I'm going to move on to the third criteria, that criteria we are talking about today, which to me is extremely important for two reasons. One, it's used even more now, almost as much now as it was 40 years ago and it competes with NPV in the proportion of people, even in the developed capital markets who use it. It's called the internal rate of return. I want to spend a lot of time on it and emphasize it similarly as I did with NPV, I went quickly over payback but I'll recommend very strongly, don't use it. However, I think IRR is used almost as much or in fact slightly more than NPV and I want you to understand it fully. That's why at the beginning of this class, I decided that I'm not going to just teach you what is maybe the better thing to do. You need to also recognize what's done in the real world and recognize its strengths and weaknesses and IRR is very subtle. IRR is seductive, it's subtle, it's intuitive, yet it has problems. It's not blatantly got issues like payback does, right? So let's start. I want you to recognize that, ironically, even though it's used a lot and we all get a feeling like we know it, we don't. Therefore, I have to do a lot of effort here on what the heck is it? Let me ask you this, as always what is the IRR of this simple example? What is happening? At time here you're spending a $100 million and let's make everything in millions so that we're not worried about, oh, for 10 bucks, why should I even do this problem? We wants some excitement in life so let's make it exciting. You have an idea or somebody has an idea which involves $100 million of outflow, setting up a factory, getting the right thing and it'll last for one year. Again, for simplicity, we'll go longer. How much does it get you in one year? Hundred and ten, can you tell me the rate of return on this? I'll pause for a second because I think if you have a little bit of math ability in your mind, you should tell me the answer. The return, everybody intuitively understands. It's how much did you make on the investment you put in? Look what you'll tell me. I think almost all of you will tell me the answer is 10 percent. The reason you are going to tell me that is, how much have I made over one year? Yes, I spent 100 subtracted out from the 110 but remember the units. It's on how much did I make 10 bucks? Hundred, so it's 10 percent. I gave you a very simple example. What is the IRR of this problem? 10 percent. Let me see what you have done. This is what you've calculated. I'm just reflecting what you did in your mind. I think this is an excellent way of teaching IRR that I found over the years, rather than just throwing a formula at you. I think I cannot say it often enough. How just a little bit of insight on how to teach or how to understand something yourself, how it goes a long way and I follow simple principle which I hope I am reflecting in everything I'm doing. I just try to think, "What the heck am I doing?" Before I use a formula. Think about r, it's very intuitive. FV is the future value, PV is the present value, you subtract the present value from the future value and what is the present value? It's a negative number because I made an investment of 100 and then you divide by your investment which was the present value and this is what you came up with. Two things to remember about this. One, it's a percentage and it's per period. In this case, year. It's a number that is calculated over time. It's a percentage. Because it's calculated over time, it applies to a period of time. If your time is one year, it's 10 percent, if time is one month, probably a smaller number. How would you say it in English? You'll say, "What is my final sum and what is the initial sum?" which is what I put in. The difference between the top and bottom is many time is called, the money you made or the profit divided by your investment, which is 10 bucks, divided by an investment of 100 bucks. Pretty obvious. Now, I'm going to mess with you, meaning I'm going to try to figure out whether you really know rate of return and what does it mean? What is the intuition? What is the NPV of the idea if you use the IRR to calculate it? What am I saying here? What is my cash flow? What is the NPV of the idea if I do do it? Before I go to the next bullet point, let me just quickly write something here. The NPV of the idea would be minus 100 plus 110 divided by 1 plus R. Why am I dividing by 1 plus R? Because I want to bring the 110 back. The question I'm asking you is, you calculated your IRR and you've put it in here, 10 percent, what do you get? Zero. This is very important because I'm going to use this formula later. So see what IRR is doing. If I use my IRR to calculate my NPV, the answer should always be zero, and the reason is very simple. The internal rate of return is called internal rate of return because it only needs