A and B.

Â They're right in front.

Â I'll let you just kind of reflect on that.

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

Â there is, the clip is not broken up video for certain examples.

Â This example take a break after this, think about it.

Â Next example take a break after that and think about it.

Â So here are your cash flows, Project A, 0, 1, 2.

Â -2,000, 400, 2,400.

Â Remember, the timing of it is very simple.

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

Â Similarly for Project B.

Â 3:33

Now, what I'm going to do is I'm going to calculate the IRR using Excel with you.

Â However, remember, what is the IRR?

Â IRR is that rate of return which makes the NPV of this project 0.

Â For example, if there was only one featured you know what you would do.

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

Â make your life a little more difficult.

Â So we go to calculator.

Â So are you ready?

Â We are going to calculate it using Excel.

Â You can use calculators still.

Â So lets go to Excel and if you notice,

Â I have already put in the numbers for cash flows.

Â If you go up to row number one,

Â what do you'll notice is in cell A1, I have -2000.

Â In cell B1, I have 400 and in cell C1,

Â I have 2400, and this is Project A.

Â Project B is -2000, 2000, 625.

Â So let's just try and do the IRRs.

Â 4:41

So, IRR Function.

Â Remember, you have to put equals sign.

Â Open up parentheses.

Â Let's do project 1.

Â Remember, it's in row one.

Â Where, A1 through C1.

Â Okay, I think I got it.

Â Did I get the colon?

Â Yep, I'm not going to put in a guess and see if it works.

Â Turns out, it does.

Â So what is 20%, 20% is the IRR of which project?

Â 5:29

IRR, a2:c2.

Â I'm just telling it where the numbers are.

Â 25.

Â So think about this.

Â I will choose which project first.

Â Almost everybody would say, go for

Â project number two because it gives you a higher rate of return.

Â And this is where problems start.

Â So I'm going to now go back to our presentation and

Â it's very obvious that I've calculated the IRRs.

Â And the IRRs, I'll just write them down here, is 20%, 25%.

Â Let me just reiterate one thing, what is the IRR?

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

Â that's the rule of thumb for calculating the number because with compounding,

Â the number is very tough to calculate.

Â So at 20% NPV is 0,

Â at 25% NPV is 0.

Â But now the question I'm asking you is,

Â which of these two projects do you think most people would choose?

Â They would choose Project B.

Â 6:51

And why do we call it a short-term bias?

Â Just stare at it, which project is, are they similar in length?

Â Yes.

Â Physical life is two years of both projects.

Â So what short-term bias am I talking about?

Â Just stare at these two numbers from the time being.

Â 7:10

What do you see?

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

Â whereas Project B is giving the cash flows early.

Â Which one does IRR favor?

Â It favors B because of that earlier cashflow.

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

Â I'm just saying that comparing 25% with 20 is not the right way to do things.

Â And I'll show you why not in a second.

Â However, let me ask you, what's missing when I compare 25 with 20?

Â And this is so common in the real world.

Â What's missing is, I'm comparing things internally.

Â 7:53

What is my real benchmark even for IRR?

Â What is the cost of capital outside?

Â So I am not even looking at R.

Â So this is key to decision making.

Â Remember all value is relative.

Â So if I just compare internally, my investor

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

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

Â Where is the competition?

Â It's over there.

Â Right?

Â So there is a fundamental problem.

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

Â 8:32

So in order to do that, we have to do a couple of things.

Â So let me ask you to do NPV calculations based on 5%, 20% or 11%.

Â Why am I giving you three numbers?

Â Because you can do the analysis of your competitors, or your investor will see.

Â And we don't know what the discount rate or little r is.

Â So the little r could 5%, it could be 20%, or it could be 11%.

Â There's a reason why I'm choosing all three.

Â And you'll see it in a second, but should be pretty simple for

Â you to calculate the NPV of both projects using 5, 20, or 11.

Â And I'm going to go to Excel to do this but only for a second.

Â Because I think you should know how to calculate the NPV of these.

Â Then I'll just put up the numbers for you, but I'd encourage you,

Â when you take a break, to calculate the numbers.

Â Fair enough?

Â You know how to do the NPV of project A, what do you do?

Â Minus two thousand, plus one.

Â 400 divided by 1 plus r in parentheses

Â plus 2400 divided by 1 plus r squared.

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

Â 9:48

Figure out what the value of your project is, okay?

Â So what I'm going to do is I'm going to go back, and

Â I'm going to use 5% to calculate.

Â So let's do this.

Â Let's do the NPV, and

Â NPV, and remember NPV has some problems with it,

Â so just remember that for a second.

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

Â it is not your IRR, what is it?

Â It's that rate of return your investor will look at to compare you to them.

Â And we are doing project A.

Â So what after that?

Â After that it's asking for values.

