1 00:00:00,090 --> 00:00:02,430 The following content is provided under a Creative 2 00:00:02,430 --> 00:00:03,820 Commons license. 3 00:00:03,820 --> 00:00:06,030 Your support will help MIT OpenCourseWare 4 00:00:06,030 --> 00:00:10,120 continue to offer high quality educational resources for free. 5 00:00:10,120 --> 00:00:12,690 To make a donation, or to view additional materials 6 00:00:12,690 --> 00:00:16,620 from hundreds of MIT courses, visit MIT OpenCourseWare 7 00:00:16,620 --> 00:00:17,830 at ocw.mit.edu. 8 00:00:27,109 --> 00:00:28,650 ANDREW LO: In today's lecture, I want 9 00:00:28,650 --> 00:00:33,300 to continue where we were last time in talking 10 00:00:33,300 --> 00:00:38,310 about applications of the net present value rule 11 00:00:38,310 --> 00:00:42,210 to capital budgeting and project financing. 12 00:00:42,210 --> 00:00:44,370 As promised, today what I'm going to do 13 00:00:44,370 --> 00:00:48,750 is to talk specifically about other alternatives 14 00:00:48,750 --> 00:00:53,550 to net present value that are not recommended, 15 00:00:53,550 --> 00:00:55,740 but which you need to know about simply 16 00:00:55,740 --> 00:00:59,790 because they actually are used in practice to some degree. 17 00:00:59,790 --> 00:01:02,880 And you have to be an intelligent consumer 18 00:01:02,880 --> 00:01:04,709 of all of these different ideas so 19 00:01:04,709 --> 00:01:06,120 that you can pick and choose. 20 00:01:06,120 --> 00:01:07,740 And actually, there are some instances 21 00:01:07,740 --> 00:01:09,780 where these other alternatives can 22 00:01:09,780 --> 00:01:13,050 shed some light on the particular problem 23 00:01:13,050 --> 00:01:15,030 and challenges at hand. 24 00:01:15,030 --> 00:01:18,120 I'll try to describe those as we go over them. 25 00:01:18,120 --> 00:01:21,000 Before I do, a student came up and asked me 26 00:01:21,000 --> 00:01:25,200 about a concept called adjusted present value. 27 00:01:25,200 --> 00:01:26,700 I wanted just to make a note of that 28 00:01:26,700 --> 00:01:29,670 because, so far, we've been talking about NPV. 29 00:01:29,670 --> 00:01:35,400 But in fact, both the textbook, as well as the best practices, 30 00:01:35,400 --> 00:01:37,380 would suggest that you use something 31 00:01:37,380 --> 00:01:40,020 called adjusted present value. 32 00:01:40,020 --> 00:01:41,910 Which basically makes adjustments 33 00:01:41,910 --> 00:01:45,480 for things like taxes, project interactions, 34 00:01:45,480 --> 00:01:50,880 strategic alternatives, optionality, and so on. 35 00:01:50,880 --> 00:01:53,400 I want to recommend that you first of all, keep in mind 36 00:01:53,400 --> 00:01:56,490 this notion of adjusted present value. 37 00:01:56,490 --> 00:02:00,030 That's what you'll be learning about in 402, and in more 38 00:02:00,030 --> 00:02:02,310 advanced courses on capital budgeting and project 39 00:02:02,310 --> 00:02:03,340 financing. 40 00:02:03,340 --> 00:02:06,670 So for now, NPV is the right answer, 41 00:02:06,670 --> 00:02:09,270 but when you learn more about how to make those adjustments, 42 00:02:09,270 --> 00:02:10,750 you're going to want to use them, 43 00:02:10,750 --> 00:02:15,780 and then we call the particular criterion APV instead of NPF. 44 00:02:15,780 --> 00:02:19,479 Just terminology that you should be aware of. 45 00:02:19,479 --> 00:02:21,520 All right, so what I want to do today, as I said, 46 00:02:21,520 --> 00:02:25,560 is to talk about three other approaches to capital budgeting 47 00:02:25,560 --> 00:02:29,190 that various professionals have used in the past, 48 00:02:29,190 --> 00:02:32,740 and which some are used to a great extent even today. 49 00:02:32,740 --> 00:02:36,570 And they are payback period and the discounted version of that 50 00:02:36,570 --> 00:02:39,300 called discounted payback. 51 00:02:39,300 --> 00:02:44,110 Second is the IRR, Internal Rate of Return, 52 00:02:44,110 --> 00:02:48,370 and the third is the profitability index. 53 00:02:48,370 --> 00:02:53,800 Each of these have its own particular uses, 54 00:02:53,800 --> 00:02:56,590 and I'm going to try to describe them to you very briefly. 55 00:02:56,590 --> 00:02:59,530 And then we're going to talk about different applications. 56 00:02:59,530 --> 00:03:02,050 The bottom line, just to be sure that there's 57 00:03:02,050 --> 00:03:08,240 no misunderstanding, NPV is always the right thing to do. 58 00:03:08,240 --> 00:03:12,190 So that's what we're recommending for any capital 59 00:03:12,190 --> 00:03:14,300 budgeting application. 60 00:03:14,300 --> 00:03:16,630 However, you should still understand 61 00:03:16,630 --> 00:03:18,610 what these three other alternatives are so 62 00:03:18,610 --> 00:03:21,010 that you can speak about them intelligently, talk 63 00:03:21,010 --> 00:03:25,020 about their advantages, and disadvantages. 64 00:03:25,020 --> 00:03:27,600 All right, so let's get started. 65 00:03:27,600 --> 00:03:28,980 Payback period-- oh, question. 66 00:03:28,980 --> 00:03:29,130 Yeah? 67 00:03:29,130 --> 00:03:30,558 AUDIENCE: Is this for [INAUDIBLE]? 68 00:03:30,558 --> 00:03:34,075 I mean you speak pretty firmly about NPV being better. 69 00:03:34,075 --> 00:03:34,700 ANDREW LO: Yes. 70 00:03:34,700 --> 00:03:39,370 So is it people using those other methods are wrong, 71 00:03:39,370 --> 00:03:46,600 or less intelligent, or is there anyway to kindly describe that? 72 00:03:46,600 --> 00:03:48,689 ANDREW LO: So the question is, why are they 73 00:03:48,689 --> 00:03:49,980 using these other alternatives? 74 00:03:49,980 --> 00:03:51,930 Let me get to that later, OK? 75 00:03:51,930 --> 00:03:54,420 I mean, one could argue that they're less intelligent. 76 00:03:54,420 --> 00:03:56,490 Not everybody is able to get into MIT 77 00:03:56,490 --> 00:03:59,490 and take this wonderful course. 78 00:03:59,490 --> 00:04:02,910 So by definition, they're less intelligent. 