2:19

Being able to answer each one of these questions when considering an idea

Â would give us a good basis for assessing its value.

Â However, as we will soon learn, the first two statements about the return

Â on investment and the payback period are at best naive expressions of value.

Â While the third, the net present value method is more sophisticated but

Â still not good enough to make that final decision unambiguously clear.

Â 3:36

Okay, so let's begin with the most commonly used method in business speak

Â anywhere and everywhere around the world.

Â And that is known as the ROI, or return on investment.

Â But in finance, we use a slightly modified version of this known as the AAR,

Â or the average accounting rate of return.

Â AAR, average accounting rate of return, which is a simple ratio.

Â And what this does is it takes an average of the income that you project.

Â Basically, the net income that is projected from the ideal

Â project that you have, divided by the average investment,

Â or sometimes known as the book value of the investment, okay?

Â So, it's a simple ratio of income over investment return on investment.

Â So, let's do a quick example to see how this works.

Â All right, what I'm going to do is draw a timeline here.

Â And I'm going to have a 3 year investment.

Â 1, 2, 3 years.

Â And what I will be investing is,

Â let's assume a $1,000 investment that I make today, right now.

Â So I'm going to invest $1,000 right here, today.

Â And I'm going to get back income that is projected

Â to be 30, and then 75, and then 120.

Â That is my forecast.

Â So I have a fairly simplified set of numbers here.

Â The numerator, the net income is right here.

Â And here is my investment.

Â How do I figure out, what is the AAR?

Â Well, I can take these three numbers and their average,

Â 30 + 75 + 120, and then divide it by the average investment,

Â which is going to be 1,000 / 2.

Â Now if you're wondering why am I dividing it by 2,

Â remember that any investment over time,

Â if you make this much investment, in this case 1,000.

Â And then if you depreciate that investment over time to 0,

Â then the average is between 0 and 1,000,

Â somewhere here, which is this number 500.

Â So if you work this out, what you get is,

Â you get 75 divided by 500,

Â which gives you an AAR of 15%.

Â That is the result from this first technique.

Â 6:18

Is this good?

Â Is this not good enough?

Â Well, we obviously need a benchmark.

Â We need something to evaluate this with.

Â So that's the first limitation of the method,

Â is it's very difficult to compare and assess this rate.

Â Because my assessment might be very different from your assessment.

Â And so a lot of subjectivity comes into place.

Â The other point you notice is that we're using book values and not market values.

Â So, the depreciation may not occur in this way.

Â 6:45

And then, we're completely ignoring what we learned from our first course,

Â which is numbers in the future are not equal to numbers today.

Â So, what happened to time value of money?

Â Well, this method absolutely ignores it.

Â And so, you end up getting rates of return that are not really that meaningful.

Â The only redeeming factor about this is that, this kind of information is

Â available from financial statements and is pretty easy to calculate.

Â So the decision is, I've got some information but

Â I'm not really that comfortable with the input nor with the output.

Â So let's look at the second method.

Â 7:25

Now the second method is actually even simpler than this one, and

Â it's called the payback period.

Â How do you define the payback period?

Â The payback period is simply the time it takes to recover your initial investment.

Â In layman terms, we can say, how long does it take to recover your money,

Â or to get back your money?

Â 7:47

So, to calculate this payback, [COUGH] again,

Â we work with a quick example, a simple example.

Â And let's assume, again, a 3 year timeline for an investment.

Â This time we'll just use different numbers to differentiate it, so

Â I'm going to draw my three year timeline 1, 2, and 3.

Â And what I'm doing this time is that I'm going to be investing.

Â Let's say $200 today.

Â Just use some different colors here.

Â I'll invest 200 today, and I'm hoping to get back 50 after 1 year,

Â 100 after 2 years, and then 150 after 3 years.

Â Okay?

Â One of the differences I'd like you to note right away is that instead of using

Â accounting values which I use for this particular method.

Â I'm going to be using cash flows for the payback method.

Â So this is an important distinction we're going to make in our third video,

Â when we focus very, very squarely on what our cash flows,

Â where do we get these cash flows from.

Â Right now I'm just assuming I have them.

Â So the payback cost.

Â How long does it take to recover your initial investment.

Â Now you could do this in your head, but

Â it's obviously easier if we do this in some systematic way.

Â One way to do that is to accumulate these cash flows.

Â And so what we do is we'd simply start accumulating them.

Â Times 0 means I need $200 to recover, how long does that take?

Â Well, in one year I'm getting 50 so that means I still need 150.

Â Now by the end of the second year I have

Â received 100, I needed 50 so I still require another 50 and

Â you can see that 50 is being recovered in this year 3, so I simply take a ratio of

Â what I need By what I'm receiving, [COUGH] which gives me a fraction which is 0.33.

