Hi, I just wanted to take a break because we have had almost one and half hours plus I think of video right now, for today. And I'm going to go over the length of the video not kind of constraining me on what I do. However I have also think that the amount of information you need in a week, needs to be appropriate for a beginning class. So 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 ten minutes. Because I think it, what it does, it there's a benefit to you being involved longer than ten minutes on certain things. Why did I pause now? Because I think IRR is not easy. IRR is used because a return is a very natural thing for people to think about. So I want you to first understand the mechanics of IRR. A lot of people get very confused as about, why am I trying to make the MPV 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 a multiple cash flows. So 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 internalize and give you, 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 very recognized that 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. So let me do one more example. And 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. And 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. So, what is the IRR of this idea? There's an outflow today of 100 million, there's an inflow of 230, and then there's 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 and projecting instead of hiding year two. They're 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? And the answer is yes, right? So let's do this problem. What is the definition of IRR? The definition of IRR is, that rate of return which makes NPV zero. Okay, so 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. And 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. And just make sure if I have the 132 right. Okay, so, let's make it -132 I apologize, I have big, fat fingers. Okay, so. >> [INAUDIBLE] >> Grant, sitting next to me just told me I was being a bozo. Nervous fingers, I put in two negative 132, okay. Why is that important? Because a negative and a positive cash flow are totally different things. Okay, IRR, we are all set, A1 through C1, right? Got it? You got it right? Okay, answer is 10%. But here's where I throw you a curved ball. Let me try and make another calculation for you. And let's do IRR. And this is where one of the few times where I'll take advantage of knowing the answer, okay but I want to point out something really important about IRR. All right, and let me throw in a guess. So what did I find? I found that my second guess works too. So what do I have? I don't have one IRR. I have two IRRs which tells me what the heck do I do, right? And this is where the graphics will help me. And can this happen? Yes, in fact, you can get as many IRRs. You may, don't have to, but you can get as many IRRs as change in sign. And I don't want to just get belittle this point, but I told you, today we stop at mechanics of IRR. I just felt compelled to show you one example. Okay, so 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. So remember Zero. Please do this in your own time with this example and this is r. So let me ask you the following question. What is the easiest case for IRR? Remember the computer can't do this problem, right? Because what is the computer trying to do? It's trying to make -100 + 230 for over 1 + IRR, + negative 132 divided by 1+ IRR squared. This r is equal to zero. So yes it's one equation and one unknown, but you know you're kind of [LAUGH] You're kind of guessing. So the computer guesses faster than you, all right? So suppose I put in zero for IRR. What's the beauty of zero? I'm 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. So that can't be the error. As you start going up, this is 10%, 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. So, look for the simple thing confusion created. Now, 20 to 10% are two IRRs. So, what the heck do you do? The good news is you can go to your best compatible alternative. Remember little r? And you are hoping that the little r is somewhere between 10% and 20%, why is that? You're hoping that your idea is such that, other people, in doing similar things their returns fall in this range. And the reason for that is, if it falls within this range, you are in the positive NVP range, right? This is a, in some senses practically very posssible but rarely a mechanical issue, right? 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 to 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. And 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. So remember, an intuitive decision rule when comparing mutually exclusive, mutually exclusive means you have to kind of choose between them, would you accept with the highest IRR? Like, remember when I told you you have two projects you want to choose 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 next time, and think about it. This rule is, unfortunately, incorrect, as the examples that will follow will demonstrate. And 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 for this week. The assessments will double check your understanding of PV and NPV, make you do some NPV and IRR calculations and we'll be ready next week to pick up where we are leaving off. May the force always be with you and keep smiling. See you next time, bye.