79 00:04:02,910 --> 00:04:07,350 But no, I don't want to make such a blanket statement. 80 00:04:07,350 --> 00:04:09,840 I think that, partly, you'll find 81 00:04:09,840 --> 00:04:11,880 that these other techniques have been 82 00:04:11,880 --> 00:04:16,709 used in practice both because of cultural inertia. 83 00:04:16,709 --> 00:04:19,200 They were the first to have come on the scene 84 00:04:19,200 --> 00:04:21,630 before NOV was fully worked out. 85 00:04:21,630 --> 00:04:24,039 So people are just used to doing things the way 86 00:04:24,039 --> 00:04:25,080 they're used to doing it. 87 00:04:25,080 --> 00:04:26,970 People don't like change, necessarily, 88 00:04:26,970 --> 00:04:29,520 when it's particularly forced upon them. 89 00:04:29,520 --> 00:04:34,200 But the second reason is that these other methods capture 90 00:04:34,200 --> 00:04:37,560 other aspects of risk that, in certain cases, 91 00:04:37,560 --> 00:04:40,950 may actually be more important for the particular individual 92 00:04:40,950 --> 00:04:41,730 decision makers. 93 00:04:41,730 --> 00:04:43,635 For example, we've talked about a lot 94 00:04:43,635 --> 00:04:44,760 of different kinds of risk. 95 00:04:44,760 --> 00:04:49,030 Market risk, estimation risk, credit risk. 96 00:04:49,030 --> 00:04:51,580 But what's the most important risk to all of you 97 00:04:51,580 --> 00:04:55,120 once you start working in your jobs? 98 00:04:55,120 --> 00:04:55,996 AUDIENCE: [INAUDIBLE] 99 00:04:55,996 --> 00:04:56,661 ANDREW LO: What? 100 00:04:56,661 --> 00:04:57,580 AUDIENCE: [INAUDIBLE] 101 00:04:57,580 --> 00:04:58,371 ANDREW LO: Exactly. 102 00:04:58,371 --> 00:04:59,410 Career risk. 103 00:04:59,410 --> 00:05:03,310 Career risk is probably the most important risk 104 00:05:03,310 --> 00:05:06,400 from the typical perspective of the decision maker. 105 00:05:06,400 --> 00:05:08,200 And frankly, some of these measures 106 00:05:08,200 --> 00:05:12,010 that I'm about to describe focus on career risk 107 00:05:12,010 --> 00:05:14,590 more than they do on the risk to the investor, 108 00:05:14,590 --> 00:05:15,940 or the shareholder. 109 00:05:15,940 --> 00:05:19,450 What I'd like you all to focus on in doing your jobs 110 00:05:19,450 --> 00:05:22,540 is to try to maximize the value of the company 111 00:05:22,540 --> 00:05:24,700 from the perspective of the owners of the company. 112 00:05:24,700 --> 00:05:27,010 You are agents of the owners, so therefore, you 113 00:05:27,010 --> 00:05:31,070 want to maximize the value to the shareholders. 114 00:05:31,070 --> 00:05:33,460 But in fact, the way people behave 115 00:05:33,460 --> 00:05:35,180 is often somewhat different. 116 00:05:35,180 --> 00:05:36,850 So we'll talk about that as we describe 117 00:05:36,850 --> 00:05:38,230 each of these measures. 118 00:05:38,230 --> 00:05:40,720 In fact, let's talk about the first measure as a way 119 00:05:40,720 --> 00:05:44,460 to illustrate the point about career risk. 120 00:05:44,460 --> 00:05:47,550 Payback period is a very simple concept. 121 00:05:47,550 --> 00:05:51,030 It is simply the minimum number of years 122 00:05:51,030 --> 00:05:54,420 that it requires for a particular investment 123 00:05:54,420 --> 00:05:56,800 to pay back. 124 00:05:56,800 --> 00:06:00,024 So if you invest a million dollars in a project, 125 00:06:00,024 --> 00:06:02,440 and it's going to generate some revenues, the question is, 126 00:06:02,440 --> 00:06:07,440 how long is it going to take before the project earns 127 00:06:07,440 --> 00:06:08,400 a million dollars? 128 00:06:08,400 --> 00:06:11,820 Namely, it pays back the original investment. 129 00:06:11,820 --> 00:06:14,620 So the definition, here, is simple. 130 00:06:14,620 --> 00:06:17,490 If you assume that cf1 through cfk 131 00:06:17,490 --> 00:06:19,740 are the cash flows to the project, 132 00:06:19,740 --> 00:06:21,590 and you invest a certain amount of cash, 133 00:06:21,590 --> 00:06:28,010 cf0, initially, then the question is, how long a period 134 00:06:28,010 --> 00:06:32,360 do you need so that the sum of the future cash flows 135 00:06:32,360 --> 00:06:34,140 exceeds the initial investment? 136 00:06:34,140 --> 00:06:38,670 What's the minimum number of periods for that to happen? 137 00:06:38,670 --> 00:06:43,470 And that minimum, k, is called the payback period. 138 00:06:43,470 --> 00:06:46,250 Now, right away you see that there's 139 00:06:46,250 --> 00:06:48,200 a problem because we're adding cash 140 00:06:48,200 --> 00:06:50,700 flows in different periods. 141 00:06:50,700 --> 00:06:54,050 So I hope by now, when you look at an expression like that, 142 00:06:54,050 --> 00:06:58,970 it causes you great cognitive dissonance and pain 143 00:06:58,970 --> 00:07:00,020 to look at that. 144 00:07:00,020 --> 00:07:01,730 It's like adding pounds to yen. 145 00:07:01,730 --> 00:07:03,950 Remember we did that the first day of class, right? 146 00:07:03,950 --> 00:07:07,190 Three pounds plus 25 yen is what? 147 00:07:07,190 --> 00:07:08,150 I don't know. 148 00:07:08,150 --> 00:07:10,100 So when you're adding these cash flows, 149 00:07:10,100 --> 00:07:13,670 it doesn't make sense because you're adding different units. 150 00:07:13,670 --> 00:07:15,170 But let's forget about that for now. 151 00:07:15,170 --> 00:07:16,795 Let's just look at the equation and try 152 00:07:16,795 --> 00:07:19,460 to divine what we mean from it. 153 00:07:19,460 --> 00:07:22,160 For independent projects, a criterion 154 00:07:22,160 --> 00:07:24,280 that you might construct using payback 155 00:07:24,280 --> 00:07:27,800 is to accept the project if k is less than 156 00:07:27,800 --> 00:07:31,160 or equal to some pre-specified threshold, t star. 157 00:07:31,160 --> 00:07:33,480 And for mutually exclusive projects, 158 00:07:33,480 --> 00:07:35,690 where you can only take one, pick the project 159 00:07:35,690 --> 00:07:38,900 that has the smallest payback period 160 00:07:38,900 --> 00:07:40,830 subject to that threshold t star. 161 00:07:43,580 --> 00:07:46,370 That's the typical approach to using payback. 