Â And so the answer is 1 year,

Â 2 year, 0.33 and that's the payback, 2.33 years.

Â 2.33 years is equivalent to 2 years and 4 months.

Â 10:04

Once again I have a problem, what do I compare this payback with?

Â Is this too long, is this too short?

Â Again, this would be a very subjective decision, but because for

Â me, this might be too long, for you it might not be that long at all.

Â Again, I'm ignoring the time value of money.

Â And again, I'm being fairly myopic about this because let's say

Â that my cutoff period was 3 years.

Â 10:33

If my cutoff period is 3 years, then this is a good investment,

Â because I've recovered my money before the 3 year cutoff.

Â But if my cutoff period was 2 years,

Â I would reject this project, because I'm getting a payback that's too late.

Â In fact, even if I had a million dollars after 2 years, I

Â would simply reject this project, because I'm not looking beyond the 2 years.

Â So this way, it's biased against very long term projects.

Â 11:01

Again naive method but pretty easy to calculate.

Â It kind of gives me a sense of risk because I know how long my money is

Â exposed for.

Â And it's very much biased towards liquidity.

Â One thing I could do to improve this method

Â is to include the discounted version of it.

Â So instead of using these values, I could use their present value equivalents, okay?

Â Let me show you how to do therefore the discounted payback.

Â We need a discount rate.

Â We're going to assume that rate is 10%.

Â So we'll just take the numbers as we had them in this example which was,

Â we have an investment today of 200 and

Â then we're expecting to get back cash flows of 50 followed by 100 and then 150.

Â Now if we want the present value equivalent,

Â remember the present value formula was the amount

Â right multiplied by 1 over 1+r raised to the power t.

Â That gives us the factor so if we apply that factor or

Â year 1 it's 1 over 1.1 raised to the power 1 in this case and

Â that factor itself works out to .909.

Â Do that again for year 2.

Â 1 over 1.1 raised to the power of 2, which is 0.8.

Â If you work this out 0.826.

Â Do it again for year 3.

Â 1 over 1.1 raised to the power of 3, which gives us a factor of 0.751.

Â So simply to carry these calculations so

Â you can see them I'm just going to recopy them here.

Â 0, 1, 2, 3. We still have minus 200 and

Â then if we multiply the factor by the amount 0.9 or 9 times 50.

Â That's going to give me a value of 45.5.

Â 0.826 times a hundred gives me 82.6.

Â 0.71 51 times 150 gives me a value of 112.7.

Â Now you can see these cash flows are different from

Â these ones because they are lower, they are in present value.

Â So the payback should be longer.

Â Let's figure out the payback.

Â If we accumulate the cash flows.

Â I need 200.

Â I'm getting 45.5 that means if I subtract the two,

Â I still need 150, I think this is right, 154.5.

Â We double-check these a little later on.

Â Subtract 82 from this, I still require 71.9.

Â And now I can see they're coming in the third

Â year 71.9, again taken as a fraction,

Â 112.7 gives me 0.638.

Â So the payback is now 2.638.

Â You can see that is a bit longer than what we had before which was 2.33 years.

Â 14:09

Very useful if the numbers are very large, or

Â if the time periods are very long then you can get dramatically different paybacks.

Â But in principle now we know how this works.

Â We now get to the third method probably the most preferred one because it doesn't

Â suffer from any of the disadvantages that I mentioned for the AAR and

Â the payback method.

Â This is known as the net present value method.

Â The net present value method is going to give us one magical number

Â in today's dollars.

Â That suggest where the value is being created or where the value is being lost.

Â And we're going to accept the project if the NPV work so

Â to be greater than or equal to 0.

Â all right?

Â So let's see how that actually works.

Â I'm going to use the same numbers as I did with the payback.

Â You remember I had a timeline It was a 3 year project.

Â 15:04

And what we were doing in this case, we had a bunch of cash flows.

Â We were investing 200 today and then we were getting back 50,

Â and then 100, and then 150.

Â Right?

Â Now, I showed in the discounted payback that, in order to

Â calculate the discounted payback, we had to convert this into present values.

Â 15:27

That's exactly what we do in NPV method, except we don't look for

Â the number of years, we simply sum up the discounted inflows with the outflow.

Â So let's apply the present value factors to cash flows in computing the NPV.

Â We can start by simply looking at the first number which is already in

Â present value.

Â That is minus 200.

Â And then add to this the 50, that we're receiving converted in present

Â value That's 2 divided by 1.1 raised to the power 1, time period 1.

Â Plus take the next number divided by 1.1 to the power 2

Â because we're looking for the factor for two periods.

Â And then 150, 1.1, you can guess, you were right.

