Hi. I think it would be fair to say that what we just did is something that you really need to internalize and something that the real-world and you should use more rather than less, but to give you some flavor, if you ask people running companies in the US, maybe 40-50 years ago or even 30 years ago, have you heard of NPV? Many would say yes. Do you use NPV? Maybe 30 percent would say I'm just throwing out a number which may not be exactly right, but will give you a sense of what's going on. What else would you use, and we're going to talk about those now. However, the important point is not what those other two are necessarily, the point I'm trying to make now is if you ask people now that 30 percent has jumped to more than 75 percent. As I said before, knowledge creation is probably the key competitive advantage of good universities in the world, and I think it's fair to say that but for research in this area, these new adoptions would not have happened. By the way, this is not plug and chug. In fact you can make it into plug and chug and that's what happens even now, but it's not. It's very deep. In fact one of my colleagues in the profession, very well-respected, said that's all we have to offer. Finance just has to offer NPV. How do you deal with time and so on and so forth? I think he's exaggerating, because we will talk about risk later, but it's very important to internalize what does NPV mean before you start cranking through problems. Let's go on to other methods that are used. One of the competing criteria which is age-old, it probably started in the cave. I'm sure NPV didn't start in the cave. As a concept, it did, but you didn't have ways of calculating. Payback period. What does that mean? Let me again throw out an example. You're spending $1,000 today, make it a million, whatever. Three hundred you're getting at the end of the first year. Remember what is the end of the first year? 0-1. End of the second year, you're getting 700, end of the third year, you're getting 2,000. Now how many points in time? Four. How many periods in time? Three, and remember, this doesn't have to be a yearly problem. It has to be a problem that fits your needs. For example, if you're doing daily stuff, and logistics is very important, and you're measuring things on a daily level, you may want to do the spreadsheet on a daily basis, and that's where Excel or ability to compute helps, but let's look at this example. What do you think is the payback? You're spending 1,000, you get 300 in the first year, 700 at the end of the second year, and 2,000 after that. The payback is what? Two years. Why? Because payback asks the following question. How long does it take for me to get my investment back? I'm not even going to write the answer here. It's pretty obvious that $1,000 comes back to me in three years. I mean in one year, I get 300. In the second year, I get 700, and let me just make a simple point here, is that you just want to add these two numbers, and you get a 1,000. Until you reach 1,000, you keep going. So the answer is two. Just a couple of details. Suppose the second year was 500, what would you do? You'd say the payback period is what? Shorter or longer? Longer. Instead of two, it's greater than two. By how much? Well it's not three because three is too long. You get too much in three years, so you get 802 years. You want another 200, and that is one-tenth of the third year, so what would you say? 2.1. Another twist to this which the real-world uses a lot is called discounted payback, because one of the disadvantages of the payback period is very obvious, you're basically stabbing me. You're saying, "Heck, I don't care about the opportunity time value of money. Who cares." You're basically saying finance is useless which may be true, but the point is there's an obviously cost to time and you recognize that. So I'm not taking that into account. Suppose we stick with the original problem, and we say what's the payback period with the discounting? If you discount what is going to happen to your payback period, remember it's two years in our original problem. If you discount, I just want you to recognize one thing, and that alone. I don't want you to calculate discounted payback and you'll see in a second why. I want you to recognize what will happen to the payback period: will it increase or decrease. Why? Because that gives me a sense and you yourself so that you can judge have you really understood what's going on. Answer, it has to be greater than two. Why? Because if you discount, you don't discount one thing in this problem and that's $1,000. Why? Because it's happening exactly today. So what will happen to $300? It'll become less than $300 when you bring it back. What will happen to $700? It'll become less than $700. So what will happen? You will discount the $2,000 as well, and what will you do? The payback will go up because now it will take longer in discounted terms to get the money back. I again repeat, I wanted to emphasize these two twists: one, if you go more than two years, what does it mean as a fraction? That's what the practice is. The second is what happens if you do a discounting? But I don't want you to think that payback period discounted or otherwise is a good thing to use, and the reasons are, let's do it. I don't want to spend too much time on stuff that I think is pretty bizarre. So does it make sense? Well I don't think so, and you'll see in a second. Why would you worry about how soon do you get your money back? There are certain contexts in which you would, but in context that we are talking about, you shouldn't worry, and the reason is you would want your money back maybe because you want to reinvest it in the idea, but remember if your idea is good, people should line up to support you. I agree that