162 00:07:46,370 --> 00:07:50,420 Clearly, this is a relatively shortsighted approach. 163 00:07:50,420 --> 00:07:53,500 It doesn't take into account scale, how much money you're 164 00:07:53,500 --> 00:07:54,650 going to make from this. 165 00:07:54,650 --> 00:07:57,140 It doesn't take into account risk, 166 00:07:57,140 --> 00:08:00,000 other than the risk of not getting paid back. 167 00:08:00,000 --> 00:08:03,740 So it's a very, very narrow focus 168 00:08:03,740 --> 00:08:07,520 in terms of what it's trying to accomplish. 169 00:08:07,520 --> 00:08:09,500 Now, we can try to fix this. 170 00:08:09,500 --> 00:08:13,260 And we can fix this by using discounted payback. 171 00:08:13,260 --> 00:08:17,270 So now at least, the cash flows are in the same units. 172 00:08:17,270 --> 00:08:20,180 So you can use discounted payback, 173 00:08:20,180 --> 00:08:25,140 but it still ignores the cash flows after the payback period. 174 00:08:25,140 --> 00:08:27,740 So in particular, you can have a project 175 00:08:27,740 --> 00:08:32,450 that requires cash inflow today, that then generates 176 00:08:32,450 --> 00:08:35,150 a bunch of positive cash flows thereafter, 177 00:08:35,150 --> 00:08:38,179 but then after the payback period, in some future date, 178 00:08:38,179 --> 00:08:40,730 it generates tremendously negative cash flows. 179 00:08:40,730 --> 00:08:43,970 Either because of some kind of liabilities that it incurs, 180 00:08:43,970 --> 00:08:45,890 or some other additional investments that it 181 00:08:45,890 --> 00:08:47,570 requires to keep it going. 182 00:08:47,570 --> 00:08:51,300 All of that stuff is ignored by payback. 183 00:08:51,300 --> 00:08:54,770 So in particular, this can have a negative NPV, 184 00:08:54,770 --> 00:08:56,810 but you might still want to take it 185 00:08:56,810 --> 00:09:00,320 because it pays back in a relatively 186 00:09:00,320 --> 00:09:01,940 short period of time. 187 00:09:01,940 --> 00:09:03,500 That's a mistake. 188 00:09:03,500 --> 00:09:05,390 But you can understand how something 189 00:09:05,390 --> 00:09:09,290 like this ended up getting put into practice, right? 190 00:09:09,290 --> 00:09:11,030 Career risk. 191 00:09:11,030 --> 00:09:13,130 If you're a manager of a division, 192 00:09:13,130 --> 00:09:17,180 and your job when you were hired is to turn it around and make 193 00:09:17,180 --> 00:09:20,420 it profitable, then it's very important 194 00:09:20,420 --> 00:09:24,260 that you take on projects with short payback periods. 195 00:09:24,260 --> 00:09:26,300 But that's not necessarily in the best interests 196 00:09:26,300 --> 00:09:31,010 of the company, or of the investors, or even of yourself 197 00:09:31,010 --> 00:09:34,370 if the incentives have been properly calibrated. 198 00:09:34,370 --> 00:09:37,430 In other words, if, as part of your compensation contract, 199 00:09:37,430 --> 00:09:40,340 they say, here, you get a bunch of stock in the company. 200 00:09:40,340 --> 00:09:42,980 We want you to maximize the value of the shareholders. 201 00:09:42,980 --> 00:09:45,920 Then what you ought to be doing is maximizing NPV. 202 00:09:45,920 --> 00:09:48,980 You're not supposed to be focusing on other aspects. 203 00:09:48,980 --> 00:09:52,220 But as a practical matter, people look at this. 204 00:09:52,220 --> 00:09:54,920 People want to know how long is it going to be 205 00:09:54,920 --> 00:09:56,810 before this thing pays back. 206 00:09:56,810 --> 00:10:00,470 Now, I don't want to argue that it's completely irrational. 207 00:10:00,470 --> 00:10:04,280 Can anybody give me a rationale for why payback is actually 208 00:10:04,280 --> 00:10:05,770 a sensible thing to consider? 209 00:10:05,770 --> 00:10:06,410 Yeah, David? 210 00:10:06,410 --> 00:10:08,334 AUDIENCE: The main thing that fueled 211 00:10:08,334 --> 00:10:10,739 this, in an NPV calculation, you're 212 00:10:10,739 --> 00:10:12,670 assuming that you know what cash flow's going 213 00:10:12,670 --> 00:10:13,840 to be way out in the future. 214 00:10:13,840 --> 00:10:14,350 ANDREW LO: Yeah, exactly. 215 00:10:14,350 --> 00:10:15,379 AUDIENCE: And if you have a big cash 216 00:10:15,379 --> 00:10:17,003 flow way out in the future end, there's 217 00:10:17,003 --> 00:10:19,440 so little certainty your career's attached to that-- 218 00:10:19,440 --> 00:10:20,440 ANDREW LO: That's right. 219 00:10:20,440 --> 00:10:23,821 AUDIENCE: --you'd want to weight effort more towards a calculus 220 00:10:23,821 --> 00:10:24,790 and-- 221 00:10:24,790 --> 00:10:25,790 ANDREW LO: That's right. 222 00:10:25,790 --> 00:10:28,000 So apart from the career risk, which you mentioned, 223 00:10:28,000 --> 00:10:30,220 but I want to downplay that because I 224 00:10:30,220 --> 00:10:33,610 want to argue that it is possible for payback 225 00:10:33,610 --> 00:10:35,620 to add value to shareholders. 226 00:10:35,620 --> 00:10:39,700 Simply because there is an implicit recognition for those 227 00:10:39,700 --> 00:10:42,970 who use payback that it's really hard to estimate 228 00:10:42,970 --> 00:10:45,160 what's going to happen in the distant future. 229 00:10:45,160 --> 00:10:48,790 So if you've got a project that pays back sooner rather 230 00:10:48,790 --> 00:10:52,120 than later, that's probably better 231 00:10:52,120 --> 00:10:54,760 because there's less certainty about what's 232 00:10:54,760 --> 00:10:56,960 going to happen in the future. 233 00:10:56,960 --> 00:11:01,150 Now there's a lot of if's in that statement, right? 234 00:11:01,150 --> 00:11:03,280 If really what you're concerned about 235 00:11:03,280 --> 00:11:06,640 is the growing uncertainty of the project, 236 00:11:06,640 --> 00:11:10,520 that ought to be reflected in the discount rates. 