2:19

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

would give us a good basis for assessing its value.

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

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

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

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

3:36

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

anywhere and everywhere around the world.

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

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

or the average accounting rate of return.

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

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

Basically, the net income that is projected from the ideal

project that you have, divided by the average investment,

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

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

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

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

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

1, 2, 3 years.

And what I will be investing is,

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

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

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

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

That is my forecast.

So I have a fairly simplified set of numbers here.

The numerator, the net income is right here.

And here is my investment.

How do I figure out, what is the AAR?

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

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

which is going to be 1,000 / 2.

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

remember that any investment over time,

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

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

then the average is between 0 and 1,000,

somewhere here, which is this number 500.

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

you get 75 divided by 500,

which gives you an AAR of 15%.

That is the result from this first technique.

6:18

Is this good?

Is this not good enough?

Well, we obviously need a benchmark.

We need something to evaluate this with.

So that's the first limitation of the method,

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

Because my assessment might be very different from your assessment.

And so a lot of subjectivity comes into place.

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

So, the depreciation may not occur in this way.

6:45

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

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

So, what happened to time value of money?

Well, this method absolutely ignores it.

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

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

available from financial statements and is pretty easy to calculate.

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

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

So let's look at the second method.

7:25

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

it's called the payback period.

How do you define the payback period?

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

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

or to get back your money?

7:47

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

we work with a quick example, a simple example.

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

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

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

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

Let's say $200 today.

Just use some different colors here.

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

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

Okay?

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

accounting values which I use for this particular method.

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

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

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

where do we get these cash flows from.

Right now I'm just assuming I have them.

So the payback cost.

How long does it take to recover your initial investment.

Now you could do this in your head, but

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

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

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

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

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

Now by the end of the second year I have

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

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

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

And so the answer is 1 year,

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

2.33 years is equivalent to 2 years and 4 months.

10:04

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

Is this too long, is this too short?

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

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

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

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

that my cutoff period was 3 years.

10:33

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

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

But if my cutoff period was 2 years,

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

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

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

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

11:01

Again naive method but pretty easy to calculate.

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

exposed for.

And it's very much biased towards liquidity.

One thing I could do to improve this method

is to include the discounted version of it.

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

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

We need a discount rate.

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

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

we have an investment today of 200 and

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

Now if we want the present value equivalent,

remember the present value formula was the amount

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

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

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

that factor itself works out to .909.

Do that again for year 2.

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

If you work this out 0.826.

Do it again for year 3.

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

So simply to carry these calculations so

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

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

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

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

0.826 times a hundred gives me 82.6.

0.71 51 times 150 gives me a value of 112.7.

Now you can see these cash flows are different from

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

So the payback should be longer.

Let's figure out the payback.

If we accumulate the cash flows.

I need 200.

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

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

We double-check these a little later on.

Subtract 82 from this, I still require 71.9.

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

year 71.9, again taken as a fraction,

112.7 gives me 0.638.

So the payback is now 2.638.

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

14:09

Very useful if the numbers are very large, or

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

But in principle now we know how this works.

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

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

the payback method.

This is known as the net present value method.

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

in today's dollars.

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

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

to be greater than or equal to 0.

all right?

So let's see how that actually works.

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

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

15:04

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

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

and then 100, and then 150.

Right?

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

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

15:27

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

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

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

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

present value.

That is minus 200.

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

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

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

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

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

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

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

let's just say $41 it is positive,

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

16:49

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

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

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

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

even though the project has not started yet, right?

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

that you're going to do a project.

And people will do the same calculation as you.

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

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

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

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

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

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

far in trying to attribute value based on these cashflows.

17:50

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

is known as the Internal Rate of Return method.

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

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

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

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

Do you accept the project, not accept the project?

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

equal than the rate that you wanted to earn.

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

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

Let's figure that out for this particular project.

18:57

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

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

And then again for

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

So I have an equation and I can solve for

that equation usually with a financial calculator.

If you don't have a financial calculator,

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

And actually if you solve for

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

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

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

which is the inverse relationship with value and rate.

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

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

44%.

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

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

And that makes this particular project also acceptable.

21:53

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

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

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

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

So I've got two points here.

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

What would be the MPV?

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

that gives me a value of 100 so

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

[SOUND] Okay?

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

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

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

identified earlier on.

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

Imagine I had another project Called Project B.

23:58

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

So we have a conflict.

Why is this conflict caused?

As I mentioned, there's several reasons,

one of them is because the scale of the project,

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

And that's why we have these different slopes.

So, as a general rule,

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

The MPV method is the preferred method,

it doesn't result in these kinds of conflicts.

24:28

So to sum it up.

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

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

the attention of those evaluating a proposal.

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

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

But before we get too confident with these methods,

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

25:27

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

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

What assumptions we'll use to derive them.

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

Well the short answer to this question is the assumptions and

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

This is at the core of understanding value creation, and

is what we will be doing right after this.