sometimes there is rationing what we call and you don't have the money, so maybe you will worry about things like this, but it turns out, I'm unwilling to believe that in a market like the US, payback should be used and it is used. So to give you some idea, more than 50 percent of people, companies admit that they use payback. To me, it doesn't make sense, and let me just give you reasons why it doesn't. What is the unit of measurement? Years, time, months, whatever. So basically, the unit of measure is measurement is time. How does that help me make a decision? The unit of measurement of MPV was what? What exactly what I used to measure other things. Do you use time to measure most things? Well, in an economy measured by time, it would make sense, but now you don't, and the beauty of money is not that it's everything in life. That's our weakness. The beauty of money is that I can compare things easily, and it's been created. The other beauty of money is it can stand on one side of every transaction. Of course like have you seen Lord of the Rings? Anything awesome has a dark side. So even Bilbo or other people supporting him, the ring was enticing to them, but they're even good people. So in my book, there's no such thing as what I just said, good people or bad people. I think it's good actions and the choices we make. Anyway little sideline. As I said, love, life is far more important than even finance. Benchmark. Not obvious to me. So you just come up with a project and say, it takes me two years to get the money back. Yes, you can't compare other ideas, how cool they are and how long it does come to payback. It's just unnecessary. It just doesn't seem worth my while when I have such more powerful ways of comparing things. Easy to communicate. I would give that a nod. A lot of people somehow start shaking their heads whenever you say payback. It's as if there is this deep understanding of value and time, and the same people can discount, so you have to understand that this ease of communication is false. The fact that you know what a year is doesn't mean you understand that a payback period of one year versus two-year versus three-year, one may seem better than the other, but what's the benchmark? Is it too good? Suppose my payback period is three, is that bad? What is the standard? Very tough. Easy to compare ideas. Again, years that it takes to get your money back, may not be the best way to compare ideas, and in fact, I don't think they are. Maybe easy to calculate is the reason why it became part of our system, and I have been shocked at how long bad habits stay with me. I know in my head that I shouldn't be doing something but still, habit takes over. Maybe this is a bad habit. I think though there's something else going on, and just a little bit on research on this idea. Who would use payback? Clearly, if you don't have money to feed yourself and your idea is the only way you can feed yourself. You will want to invest in the idea if other resources are not available. I understand that, but we're not talking about companies in a place where there's no capital markets. As I said, the fundamentals of whatever we were talking about assumes that money will flow to good ideas. That's the one good thing about globalization that has happened is free flow of money to good ideas. There are other things that are not so good, but this is not the place to talk about it. What is the other thing that could be going on? If you think of payback and I'll give you two ideas. Let me just make a little notion of payback. What's going on? If I give you $1,000, and $1,000 project A and project B. One gives 1000 right away. Sorry, plus, and then nobody knows what's going on. The other one gives 100, and then billions of dollars. Which one would pay back favor? Payback would favor project A, but life would favor project B, and the reason is very simple. Why is payback? Payback's problem is it's hungry for early cash-flows. How soon do I get my money back? That is also called myopia. I believe very strongly humans weren't created to just get myopic ideas. I don't think any entrepreneur says, you know, let me get my $1000 back and then get over with it. No, it's you want to create a long-term value, and so to give you an example, if you used payback, who would not be in this whole environment we are in, in this online? Who would not have a job? Me, and the reason is if the University of Michigan used payback to evaluate ideas, we would do Mickey Mouse things that paid back very quickly, and we wouldn't do research because B is what research is. You put in the money, takes long time for it to pay off. But when it starts paying off, it pays off big. Payback would hurt all those ideas. Please remember that payback is okay. It's easy to calculate, but it is counter to value creation, I believe very strongly, so it's a bad habit. But there is a maybe a devious reason why payback is used. Because if you are around only for a year as the CEO of the company and you're gone after that. Maybe you have an incentive and I say maybe to show the $1,000 early. Maybe partly because you get paid based on the $1,000 early. You don't have the time to wait for the billions. Why? Because your horizon is shorter than the horizon of what a value-creating idea maybe, and that's something we will not get into too much here. But there's a conflict of interest between the idea and the people who are managing the idea. That's not the so good side of globalization is that maybe people managing ideas have a conflict and they are myopic about how do they get their benefits out of it and therefore their favor payback. I'm not going to emphasize this too much. I'm just going to leave it at, payback doesn't make sense, especially because its only strength is ease of calculation.