237 00:11:10,520 --> 00:11:13,630 So I'm not saying that you should ignore it. 238 00:11:13,630 --> 00:11:16,390 What I'm saying is that payback is not necessarily the best 239 00:11:16,390 --> 00:11:18,190 way of capturing it. 240 00:11:18,190 --> 00:11:20,380 Although I think we could acknowledge that it does 241 00:11:20,380 --> 00:11:22,120 serve a useful purpose in the sense 242 00:11:22,120 --> 00:11:25,990 that it is focusing your attention on the relatively 243 00:11:25,990 --> 00:11:29,410 recent periods of cash flows. 244 00:11:29,410 --> 00:11:31,210 But there may be better ways of taking care 245 00:11:31,210 --> 00:11:33,412 of that, if that's the issue. 246 00:11:33,412 --> 00:11:34,920 A question or comment? 247 00:11:34,920 --> 00:11:35,596 Yeah? 248 00:11:35,596 --> 00:11:36,550 AUDIENCE: Liquidity? 249 00:11:36,550 --> 00:11:37,216 ANDREW LO: Yeah? 250 00:11:37,216 --> 00:11:40,605 AUDIENCE: If you have a project that takes cash outflow up 251 00:11:40,605 --> 00:11:43,331 front, and then years and years out, 252 00:11:43,331 --> 00:11:47,273 it gives you a big cash inflow. 253 00:11:47,273 --> 00:11:51,060 From that time until the cash outflow, you get nothing? 254 00:11:51,060 --> 00:11:51,730 ANDREW LO: Yeah. 255 00:11:51,730 --> 00:11:53,235 AUDIENCE: That could even present some problems 256 00:11:53,235 --> 00:11:53,880 in finance. 257 00:11:53,880 --> 00:11:54,880 ANDREW LO: That's right. 258 00:11:54,880 --> 00:11:57,930 So another aspect of payback is this liquidity issue. 259 00:11:57,930 --> 00:11:59,550 In other words, projects that pay back 260 00:11:59,550 --> 00:12:02,970 in a shorter period of time require less liquidity 261 00:12:02,970 --> 00:12:04,830 over longer horizons. 262 00:12:04,830 --> 00:12:08,782 However, once again I'm going to say, if liquidity is the issue, 263 00:12:08,782 --> 00:12:10,740 you ought to take that into account explicitly, 264 00:12:10,740 --> 00:12:13,710 and understand what the term structure of your borrowing 265 00:12:13,710 --> 00:12:15,240 costs are over different periods. 266 00:12:15,240 --> 00:12:18,821 If you factor that in, then it should already be in there. 267 00:12:18,821 --> 00:12:19,320 If. 268 00:12:19,320 --> 00:12:21,270 AUDIENCE: Is that closer to a discount rate or something-- 269 00:12:21,270 --> 00:12:22,603 ANDREW LO: That's right, it can. 270 00:12:22,603 --> 00:12:24,900 It should certainly, because we know 271 00:12:24,900 --> 00:12:26,290 that there is a yield curve. 272 00:12:26,290 --> 00:12:28,890 The typical yield curve is upward sloping. 273 00:12:28,890 --> 00:12:30,600 Typical I say, not always. 274 00:12:30,600 --> 00:12:32,575 But the typical yield curve is upward sloping. 275 00:12:32,575 --> 00:12:34,200 What that's telling you is that there's 276 00:12:34,200 --> 00:12:37,470 a premium for borrowing longer. 277 00:12:37,470 --> 00:12:40,140 So that basically gets at your liquidity issue. 278 00:12:40,140 --> 00:12:42,870 But if you have additional concerns above and beyond that, 279 00:12:42,870 --> 00:12:44,910 that should be reflected in your calculations. 280 00:12:44,910 --> 00:12:47,950 Payback is an inefficient way of capturing that. 281 00:12:47,950 --> 00:12:51,060 It's a very zero-one kind of an approach to dealing 282 00:12:51,060 --> 00:12:52,590 with that kind of an issue. 283 00:12:52,590 --> 00:12:53,237 Yeah? 284 00:12:53,237 --> 00:12:55,487 AUDIENCE: Think that people they lose the payback when 285 00:12:55,487 --> 00:12:58,204 they believe that the cash flow is 286 00:12:58,204 --> 00:13:00,180 the same all over the period. 287 00:13:00,180 --> 00:13:01,662 Which really makes sense. 288 00:13:01,662 --> 00:13:03,649 Like in multiple. 289 00:13:03,649 --> 00:13:05,940 ANDREW LO: So you're saying that it doesn't make sense. 290 00:13:05,940 --> 00:13:07,564 AUDIENCE: It makes sense, when the cash 291 00:13:07,564 --> 00:13:08,560 flow will be the same-- 292 00:13:08,560 --> 00:13:10,020 ANDREW LO: If the cash, yes, that's right. 293 00:13:10,020 --> 00:13:12,500 If the cash flow is going to be level, then it makes sense. 294 00:13:12,500 --> 00:13:12,780 You're right. 295 00:13:12,780 --> 00:13:13,686 AUDIENCE: Like multiple. 296 00:13:13,686 --> 00:13:15,519 You have a multiple for industry, you use it 297 00:13:15,519 --> 00:13:16,410 and you have it. 298 00:13:16,410 --> 00:13:18,030 ANDREW LO: That's right, that's right. 299 00:13:18,030 --> 00:13:20,520 There are conditions under which payback 300 00:13:20,520 --> 00:13:22,200 can give you sensible results. 301 00:13:22,200 --> 00:13:25,390 But think about how restrictive those conditions are. 302 00:13:25,390 --> 00:13:27,270 You need to have level cash flows, 303 00:13:27,270 --> 00:13:31,530 and moreover, you have to be comparing projects, all of whom 304 00:13:31,530 --> 00:13:34,620 have level cash flows and have comparable risks. 305 00:13:34,620 --> 00:13:37,527 If they have different risks, or different levels of cash flows, 306 00:13:37,527 --> 00:13:39,360 or different liquidity, all of those things, 307 00:13:39,360 --> 00:13:40,770 cannot be captured by payback. 308 00:13:43,450 --> 00:13:45,800 So I don't want to beat up too much on it. 309 00:13:45,800 --> 00:13:47,650 This is a relatively easy target. 310 00:13:47,650 --> 00:13:51,230 The point is that it provides some information, 311 00:13:51,230 --> 00:13:52,825 and you should know what it is. 312 00:13:52,825 --> 00:13:54,700 Regardless of whether you're going to use it. 313 00:13:54,700 --> 00:13:57,260 You ought to be able to have that at your fingertips 314 00:13:57,260 --> 00:13:59,770 so when somebody says, and undoubtedly somebody 315 00:13:59,770 --> 00:14:02,830 will say to you, when you're pushing a project, 316 00:14:02,830 --> 00:14:05,684 they're going to say, what's the payback period. 317 00:14:05,684 --> 00:14:06,850 You need to know the answer. 318 00:14:06,850 --> 00:14:08,380 It's not good enough for you to say, 319 00:14:08,380 --> 00:14:10,780 my 401 professor told me it doesn't make sense. 