Hi. I just wanted to take a break because we have had almost one-and-a-half hours, plus, I think of video right now for today. I'm going to go with the length of the video not constraining me on what I do. However, I think that the amount of information you need in a week needs to be appropriate for a beginning class. What I'm going to do is I'm going to take breaks when I think they're absolutely needed, but I'm not going to take breaks every 10 minutes because I think what it does is, there's a benefit to you being involved longer than 10 minutes on certain things. Why did I pause now? Because I think IRR is not easy. IRR is used because return is a very natural thing for people to think about. I want you to first understand the mechanics of IRR. Lot of people get very confused as about, why am I trying to make the NPV zero? I want you to spend a lot of time this week in your assessments in figuring out NPV, which is intuitive, then spending a lot of time on IRR, in the calculation mode, and simple notion of how do I calculate IRR in multiple cash flows. I'll do another example but in this example, what I'm going to do is I'm going to show you a weakness of IRR that's pretty obvious. But then, next week also is on decision-making. I'm going to come back and then show you, once you're very familiar with the calculation of IRR, I'm going to start showing you some examples that are much more intuitively complex and practically easy to do the number-crunching once you're internalized, you'll have practice and so on. But practically very easy to do, but conceptually a little tough and I don't want you to think that that's easy. That's where you recognize the real weaknesses of IRR and maybe perhaps why it is very different from payback and kind of seductive on the one hand but may have similar problems. Let me do one more example. In this example, we'll be calculating IRR, but I'm going to make your life a little bit difficult. This is the last thing we'll do for this week. I'm throwing in a calculation idea simply because just calculating IRRs could also be an issue. Forget about other deeper issues we'll talk about next week. What is the IRR of this idea? There's an outflow today of 100 million. There's an inflow of 230 and then there is an outflow of 132. Now, is this possible? Just the fact that there are two outflows and one inflow does it make it a bad idea? Answer is no. At least people are being honest in projecting instead of hiding year 2, they are saying, I know this is a little perverse, that there's a positive outflow and then a negative, but the fundamental idea is not that it's a two-year project. That's for simplicity. The fundamental idea here is, can the sign of cash flows change? Can profits become negative in the future and then positive again. The answer is yes. Let's do this problem. What is the definition of IRR? The definition of IRR is, that rate of return which makes NPV zero. What I'm going to do is, I'm going to do it graphically in a second, but let's go and first, do the calculation on tab. Turns out here, I already know the answers so we'll do it because I don't want you to waste your time on this. IRR, what do I press? Cell A1. I already put in the numbers negative 100, the next number is 230, and the last number is 132. Just make sure if I have the 132 right. Let's make it negative a 130. I apologize, I have big fat fingers. [inaudible] Ryan sitting next to me, just told me I was being a bozo nervous fingers, I put in two negative, 132. Why is that important? Because a negative and a positive cash flow are totally different things. IRR, we are all set, A1 through C1, right?. Got it? We've got it right? Answer is 10 percent. But here's where I'll throw you a curveball. Let me try and make another calculation for you. Let's do IRR, and this is one of the few times where I'll take advantage of knowing the answer. But I want to point out something really important about IRR. Let me throw in a guess. What did I find? I found that my second guess works too. What do I have? I don't have one IRR, I have two IRR, which tells me what the heck do I do. This is where the graphics will help me. Can this happen? Yes. In fact, you can get as many IRRs, you don't have to, but you can get as many IRRs as change in sign. I don't want to just belabor this point, but as I told you today we'll stop with the mechanics of IRR, I just felt compelled to show you one example. What I'm going to do now is, I'm going to move back to the PowerPoint and I show you now one final thing on the graphics. Remember zero, please do this in your own time with this example and this is r. Let me ask you the following question, what is the easiest case for IRR? Remember the computer can't do this problem. Because what is the computer trying to do? It's trying to make negative 100 plus 230 over 1 plus IRR plus negative 132 divided by 1 plus IRR squared. This all is equal to 0. Yes, it's one equation and [inaudible] , but you're guessing. The computer guesses faster than you. Suppose I put in zero for IRR, what is the beauty of zero? I am right here and now I have to figure out the NPV. What is the NPV? 230 million minus 100 million is what? 130 minus 132 so you're in the negative 2 million zone. That can't be the IRR. As you start going up, this is 10 percent, this is not drawn to scale, that's how the behavior of NPV will change. Now tell me, where would you rather be? Would you like to be here in your decision-making? Or would you like to be in a positive NPV zone? You'd like to be in the positive NPV zone. Look what a simple thing confusion created. Now, 20-10 percent are two IRR so what the heck do you do? The good news is, you can go to your best comparable alternative. Remember little r? You are hoping that the little r is somewhere between 10 percent and 20 percent. Why is that? You're hoping that your idea is such that other people in doing similar things, their returns fall in this range. The reason for that is if it falls within this range, you're in the positive NPV range, right? In some senses practically very possible, but really a mechanical issue. Because you can force the computer to calculate multiple IRRs. You can twist your rule of thumb to figure out where positive NPV is. I don't want to emphasize this too much so I would say this, just do the calculation and figure out that you could have multiple IRRs. What I want to do starting next week, the first half, approximately, I want to spend on why this decision criteria used almost more than NPV all over the world, could have more serious issues which you cannot think of. The thing that I'll be doing there would be simply this. In life you don't get to choose one project, you get to do multiple projects. You get to choose among multiple. Remember, an intuitive decision rule when comparing mutually exclusive, mutually exclusive means you have to choose between them, would you accept with the highest IRR? Remember, when I told you if you have two projects, you want to pick one using NPV, which one to pick? The higher value creation. Here, most people think the higher IRR will give you the right decision. We'll see you next time and think about it. This role is, unfortunately, incorrect as the examples that will follow will demonstrate. I've always told you, I can always tell you this and say go home, don't use IRR, it has got problems. We will do detailed problems to understand, but I want you to spend time on the assessments. The assessments will double-check your understanding of PV, FV, PMT, make you do some NPV and IRR calculations. May the force always be with you and keep smiling. See you next time. Bye.