one thing to calculate it. Remember, to calculate NPV, you need two things; you need 100, negative 110. But for IRR to calculate it, look at this, all I needed was the 110 and 100, which is the cash flows. That's why it's called internal. It's internal to the idea. When I calculate a 10-percent rate of return and use that same IRR, which is based on the cash flows to then calculate the NPV of the idea, what am I using? I' using the ideas own return to calculate the NPV. Is that right? Answer is obviously not. Why? Because if I use my own rate of return to calculate my own value, I'll come up with where I began, zero. Remember, this equation is not what you should do to figure out NPV, this equation just tells you what the textbook tells you. Suppose you want to calculate the IRR of the following problem; negative 100, 110. What is the rule you'll use to calculate it? Well, you'll use the rule of figuring out that number which makes your NPV zero. The intuition here is to remember you're using your cash flows to figure out your rate of return. That's all you're doing, and it's a mechanical process of calculating. Let's use a little bit. What does this tell us? Negative 100 equals negative 110 over 1 plus R. Both sides have become negative. I've taken this to the other side, which implies R is equal to 10 percent. This is a rule of thumb we use in calculating R. In this example, it's very straightforward. Let me ask you, let's do a simple exercise. In this example, suppose I don't know my IRR. The first number to start is what? Zero. Why zero? What will you get? Minus 100 plus 110 divided by 1 plus 0 is 10 bucks and it's not equal to zero. Then try a higher number. It's called trial and error, which the laptop or the computer will do to figure out your rate of return. But it's such a simple problem you don't need Excel to do it. I'm going to now ask you, is this idea a good idea? Sorry, there's a little bit of overlap with my writing, but we'll manage. Is this idea a good idea? Which idea? An idea where I spend 100 bucks and get110. What do you think? I hope you say you don't know, because lot of people will turn around and say, very cool idea, 10 percent rate of return. But the tragedy of IRR is that it has no benchmark built-in. There's nothing that tells me whether the 10 percent is good or bad. Let me bring in that thing that I've asked you to put away at the back of your head, risk. Right now we're ignoring risk, so it's becoming difficult to internalize this. But suppose the risk of this business is such that even 20 percent rate of return is too low, is this a good idea? Maybe not. On the other hand, if the risk is so low that you are a genius, you are able to create 10 percent rate of return, it's a good idea. Here's the question. What if others in this type of business are making eight percent? Tell me, what is this eight percent now? What do I mean by others in this type of business making eight percent? This is called R. Remember, if I want to calculate the NPV of this idea, it is what others are doing who are my competitors in a similar business. That is to be used as my discount rate. Now tell me, what will you do. Is this idea good or bad? It's a great idea. Why? Because I'm making 10 percent and everybody else is making less. What should happen? Money should flow to me, not just mine, other peoples. Is that clear? Why? Please do this. What is the NPV of this at eight percent? You'll find it's greater than zero. I'm not even going to do it, you can do it visually. Minus 100 plus 110 divided by 1.08 has to be a number greater than zero, because at 1.1, it's exactly equal to zero. Now let me throw in a little curve ball here. Suppose instead you made a mistake, your analysis wasn't right. You go and try to figure out, did I get other people in this business? Did I measure their return? There are ways of doing that we will get to later in the class. You find out, oh boy, no I was wrong. Other people actually making 12 percent on ideas like this. Should I do this or not? No, because others are doing better than I am, so R in this case is greater than IRR. Don't do it. You'll find that NPV is less than zero. The important element in all of this is to remember that if you calculate an IRR of 10 percent, it doesn't mean anything in isolation. The first thing to remember is doing an IRR calculation just requires you to know your business well. It's internal to your business. All it needs is your business' initial investments and future profits. However, it's not telling you anything because there's no benchmark. If the benchmark is eight percent and you are making it 10 percent, good news. But if your benchmark is 12 percent, that's what other people are making, somebody would be really silly, including yourself to put your investment in your project rather than other people's projects.
