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I'm going to move on to some, the third criteria, that criterion we are talking

Â about today, which to me, is extremely, extremely important for two reasons. One,

Â it's used even more now. I mean, almost as much now as it was 40 years ago. And it

Â competes with NPV in the proportion of people, even in the developed capital

Â markets we use it. It's called internal rate of return. I want to spent a lot of

Â time on it and emphasize it similarly as I did with NPV. I kind of went quickly over

Â paybag, but I'll recommend very strongly don't use it, okay? However, I think IRR

Â is used almost as much, or in fact, slightly more than NPV. And I want you to

Â understand it fully. So, that's why at the beginning of this class, I decided that

Â I'm not going to just teach you what is maybe the better thing to do. You need to

Â also recognize what's done in the real world. And recognize its strengths and

Â weaknesses. And IRR is very subtle. Irr is seductive, it's subtle, it's intuitive,

Â yet it has problems. It's not blatantly got issues like payback does, right? So,

Â let's start. And I want you to recognize that ironically, even though it's used a

Â lot and we all get a feeling like we know it, we don't. So, therefore I have to do a

Â lot of effort here on what the heck is it. So, let me ask you this, as always, what

Â is the IRR of this simple example? So, what is happening? At time zero, you're

Â spending 100 million dollars, and let's make it for convenience so that you're

Â not, let's make everything in millions. So, that we are not worried about all for

Â ten bucks, why should I even do this problem, right? You know [laugh], you want

Â some excitement in life, so let's make it exciting. You have an idea or somebody has

Â an idea which is involves 100 million dollars of outflow, setting up a factory,

Â getting the right thing and it'll last for one year. Again, for simplicity, we'll go

Â longer. How much does it get to you in one year? 110. Can you tell me the rate of

Â return on this? I'll pause for a second because I think if you have a little bit

Â of Math ability in your mind, you should tell me the answer. The return? Everybody

Â intuitively understands. It's how many did you make on the investment you put in. So,

Â look what you tell me, I think almost all of you will tell me the answer is ten%.

Â And the reason you're going to tell me that is how much of I made over one year?

Â Yes, I spent 100, subtracted out from the 110. But remember, the units, it's on how

Â much did I make ten bucks? 100. So, it's ten%, right? So, I give a very simple

Â example. So, what is the IRR of this problem? Ten%. Okay, let me see what you

Â have done. This is what you've calculated. I'm just reflecting what you did in your

Â mind. And I think this is an excellent way of teaching IRR that I've found over the

Â years rather than just throwing a formula at you. I think I really, I cannot say it

Â often enough how just a little bit of insight on how to teach or how to

Â understand something yourself, help goes a long way and I follow simple principle

Â which I hope I'm reflecting in everything I'm doing. I just try to think, what the

Â heck am I doing before I use a formula. So, think about R, it's very intuitive. Fv

Â is the future value. Pv is the present value. You subtract the present value from

Â the future value. And what's the present value? It's a negative number because I

Â made an investment of 100 and then you divide it by your investment, which was

Â the present value. And this is what you came up with. Two things to remember about

Â this One, its a percentage and it's per period, in this case, year. So, it's a

Â number that is calculated over time, alright? And, it's a percentage. Because

Â it's calculated over time, it applies to a period of time. So, if your time is one

Â year, the ten percent of the time is one month, probably a smaller number. How

Â would you say it in English? You'll say, what is my final sum and what is the

Â initial sum which is, what I put in. And the difference between the top and part

Â many times called, the money you made or the profit, divided by your investment,

Â which is ten bucks, divided by an investment of 100 bucks, right? Pretty

Â obvious, right? So, now I'm going to mess with you, meaning I'm going to try to

Â figure out whether you really know rate of return and what does it mean. Okay. What

Â is the intuition? What is the NPV of the idea if you use the IRR to calculate it?

Â What am I saying here? What is my cash flow, alright? What is the NPV of the idea

Â if I do, do it. So, let me just quickly before I go to the next bullet point, let

Â me just quickly write something here. The NPV of the idea would be -100 + 110 / one

Â + R, alright. Why am I dividing by one + R? Because I want to bring the 110 back.