Â Now remember, don't give value zero for NPV, that's a little quirk.

Â 10:43

Everybody okay, B1, C1, no A1.

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

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

Â So, where does the net come from?

Â From adding back A1, which is almost always negative.

Â You need effort to create something of value.

Â So let's see what the answer is.

Â You get 557.8 so about 558 bucks.

Â Okay?

Â Let's do the same thing for project B.

Â I'm going slow here so that we kind of recap calculations,

Â as I said I promise I'll recap but I won't spend time.

Â On doing for all interest rates, okay?

Â So what do you do?

Â You do .05.

Â Now, where are my cash flows?

Â Remember, starting with year one.

Â So B2 colon C2, plus what do I add back?

Â A2.

Â Everybody okay?

Â 471 .66.

Â So what I'm going to do now is I'm going to go back and

Â write out all these numbers.

Â Okay. And

Â confirm that we are all on the same page.

Â Okay.

Â So just give me a second here, and we'll get going.

Â So remember the two numbers we just did.

Â We did 558 and 472.

Â And let's go back, and let's work with this now.

Â So in NPV, I'm going to start writing here.

Â At 5%, was what?

Â 558 and 472.

Â So the first question I'll ask you is, so suppose you do your analysis and

Â your projects A and B.

Â You're responsible for the cash flows, but now you go and judge them at 5%.

Â Which one will you choose?

Â 12:47

Suppose this is millions of dollars which one will you choose?

Â Because if it's just dollars, you would say come on, you're wasting my time.

Â It's not worth my time to put in the effort to calculate.

Â Suppose this is millions, and believe me,

Â corporations use millions of dollars to make decisions.

Â Which one will you choose?

Â 13:10

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

Â 20%.

Â So now you go and say suppose my best alternative for

Â the investor and for me, my competition is earning 20%.

Â At 20% I know this is zero because I just calculated the IRR,

Â and it turns out the answer to this is 101.

Â What's happening now?

Â I just flipped.

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

Â So you see what's going on.

Â IRR rule always said, if you were using it blindly,

Â choose B over A, but now,

Â I'm giving you two scenarios where it depends.

Â So at 5% go with A.

Â At 20% go with B.

Â Finally, I gave you an 11% rate of return.

Â What was the scenario there?

Â Turns out the numbers are 308, 309.

Â What's going on here?

Â 14:22

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

Â One, at the rate of return that's relatively low for

Â the competition, I should choose Project A.

Â At very high rates of return for this kind of project, I would choose B.

Â But at about 11%, what's true?

Â I'm roughly the same.

Â So I'm indifferent between A or B.

Â So I'll put this or this.

Â This is also one way of thinking about what we call in the real world is a kind

Â of a break even analysis.

Â So this is, 11% is the point at which you're indifferent between the two,

Â and I would really like you to draw graphs to emphasize this.

Â I'm going to now draw graphs.

Â But remember the graph will be

Â 15:14

NPV vs rate of return, and I'll show you all the numbers.

Â Okay, so let's get started.

Â This is very cool stuff actually, and it's not that difficult to do.

Â 15:43

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

Â Very straightforward.

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

Â The first project's NPV is 800.

Â Why?

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

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

Â 16:12

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

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

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

Â Right?

Â 17:04

The NPVs are the same.

Â And they were about what?

Â 309.

Â So what is this graph telling you?

Â That at 11%, you don't care between the two projects.

Â But at 5%, which one would you choose?

Â A.

Â 17:35

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

Â And the point here is very simple.

Â You will choose Project A if the competitors are earning

Â anything up to 11%.

Â After that,

Â you will choose B if then other competition is earning more than 11%.

Â Let me ask you a simple question, and then we'll take a break.

Â When would you choose neither?

Â 18:08

It's very simple.

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

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

Â are both projects negative NPV?

Â The answer is, more than 25%,

Â because if the discount rate is more than 25%, and remember,

Â the discount rate, little r, is what the competition is earning, it's neither.

Â It's not easy to calculate.

Â We'll spend a whole bunch of time on that, when we do risk and return.

Â But the point I'm saying is that it's the most important ingredient to

Â decision making.

Â So if the discount rate is more than 25%, you won't choose either.

Â So I have just shown you the very simple example

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

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

Â 19:05

It's biased in favor of projects that show you early cash flows.

Â Let's take a break now.

Â Think about this.

Â Take even a few hours thinking about it because it's extremely important.

Â I genuinely believe that there are two kinds of people out there.

Â Those who do not understand IRR and can therefore learn.

Â And I learned, hopefully you are learning, or you already know these issues.

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

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

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

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

Â Right? But it's a very sophisticated kind of

Â bias.

Â If you want things in the short term for whatever reason and

Â I'll talk about that in a second.

Â What will you tend to do?

Â You'll tend to favor IRR as a decision making groove.

Â