320 00:14:10,780 --> 00:14:12,820 You've got to basically have an answer, 321 00:14:12,820 --> 00:14:16,240 and then argue that while payback doesn't 322 00:14:16,240 --> 00:14:18,535 summarize all of the characteristics 323 00:14:18,535 --> 00:14:19,660 that we're concerned about. 324 00:14:22,870 --> 00:14:25,810 Second method, the profitability index. 325 00:14:25,810 --> 00:14:31,390 Now this one is another easy criterion to criticize, 326 00:14:31,390 --> 00:14:36,010 but it's so close to NPV that the only thing that really is 327 00:14:36,010 --> 00:14:38,510 an issue is the scale factor. 328 00:14:38,510 --> 00:14:39,940 So let me explain. 329 00:14:39,940 --> 00:14:46,652 Profitability index is simply the gross present value, as 330 00:14:46,652 --> 00:14:47,860 opposed to net present value. 331 00:14:47,860 --> 00:14:50,380 It's the gross present value, divided 332 00:14:50,380 --> 00:14:52,120 by the initial investment. 333 00:14:55,010 --> 00:14:58,030 So the present value is simply the present value 334 00:14:58,030 --> 00:15:02,450 of all the cash flows, divided by the initial investment. 335 00:15:02,450 --> 00:15:05,840 So you could think of it as a gross rate of return. 336 00:15:05,840 --> 00:15:08,390 In other words, 1 plus the net rate 337 00:15:08,390 --> 00:15:12,680 of return of your investment in this project. 338 00:15:12,680 --> 00:15:15,260 If the profitability index is greater than 1, 339 00:15:15,260 --> 00:15:16,830 take the project. 340 00:15:16,830 --> 00:15:19,550 If it's less than 1, don't take the project. 341 00:15:19,550 --> 00:15:23,150 And if you've got a bunch of mutually exclusive projects, 342 00:15:23,150 --> 00:15:26,270 pick the one that has the highest profitability index. 343 00:15:29,170 --> 00:15:31,980 That's the approach. 344 00:15:31,980 --> 00:15:33,886 Now what's wrong with this? 345 00:15:33,886 --> 00:15:36,280 It's not that far off from NPV. 346 00:15:36,280 --> 00:15:39,550 In fact, you could show that with a profitability 347 00:15:39,550 --> 00:15:43,420 index is greater than 1, you've got a positive NPV project. 348 00:15:43,420 --> 00:15:45,880 When the profitability index is less than 1, 349 00:15:45,880 --> 00:15:47,450 you've got a negative NPV project. 350 00:15:47,450 --> 00:15:51,640 So in terms of taking or not taking a project, 351 00:15:51,640 --> 00:15:53,479 it's actually the same as NPV. 352 00:15:53,479 --> 00:15:54,417 [INAUDIBLE]? 353 00:15:54,417 --> 00:15:56,996 AUDIENCE: The thing it doesn't tell you is how much they 354 00:15:56,996 --> 00:15:59,290 usually must have [INAUDIBLE]. 355 00:15:59,290 --> 00:16:01,486 It can be $1 or $1 billion. 356 00:16:01,486 --> 00:16:02,860 ANDREW LO: That's right, exactly. 357 00:16:02,860 --> 00:16:04,651 There's nothing that tells you about scale. 358 00:16:04,651 --> 00:16:09,990 So, if you guys give me $1 and I give you back $2, 359 00:16:09,990 --> 00:16:13,300 that's going to have a profitability index of 2. 360 00:16:13,300 --> 00:16:15,870 Which is going to look really good relative 361 00:16:15,870 --> 00:16:18,690 to an investment in Berkshire Hathaway 362 00:16:18,690 --> 00:16:22,220 20 years ago, because that may not have given you 363 00:16:22,220 --> 00:16:24,170 the same profitability index. 364 00:16:24,170 --> 00:16:26,090 But Warren Buffett has made a lot more money 365 00:16:26,090 --> 00:16:27,710 than just a dollar. 366 00:16:27,710 --> 00:16:29,930 So, this ignores scale and that's 367 00:16:29,930 --> 00:16:32,210 obviously something that you can't 368 00:16:32,210 --> 00:16:36,350 afford to do when you've got mutually exclusive projects 369 00:16:36,350 --> 00:16:37,589 where you're ranking them. 370 00:16:37,589 --> 00:16:40,130 You don't want to pick the one with the highest profitability 371 00:16:40,130 --> 00:16:40,629 index. 372 00:16:40,629 --> 00:16:42,680 What you want to do is to pick the one that 373 00:16:42,680 --> 00:16:45,470 is generating the most value for you, 374 00:16:45,470 --> 00:16:47,480 in terms of dollars and cents. 375 00:16:47,480 --> 00:16:49,190 In other words, NPV. 376 00:16:49,190 --> 00:16:53,825 So once again, NPV, although is very close to this, 377 00:16:53,825 --> 00:16:55,700 is actually preferred because you're actually 378 00:16:55,700 --> 00:17:01,700 getting a hard amount of dollars and cents as the bottom line. 379 00:17:01,700 --> 00:17:06,420 Any questions about profitability index? 380 00:17:06,420 --> 00:17:07,688 Yes? 381 00:17:07,688 --> 00:17:10,108 AUDIENCE: A lot of time, the money that you have 382 00:17:10,108 --> 00:17:13,788 in hand investment is limited. 383 00:17:13,788 --> 00:17:18,280 [INAUDIBLE] play into a role like when you have projects. 384 00:17:18,280 --> 00:17:22,130 ANDREW LO: Well, it does play a role. 385 00:17:22,130 --> 00:17:25,119 So the question is, if you have a limited amount of money 386 00:17:25,119 --> 00:17:27,700 to invest, does that play a role? 387 00:17:27,700 --> 00:17:29,650 It absolutely does play a role, but it 388 00:17:29,650 --> 00:17:34,420 plays a role that is contrary to what the profitability 389 00:17:34,420 --> 00:17:36,310 index wants to do for you. 390 00:17:36,310 --> 00:17:37,960 The profitability index is simply 391 00:17:37,960 --> 00:17:41,410 telling you whether something is a positive or negative NPV. 392 00:17:41,410 --> 00:17:43,219 It's not telling you how much NPV 393 00:17:43,219 --> 00:17:45,010 you're going to get for the amount of money 394 00:17:45,010 --> 00:17:46,750 you're going to invest. 395 00:17:46,750 --> 00:17:50,260 So what you need to do is to focus on the latter. 396 00:17:50,260 --> 00:17:52,390 In other words, how much cash are you 397 00:17:52,390 --> 00:17:55,450 going to be able to generate from a particular project? 398 00:17:55,450 --> 00:17:57,970 $50, or $50 million? 399 00:17:57,970 --> 00:17:59,810 That really makes a big difference. 