Â The question I'm asking you is, you've calculated your IRR. And you put it in

Â here, ten%. What do you get? Zero. And don't, this is very important because I'm

Â going to use this formula later. So, see what, what IRR is doing. If I use my IRR

Â to calculate my NPV, the answer should always be zero. And the reason is very

Â simple. The internal rates of return is called internal rate of return because it

Â only needs one thing to calculate it. Remember, to calculate MPV you need two

Â things, you need 100, -110. But for IRR, to calculate it, look at this. All I

Â needed was the 110 and the 100 which is the cash flows. So, that's why its called

Â internal, its internal to the idea. So, when I calculate the ten percent rate of

Â return and use that same IRR which is based on the cash flows to then calculate

Â the NPV of the idea, what am I using? I am using the ideas own return to calculate

Â the NPV, is that right? Answer is obviously not. Why? Because if I use my

Â own rate of return to calculate my own value, I'll come up with what I've began.

Â Zero, right? So, remember, this equation is not what you should do to figure out

Â NPV. This equation just tells you what the textbook tells you. Suppose, you want to

Â calculate the IRR of the following problem. -100, 110. What is the rules

Â you'll use to calculate it? Well, you'll use the rule of figuring out that number

Â which makes your NPV, zero. And the intuition here is, to remember you're

Â using your c ash flows to figure out your rate of return. That's all you are doing.

Â And it's a mechanical process of calculating. So, let's use this use this a

Â little bit. What does this tell us? -100 =,, - 110 / one + R. So, both sides have

Â become negative. I have taken this to the other side which implies R = ten%. So,

Â this is the rule of thumb we use in, in, in, in calculating R. In this example,

Â it's very straightforward. So let, let me ask you, let's do a simple exercise. In

Â this example, suppose I don't know my IRR, the first number to start is what? Zero.

Â Try zero, what will you get? -100 + 110 / one + zero is ten bucks and it is not

Â equal to zero, right. Then try a higher number, its called trial and error which

Â the laptop or the computer will do to figure out your rate of return. But, its

Â such a simple problem, you don't need the Excel to do it, okay? So, I am going to

Â now, ask you, is this idea, a good idea? Sorry there's a little bit of overlap with

Â my writing but we'll manage. Is this idea, a good idea? Which idea? An idea where I

Â spent 100 bucks and get 110. What do you think? I hope you say you don't know,

Â because a lot of people will turn around and say, very cool idea, t10 percent rate

Â of return. But the tragedy of IRR is, that it has no benchmark built in. There's

Â nothing that tells me whether the ten percent is good or bad. So, let me bring

Â in that thing that I'll ask you to put away at the back of the head, risk. Right

Â now, we are ignoring risk so it is becoming difficult to internalize this.

Â But suppose, the risk of this business is such, that even twenty percent rate of

Â return is too low. Is this a good idea? Maybe not, right? On the other hand, if

Â the risk is so low, that you're a genius, you're able to create ten percent rate of

Â return, it's a good idea. So, here's the question. What if others in this type of

Â this business are making eight%? Tell me what is this eight percent now? What do I

Â mean by others in this type of business making eight%? This is called R, remember?

Â If I want to calculate the NPV of this idea, it is what others are doing who are

Â my com petitors in a similar business. That is to be used as my discount rate.

Â Now, tell me, what will you do? Will you do, is this idea good or bad? It's a great

Â idea. Why? Because I'm making ten percent and everyone else is making, less, what

Â should happen? Money should flow to me, not just mine, other people's. Is that

Â clear? Why, and please do this. What is the NPV of this at eight%? And you'll find

Â it's greater than zero. I'm not even going to do it. You can do it visually. -100 +

Â 110 / 1.08 has to be a number greater than zero, because at 1.1, it is exactly equal

Â to zero. Now, let me throw in a little curve ball here. Suppose, instead, you

Â made a mistake, your analysis wasn't right, you go and try to figure out, did I

Â get other people in this business right, did I measure their return right and there

Â are ways doing that, we will get to it later in the class and you find out, oh

Â boy, no I was wrong. Other people are actually making twelve percent on ideas

Â like this. Should I do this or not? No, because, others are doing better than I

Â am. So R, in this case is greater than IRR. Don't do it. And you'll find that NPV

Â is less than zero. So, the important element in all of this is to remember,

Â that if you calculate an IRR of ten%, it doesn't mean anything in isolation. So,

Â the first thing to remember is doing an IRR calculation just requires you to know

Â your business well. It's internal to your business. All it needs is your business's,

Â business's initial investments and future profits. However, it's not telling you

Â anything, because there is no benchmark. So, if the benchmark is eight percent and

Â you'll be making it ten%, good news. But if your benchmark is twelve%. That's is

Â what other people are making, somebody would be really silly, including yourself,

Â to put your investment in your project rather than other people's project.

Â