Let's walk through the properties of IRR. There are other measures which I won't talk about. I've talked about NPV and we'll run with it after this for the entire class. I've talked about payback and pushed it aside. It doesn't make sense. IRR makes a lot of sense. But here are the properties I'm concerned about. Let's start. The first property we said, does it make sense? Here what I would like to do is I would like to scribble some thoughts. I know my writing is not the best in the world, but hopefully, while I'm talking and writing, it makes life simple for you. Does it make sense? Maybe. The reason is, lot of people like rates of return, they come naturally to us, percentages are life. Maybe it does make sense and maybe that's what creates a little bit of a problem. However, I would put maybe with a bunch of question marks because it at the gut level makes sense. We naturally gravitate towards it, but that doesn't mean it's right. A lot of things are seductive and seemingly right, but they have issues and that's why we learn and try to investigate. Unit of measurement. As I said, the make sense part is a very broad question and now we're digging deep. What's the unit of measurement? Remember I told you that I think the more I think about life and more I think about something that I know a lot about, I try to dig into what the heck is going on. Now, what is the unit of measurement? In some senses, it's very cool. It's unit free. It's a number, it's a percentage. That's cool. But what the danger is, what is the relationship between this and a value measurement? How do we measure value? We measure value in terms of something that's acceptable right around. If I told you your project has 25 percent rate of return, you may feel good about it, but you have to ask yourself, what does it mean in terms of value measurement? Here's the problem. Value measurement usually would be either in dollars or in rupees or whatever your currency is. There's really no connection between the two and that's why you have a rule of thumb. What? Even if you use IRR, what do you have to compare it to? The alternative best. Why? Because that process hides value behind it. In other words, if IRR is greater than R in a simplistic world, you are creating positive value. The unit of measurement being a percentage, will make you very cautious. Why? Because it's not directly value. Benchmark obvious? I think the benchmark is not obvious if you're looking internally. What's the benchmark? Was one better than the other? That really is not a good thing. In dollars, it is because it's a measurement, but in percentages maybe not. What is the benchmark? This is the benchmark. If you dig deep and you realize that rate of returns are by themselves don't mean much. You have to compare them with some. What is the benchmark? What would I have earned elsewhere instead of giving you my money? That elsewhere is a deep number. It's obvious at some level, but we'll spend a lot of time figuring it out. Which of the methods I've suggested automatically builds it in NPV? NPV forces me to do everything right and is one number in the end, it's wrong because it's based on expectations. But the process of thinking is right. If you have very high positive number in your NPV calculations, chances are that you have found something valuable. Easy to communicate. Now this may be its strength. Yes. It's very easy to stand up and say, your rates of return in my idea is 20 percent. I think everybody nods, everybody says, man, that's cool. It's easy to communicate but is it? By itself very easy to communicate, but to say, is this value creating or not? What do you have to come up with? This. In some senses, it's easy to communicate in isolation, but in value creation context, it's not. Look how much time it took trying to figure out what is IRR trying to tell us. Again, at a superficial level, like it makes sense at a real superficial level, it's easy to communicate in a superficial way. By the way, it's used left, right, and center. What's sad about it is, even when we know it's a deceptive measure, we still use it. I'll come to that in a second. Is it easy to compare ideas? Answer is absolutely not. Because direct comparisons using IRR are extremely deceptive. I just showed you there are two biases which are very devious. One is small-scale, it favors small Mickey Mouse ideas. It favors the short-term. Easy to calculate. Here's the tragedy of it. Answer is no, again. Why? Because we have to depend on an Excel because of compounding. The answer is it's not even easy to calculate. It's more difficult than NPV. Any other thoughts please feel free to add. I want to wrap this session up on decision criteria with one simple thought. That is, if you use these things listed in front of you to evaluate the ones we have covered and ones we have not covered and you can read about, what you'll find is the one that sticks out and still not perfect is NPV. IRR is used more. You have to be little bit careful when you're using IRR. In fact, I would say the following, there's no need to use it really, if you know how to do NPV. That's where we'll stop. We'll keep coming back to this issue later. I'll tell you when is it okay to compare IRRs and when is it not. In the context of value creation, real projects, try to stay away from them. Try to stay away from IRR. Why? Because scales are different, IRR is deceptive. Short-term, long-term IRR is deceptive. By the way, if the risks of the projects are different, IRR is also very deceptive. We'll get to that later. But because we haven't talked about risk. Let's stop now. I know I'm taking breaks in this time because IRR is tough to understand, but this is a natural break before we go to the next topic, which is cashflows. Remember you can start off right away if you don't want to break. Stop now. I'll take a break. We'll come back and start talking about the one ingredient common to all measures, is cashflows. Talk to you soon. See you soon. Bye.
