Professor, we have seen the concept of profitability for shareholders, can we say that we have the same approach for lenders. I mean, can we use as mutual combination also for lenders IRR? Uh, yes, we can. In one of the previous sessions, we have seen how to calculate the internal rate of return, from a point of view of a creditor. IRR is a standard measure of profitability that every possible participant in an investment can calculate. And we have seen that typically this internal rate of return is calculated using the relevant cash flows for typical creditors. During the construction phase, the contributions in terms of debt during the operational phase the repayment of this debt according to the terms and conditions that the SPV has agreed with creditors. If you shake up the two, you can calculate the internal rate of return for a typical lender. And the lender as it happens in real life. Will compare this internal rate of return with a predefined threshold. In order to understand if this IRR is higher, or lower than this threshold. In order to say go on or stop. For a typical creditor the benchmark is typically represented by a cost of funding. Either the cost of borrowing or a weighted average cost of funding that represents the cost that the bank must bear in order to provide funds to the SPV. So from this point of view, IRR can be used. However guys, we must be also careful in understanding the limitations of the IRR measure for creditors. And let me pose you this question. Let's assume that, you are creditors and you are providing at time zero an amount of money of 1000. In a one-shot sum of money to carry out the construction of a specific investment project. On this loan, you charge the SPV an interest rate of 10%. Let's assume that this bank can opt for three different methods of repayment of this 1,000. And let's assume that the maximum maturity, the maximum tenure this bank is open to accept is five years. Okay? Are you following me? Very good. Now, we can assume that this bank has the possibility to choose between three different alternatives. Alternative number one, the typical repayment schedule of a bond. Where all the principal is paid at the end. So 1000 will be paid at the end. And all the interest is paid during the life of the bond. So, between time one and time five. So from this point of view we'll have a typical, sequence of cash flow that is minus 1000 today, a sequence of interest payment from year one to year five equaling 100. 10 percent times 1000. And the principal repayment concentrated at the end. This is the bullet payment. This is the technical term. In this case, if you calculated the IRR, the IRR of this deal is exactly 10%. Second alternative, this bank, rare, it doesn't happen in reality. But it could also agree with the SPV to lend today 1,000 and be repaid an amount of 1,610.51 at the end of year five. That represent the accrued interest for five years plus the principle. If you calculate the internal rate of return this internal rate of return is again 10%. And, third hypothesis. Let's assume that, and this is what typically happens in reality, this bank agrees with the SPV to be repaid in constant principle repayments in five years, 20% random. So, at the end of the day, you will be repaid a portion of principal throughout the five years time. 200 times 5, from the year one to year five. It is obvious that in this case, the interest that you will be repaid from year one to year five will be decreasing. For the simple reason that the outstanding amount of the loan will fall down. But at the end of the day if you calculate the debt service payments that amount to 300 at the end of year one. 280 at the end of year two. 260 at the end of year three. 240 at the end of year four. 220 at the end of year five. And you calculate Internal Rate of Return, Internal Rate of Return is again 10%. So Jim, going back to your question. My point is you asked me. Can we rely upon the calculation of IRR for lenders, Yes for sure but with my example, I gave you a story whereby, at the very end, I have three different alternatives. And these three different alternatives returns exactly 10%. >> Well professor, but it seems to me that the third alternative, the amortizing option, is better for lenders given the same IRR, they start recovering the money sooner in the process >> Correct. So in reality Carlo, is what you are telling me is that. Although IRR is equivalent to 10% under the three alternative scenarios. You are indicating that as a creditor, you would certainly prefer alternative number three because you can recover sooner than later your money. And so you are less exposed to counter party risks vis a vis SPV. So it seems to me that you are telling me that these three alternatives are in reality not equivalent. Am I right? >> Yes. But if I just give a look to the IRR I cannot understand this difference. I mean, the IRR is always 10% so IRR telling me that maybe they IRR is not sufficient. Correct. This is exactly the point. I'm exactly telling you that if banks would resort only to profitability measures in order to understand, to give green light, or to stop the project, they would make a big mistake. In reality what banks do, is to on one side to appreciate. How much is the profitability? And so, IRR is certainly very well used in real life practice. However, if Carlo's right, and so I prefer to set up, in amortizing schedule for the loan, the second element a bank much check before the project starts. In order to give the final green light is, if you think well, to check that every year of the operational life. When the project is still some debt pending, the amount of cash that the project will be able to generate must be at least enough to repay the principle the interest that the bank has agreed with the special purpose vehicle to receive in that specific year. And this check has nothing to do with IRR. This is typically a check of financial sustainability. In practical terms. If you must return a bank, in year number 1, an amount of 300 million dollars, can you please check if the project has sufficient cash in that year to repay 300 million? If the answer is yes, banks can say I'm satisfied. But, if the answer is no, like in scenario number one, and scenario number two, although IRR is always 10%, banks will say, I cannot recover my own money in that specific year. So Jim, just to reconcile what Carlo was saying, with what you were saying, let me say that briefly the utility function of a typical creditor is not based on your profitability, but also on financial sustainability. In the following session, we will understand exactly how to measure financial sustainability. And I anticipate you that the key value measures for the calculation of financial sustainability go under the name of cover ratios.