400 00:17:59,810 --> 00:18:02,740 Particularly, if what you have is a limited amount of cash, 401 00:18:02,740 --> 00:18:06,760 scale is actually an important concept to you. 402 00:18:06,760 --> 00:18:09,310 The reason that economists and financial economists, 403 00:18:09,310 --> 00:18:13,030 by extension, focus on rates of return? 404 00:18:13,030 --> 00:18:16,900 Did that ever strike you as being rather odd? 405 00:18:16,900 --> 00:18:19,120 In other words, when you talk to business people, 406 00:18:19,120 --> 00:18:22,000 very often they'll speak in terms of dollar amounts. 407 00:18:22,000 --> 00:18:24,730 Like, a startup costs $15 million, 408 00:18:24,730 --> 00:18:29,320 or the profits for last quarter was a million and a half 409 00:18:29,320 --> 00:18:30,850 dollars. 410 00:18:30,850 --> 00:18:33,190 They won't talk always in rates of return. 411 00:18:33,190 --> 00:18:36,070 Whereas economists, particularly financial economists, 412 00:18:36,070 --> 00:18:38,114 they express everything in rates of return. 413 00:18:38,114 --> 00:18:40,030 I mean, that's what we've done in this course. 414 00:18:40,030 --> 00:18:44,920 We've spent most of our time focusing on r, not on v. v 415 00:18:44,920 --> 00:18:46,880 for value, r for return. 416 00:18:46,880 --> 00:18:48,610 Anybody know why that is? 417 00:18:48,610 --> 00:18:49,273 Yeah? 418 00:18:49,273 --> 00:18:51,245 AUDIENCE: We always look about opportunity 419 00:18:51,245 --> 00:18:54,696 that we miss so maybe we can change the direction 420 00:18:54,696 --> 00:18:57,670 of our money [INAUDIBLE]. 421 00:18:57,670 --> 00:18:59,110 ANDREW LO: Well, that's true. 422 00:18:59,110 --> 00:19:01,734 But why focus on return as opposed to dollars? 423 00:19:01,734 --> 00:19:03,400 I mean, if we're thinking about changing 424 00:19:03,400 --> 00:19:05,230 the direction of our portfolio, you 425 00:19:05,230 --> 00:19:06,940 might think about investing, instead 426 00:19:06,940 --> 00:19:09,670 of a hundred thousand dollars in high tech stocks, 427 00:19:09,670 --> 00:19:12,370 take that money and invest a hundred thousand dollars 428 00:19:12,370 --> 00:19:13,660 in manufacturing. 429 00:19:13,660 --> 00:19:15,730 It's still about dollars and cents, isn't it? 430 00:19:15,730 --> 00:19:18,169 When you think about your portfolio, at some point, 431 00:19:18,169 --> 00:19:20,210 you've got to look at how much money do you have, 432 00:19:20,210 --> 00:19:22,501 how much money did you have, and is the current greater 433 00:19:22,501 --> 00:19:23,230 than the latter. 434 00:19:23,230 --> 00:19:25,840 You want to know whether or not you've made money. 435 00:19:25,840 --> 00:19:29,811 Why the focus on r in this course? 436 00:19:29,811 --> 00:19:30,310 Yeah, Zeke? 437 00:19:30,310 --> 00:19:32,260 AUDIENCE: Could be to get rid of the units. 438 00:19:32,260 --> 00:19:33,760 ANDREW LO: I know, it is to get rid of units. 439 00:19:33,760 --> 00:19:35,551 But why do we want to get rid of the units? 440 00:19:35,551 --> 00:19:37,262 AUDIENCE: Compared to their numbers? 441 00:19:37,262 --> 00:19:38,470 ANDREW LO: But wait a minute. 442 00:19:38,470 --> 00:19:41,085 Why can't you compare dollars to dollars? 443 00:19:41,085 --> 00:19:42,460 I mean, you're right that you can 444 00:19:42,460 --> 00:19:45,100 compare a 3% increase in General Motors 445 00:19:45,100 --> 00:19:47,320 to a 2% decline in Microsoft. 446 00:19:47,320 --> 00:19:49,400 But you could also compare a hundred thousand 447 00:19:49,400 --> 00:19:51,910 dollar increase in your portfolio in General Motors, 448 00:19:51,910 --> 00:19:56,840 versus a $50,000 loss in Microsoft. 449 00:19:56,840 --> 00:19:57,520 Yeah, Courtney? 450 00:19:57,520 --> 00:20:00,894 AUDIENCE: It goes back to scale because it's 451 00:20:00,894 --> 00:20:04,200 a $50,000 [INAUDIBLE] for that company, 452 00:20:04,200 --> 00:20:08,225 but it could be your entire company's profit. 453 00:20:08,225 --> 00:20:12,230 So it shows a return on an individualized basis. 454 00:20:12,230 --> 00:20:14,850 ANDREW LO: It shows the return on an individualized basis, 455 00:20:14,850 --> 00:20:16,070 and it gets rid of the scale. 456 00:20:16,070 --> 00:20:16,580 That's true. 457 00:20:16,580 --> 00:20:21,030 So you're able to compare the scale for different companies, 458 00:20:21,030 --> 00:20:24,200 but what's wrong with using dollars to do that? 459 00:20:24,200 --> 00:20:25,490 I mean, if you're an investor. 460 00:20:25,490 --> 00:20:27,470 So from the investor's perspective, 461 00:20:27,470 --> 00:20:29,810 if you're looking at an investment in General Electric 462 00:20:29,810 --> 00:20:33,230 versus Microsoft, wouldn't dollars make more sense? 463 00:20:33,230 --> 00:20:35,750 Rather than returns? 464 00:20:35,750 --> 00:20:37,540 Because you can still compare them, right? 465 00:20:37,540 --> 00:20:38,040 Yeah? 466 00:20:38,040 --> 00:20:39,964 AUDIENCE: If you're going to invest 467 00:20:39,964 --> 00:20:43,331 x amount in both companies, it might create a greater impact 468 00:20:43,331 --> 00:20:44,293 on one. 469 00:20:44,293 --> 00:20:47,660 And you want to see where your money is going to be or-- 470 00:20:47,660 --> 00:20:50,130 ANDREW LO: OK, you're on the right idea. 471 00:20:50,130 --> 00:20:53,570 You have the right elements, but you haven't put it together. 472 00:20:53,570 --> 00:20:55,780 It's true that scale is the issue, 473 00:20:55,780 --> 00:20:58,220 so you've got your finger on the right concept. 474 00:20:58,220 --> 00:21:00,230 But what about scale is the issue here? 475 00:21:00,230 --> 00:21:00,800 [INAUDIBLE]? 476 00:21:00,800 --> 00:21:03,205 AUDIENCE: I think you want to develop a theory that says 477 00:21:03,205 --> 00:21:06,172 [INAUDIBLE], that basically you can tell them 478 00:21:06,172 --> 00:21:08,932 what's your return in terms of percentages 479 00:21:08,932 --> 00:21:10,890 and then they can decide I want to invest $100, 480 00:21:10,890 --> 00:21:12,770 I want to invest a million dollars. 