Â It's going to be to the power of three.

Â We work this out, what we're going to get is one unambiguous number 40.79 or

Â let's just say $41 it is positive,

Â it is greater than zero therefore, we would accept this project.

Â 16:49

It account for risk in discount rate and in this case the discount

Â rate was the same as the one in the discounted payback 10%.

Â And really, it's giving you one particular number that says,

Â this is the value that's being created right now,

Â even though the project has not started yet, right?

Â So this is going to be based on information that goes out,

Â that you're going to do a project.

Â And people will do the same calculation as you.

Â In an very efficient world and the value of the firm should change exactly by 41.

Â Of course that's not going, that's not what's going to happen in real life.

Â In real life what we'll have is people doing different calculations and

Â they may come up with this value or a higher value or a lower value and

Â that's really what people will perceive the value of the firm to be.

Â But for now, this is the first and the best method we have so

Â far in trying to attribute value based on these cashflows.

Â 17:50

So the fourth method and the final method that we're going to look at

Â is known as the Internal Rate of Return method.

Â And the Internal Rate of Return method Is actually looking for a discount rate,

Â the intolerate, that is going to force this NPV to equal to zero.

Â So the definition is, the IRR is a rate that forces the NPV to equal to zero.

Â Now, how do decide whether the IRR is a good rate, or not a good rate.

Â Do you accept the project, not accept the project?

Â Well, you compare the IRR, whether that is going to be greater or

Â equal than the rate that you wanted to earn.

Â So if it is greater than this rate, then you accept.

Â If it is less than the rate, you reject the project.

Â Let's figure that out for this particular project.

Â 18:57

But this time I'm looking for the discount rates.

Â So again, I'm looking for the IRR that I'll use in year two, the same IRR.

Â And then again for

Â year three, I'm looking for (1 + IRR) raised to the power of three.

Â So I have an equation and I can solve for

Â that equation usually with a financial calculator.

Â If you don't have a financial calculator,

Â you're going to try different rates until this equation works.

Â And actually if you solve for

Â it, you should try a rate that is going to be higher than 10%.

Â Because obviously when you increase discount rate it decreases present value.

Â That was a golden rule we learned in the first course,

Â which is the inverse relationship with value and rate.

Â We had used a formula like this and you see the inverse relationship here.

Â In this example, the IRR works out to be 19.

Â 44%.

Â Now 19.44% or about, let's just round it off to 19%,

Â clearly is greater than the rate that we wanted to earn, which was 10%.,

Â And that makes this particular project also acceptable.

Â 21:53

We also know when the discount rate was about 10%,

Â when it was 10% we know the MPV was As you can see here about $41.

Â So let's say that point is somewhere over here and

Â that's equal to about 41, corresponds to the 10% here.

Â So I've got two points here.

Â The other thing I can do is I can say, what if I had a 0% discount rate.

Â What would be the MPV?

Â Or I can simply sum up the numbers I have 150+150, 300-200 and

Â that gives me a value of 100 so

Â if I connect all the dots here, I get my so called NPV profile.

Â [SOUND] Okay?

Â [COUGH] Now you can see that this NPV profile is showing me what

Â is going on to the net present value as the discount rates increased.

Â The higher they are the lower is the NPV which was this basic principle that we

Â identified earlier on.

Â Right, now let's look at that conflict I referred to earlier on.

Â Imagine I had another project Called Project B.

Â 23:58

As we can see here, A is greater than B.

Â So we have a conflict.

Â Why is this conflict caused?

Â As I mentioned, there's several reasons,

Â one of them is because the scale of the project,

Â one of them might be requiring a larger investment than the other one.

Â And that's why we have these different slopes.

Â So, as a general rule,

Â what we do to resolve this question is stick with the MPV Method.

Â The MPV method is the preferred method,

Â it doesn't result in these kinds of conflicts.

Â 24:28

So to sum it up.

Â While it's clear that the ROI and Payback Methods come with their limitations.

Â They're pretty easy to calculate and still can go a long way towards getting

Â the attention of those evaluating a proposal.

Â However, if you can use the NPV and IRR methods, you are now in the big leagues,

Â and on the same level as most sophisticated investors around the world.

Â But before we get too confident with these methods,

Â let's remind ourselves that a method is only as good as what goes into it.

Â 25:27

I'm not referring not so much to the numbers.

Â I assumed in the examples, but where those numbers really came from.

Â What assumptions we'll use to derive them.

Â And do we have to be finance experts to generate these numbers?

Â Well the short answer to this question is the assumptions and

Â the cash flows that drive these techniques are perfectly within your grasp.

Â This is at the core of understanding value creation, and

Â is what we will be doing right after this.

Â