481 00:21:12,770 --> 00:21:13,436 ANDREW LO: Good. 482 00:21:13,436 --> 00:21:15,140 So that's following in Courtney's point 483 00:21:15,140 --> 00:21:17,820 that we want to develop a theory that suits all investors, 484 00:21:17,820 --> 00:21:20,700 so it's not focused on scale. 485 00:21:20,700 --> 00:21:22,970 But implicit in not focusing on scale, 486 00:21:22,970 --> 00:21:26,176 we're making another assumption. 487 00:21:26,176 --> 00:21:27,050 What are we assuming? 488 00:21:27,050 --> 00:21:27,550 Mike? 489 00:21:27,550 --> 00:21:29,889 AUDIENCE: In terms of focusing on the marginal dollar, 490 00:21:29,889 --> 00:21:33,826 you should actually take the highest return. 491 00:21:33,826 --> 00:21:36,246 If someone's going to triple that $3 investment, 492 00:21:36,246 --> 00:21:38,302 you should at least put your first $3 in that. 493 00:21:38,302 --> 00:21:39,625 Give them bang for your buck. 494 00:21:39,625 --> 00:21:42,040 And then go down until you're getting 495 00:21:42,040 --> 00:21:44,570 to a lower marginal return on larger investments. 496 00:21:44,570 --> 00:21:46,460 ANDREW LO: And why should you do that? 497 00:21:46,460 --> 00:21:50,624 Why should you go down the line in that manner? 498 00:21:50,624 --> 00:21:53,972 AUDIENCE: Because that will maximize your overall return. 499 00:21:53,972 --> 00:21:55,180 ANDREW LO: But wait a minute. 500 00:21:55,180 --> 00:21:57,480 I thought that if we put our money across all 501 00:21:57,480 --> 00:21:59,670 of these various different projects in proportion 502 00:21:59,670 --> 00:22:03,900 to the standard portfolio theory, the tangency portfolio, 503 00:22:03,900 --> 00:22:07,920 we get the biggest bang per unit risk. 504 00:22:07,920 --> 00:22:11,730 So, are you saying we ought to deviate from that? 505 00:22:11,730 --> 00:22:14,340 What about the theory that we developed 506 00:22:14,340 --> 00:22:18,900 requires us to focus on returns, rather than on dollars 507 00:22:18,900 --> 00:22:20,370 invested. 508 00:22:20,370 --> 00:22:23,100 You've all been very patient in not bringing up this issue. 509 00:22:23,100 --> 00:22:26,160 You've just taken it as given that I'm telling you the truth 510 00:22:26,160 --> 00:22:27,690 about focusing on returns. 511 00:22:27,690 --> 00:22:31,950 Why not focus on the actual dollars that you invest? 512 00:22:31,950 --> 00:22:32,469 Remy. 513 00:22:32,469 --> 00:22:34,427 AUDIENCE: Focusing on return is the easiest way 514 00:22:34,427 --> 00:22:37,990 to weigh it versus the risk. 515 00:22:37,990 --> 00:22:39,730 ANDREW LO: That's true, it does make 516 00:22:39,730 --> 00:22:41,590 it easy to weigh it against the risk. 517 00:22:41,590 --> 00:22:44,440 But in the end, don't you care about what your dollars at risk 518 00:22:44,440 --> 00:22:45,135 are? 519 00:22:45,135 --> 00:22:46,676 AUDIENCE: You can't check out what it 520 00:22:46,676 --> 00:22:50,670 is on the tangency portfolio. 521 00:22:50,670 --> 00:22:54,180 ANDREW LO: Well, I could rewrite the tangency portfolio in terms 522 00:22:54,180 --> 00:22:56,100 of dollars, instead of return. 523 00:22:56,100 --> 00:22:57,600 AUDIENCE: You don't want to do that. 524 00:22:57,600 --> 00:22:59,641 ANDREW LO: I don't want to do that, you're right. 525 00:22:59,641 --> 00:23:00,810 Why don't I want to do that? 526 00:23:00,810 --> 00:23:02,580 Aside from the fact that the fonts are not 527 00:23:02,580 --> 00:23:05,190 going to fit on that axis. 528 00:23:05,190 --> 00:23:06,820 Well you're on the right track. 529 00:23:06,820 --> 00:23:07,320 All of you. 530 00:23:07,320 --> 00:23:09,207 I think you sense what I'm getting at, 531 00:23:09,207 --> 00:23:10,790 but you haven't put your finger on it. 532 00:23:10,790 --> 00:23:12,450 Let me tie it all together, and tell you 533 00:23:12,450 --> 00:23:14,449 where you're getting, because I think that we're 534 00:23:14,449 --> 00:23:16,315 going to get there eventually. 535 00:23:16,315 --> 00:23:18,690 The idea is that we want to come up with a framework that 536 00:23:18,690 --> 00:23:19,830 applies to all investors. 537 00:23:19,830 --> 00:23:21,070 That's true. 538 00:23:21,070 --> 00:23:23,160 And so, it would be really convenient for us 539 00:23:23,160 --> 00:23:26,110 to be able to use returns and units of risk 540 00:23:26,110 --> 00:23:28,350 so that whatever dollars you have, 541 00:23:28,350 --> 00:23:30,330 you can simply apply the theory and find out 542 00:23:30,330 --> 00:23:31,957 where you are on that frontier. 543 00:23:31,957 --> 00:23:34,290 And just simply multiply by the initial amount of wealth 544 00:23:34,290 --> 00:23:38,190 to figure out all your dollar investments. 545 00:23:38,190 --> 00:23:43,700 Underlying that approach is a belief. 546 00:23:43,700 --> 00:23:44,720 And here's the belief. 547 00:23:44,720 --> 00:23:51,450 The belief is that we can invest however much money we want, 548 00:23:51,450 --> 00:23:54,070 and get these kind of returns. 549 00:23:54,070 --> 00:23:56,770 That's the key that all of you are groping at. 550 00:23:56,770 --> 00:23:59,180 Implicitly, I think you understood this, 551 00:23:59,180 --> 00:24:01,870 but you haven't articulated it. 552 00:24:01,870 --> 00:24:04,330 What we're assuming, when we put down 553 00:24:04,330 --> 00:24:06,640 all these equations in returns, is 554 00:24:06,640 --> 00:24:11,440 that scale doesn't matter in the sense that no matter 555 00:24:11,440 --> 00:24:13,550 whether we're investing a hundred dollars, 556 00:24:13,550 --> 00:24:17,650 or a hundred million dollars, or a hundred billion dollars. 557 00:24:17,650 --> 00:24:20,290 We're going to get the same returns. 558 00:24:20,290 --> 00:24:23,110 And the fact of the matter is that's just not true. 559 00:24:23,110 --> 00:24:27,500 Scale absolutely does matter. 560 00:24:27,500 --> 00:24:29,590 It matters because the more money 561 00:24:29,590 --> 00:24:32,260 you put into certain kinds of investments, 562 00:24:32,260 --> 00:24:35,560 the harder it will be for those investments 563 00:24:35,560 --> 00:24:38,870 to maintain the same level of return. 564 00:24:38,870 --> 00:24:41,140 Now, that has a very different impact 565 00:24:41,140 --> 00:24:44,860 among different industries and among different investments. 566 00:24:44,860 --> 00:24:48,760 For example, right now, nanotechnology 567 00:24:48,760 --> 00:24:51,140 is just beginning to take off. 568 00:24:51,140 --> 00:24:56,815 And so, if you end up putting a couple of extra billion dollars 569 00:24:56,815 --> 00:24:59,620 in nanotechnology, it's unlikely you're 570 00:24:59,620 --> 00:25:02,650 going to really affect the returns because the technology 571 00:25:02,650 --> 00:25:04,180 is still emerging. 572 00:25:04,180 --> 00:25:08,410 But if you take a very highly capacity constrained strategy 573 00:25:08,410 --> 00:25:11,540 and try to implement that same idea, 574 00:25:11,540 --> 00:25:14,800 you're going to have a very hard time doing it. 575 00:25:14,800 --> 00:25:19,480 If you decide that you want to focus on middle level software 576 00:25:19,480 --> 00:25:22,220 for dealing with file server control mechanisms, 577 00:25:22,220 --> 00:25:25,090 it's a relatively narrow sector in the technology sector. 578 00:25:25,090 --> 00:25:28,420 And you want to put $2 billion of extra money in that sector 579 00:25:28,420 --> 00:25:30,160 this month. 580 00:25:30,160 --> 00:25:31,390 Good luck. 581 00:25:31,390 --> 00:25:33,247 You'll have a very hard time doing it. 582 00:25:33,247 --> 00:25:35,080 Not to say that people won't take the money. 583 00:25:35,080 --> 00:25:37,540 I'm sure you can find people, yeah, sure give me the money. 584 00:25:37,540 --> 00:25:40,206 But they're not going to be able to produce the returns that you 585 00:25:40,206 --> 00:25:44,020 would expect from that very narrow slice of the economy. 586 00:25:44,020 --> 00:25:47,700 So all of what we've done in this course 587 00:25:47,700 --> 00:25:51,360 ignores scale from the perspective of risk and reward, 588 00:25:51,360 --> 00:25:56,454 but the one area where scale absolutely matters is NPV. 589 00:25:56,454 --> 00:25:58,620 In other words, when you're a project manager trying 590 00:25:58,620 --> 00:26:02,250 to figure out should I take Project A, or take Project B, 591 00:26:02,250 --> 00:26:03,840 scale matters. 592 00:26:03,840 --> 00:26:06,100 As Dee pointed out, in certain cases, 593 00:26:06,100 --> 00:26:09,270 you don't have more money to put into a particular project. 594 00:26:09,270 --> 00:26:11,250 In other cases, you have too much money 595 00:26:11,250 --> 00:26:14,070 that is not suitable for a certain project. 596 00:26:14,070 --> 00:26:17,850 But the bottom line in both cases is NPV. 597 00:26:17,850 --> 00:26:18,570 Dollars. 598 00:26:18,570 --> 00:26:20,524 Actual dollars and cents. 599 00:26:20,524 --> 00:26:23,190 That's what you want to focus on from the perspective of capital 600 00:26:23,190 --> 00:26:24,450 budgeting or corporate finance. 601 00:26:24,450 --> 00:26:24,950 Mike? 602 00:26:24,950 --> 00:26:27,432 AUDIENCE: If the NPV is really, really good, 603 00:26:27,432 --> 00:26:30,420 and the return is good, you should go get more capital-- 604 00:26:30,420 --> 00:26:32,130 ANDREW LO: That's right, that's right. 605 00:26:32,130 --> 00:26:34,950 If the NPV is really, really good, first of all, 606 00:26:34,950 --> 00:26:36,600 you're going to take the project. 607 00:26:36,600 --> 00:26:38,280 But secondly, what you're going to do 608 00:26:38,280 --> 00:26:40,050 is you're going to try to figure how to scale the heck out 609 00:26:40,050 --> 00:26:41,870 of the project and take as much of it as you want. 610 00:26:41,870 --> 00:26:42,510 Why? 611 00:26:42,510 --> 00:26:45,330 Because more money is preferred to less money. 612 00:26:45,330 --> 00:26:46,620 Simple as that. 613 00:26:46,620 --> 00:26:49,620 And again, anybody that violates that, see me after class. 614 00:26:49,620 --> 00:26:50,940 Be happy to help you. 615 00:26:50,940 --> 00:26:51,568 Yeah? 616 00:26:51,568 --> 00:26:53,760 AUDIENCE: If you did that it would go back to your-- 617 00:26:53,760 --> 00:26:55,190 ANDREW LO: Exactly, it would. 618 00:26:55,190 --> 00:26:56,531 AUDIENCE: Or, it would change r. 619 00:26:56,531 --> 00:26:58,540 ANDREW LO: It would change r, that's the point. 620 00:26:58,540 --> 00:27:01,320 That's why you shouldn't focus on r from the perspective 621 00:27:01,320 --> 00:27:02,430 of capital budgeting. 622 00:27:02,430 --> 00:27:04,650 From an investor's point of view, 623 00:27:04,650 --> 00:27:08,200 from a point of view of you and me, investing in the market, 624 00:27:08,200 --> 00:27:09,390 we're not going to affect r. 625 00:27:09,390 --> 00:27:12,160 I mean, I hate to depress all of you, but most of you, 626 00:27:12,160 --> 00:27:14,760 if you put your entire wealth into the market, 627 00:27:14,760 --> 00:27:18,480 you probably won't move the market by a whole lot. 628 00:27:18,480 --> 00:27:20,340 That's not true of everybody, and it's not 629 00:27:20,340 --> 00:27:21,579 true of all assets. 630 00:27:21,579 --> 00:27:23,620 But it's certainly true of the market as a whole. 631 00:27:23,620 --> 00:27:26,340 In other words, if we put all of our collective wealth 632 00:27:26,340 --> 00:27:29,370 into the S&P 500, we're not going to move it by a lot. 633 00:27:31,890 --> 00:27:34,050 But if you're a corporation, and you 634 00:27:34,050 --> 00:27:37,950 put all of your corporate wealth in one particular division 635 00:27:37,950 --> 00:27:40,050 of the particular company you're in, 636 00:27:40,050 --> 00:27:42,376 that could have dramatic consequences for the rate 637 00:27:42,376 --> 00:27:43,500 of return for that project. 638 00:27:43,500 --> 00:27:47,100 So scale matters for capital budgeting. 639 00:27:47,100 --> 00:27:50,070 It doesn't matter if you're thinking about each of us 640 00:27:50,070 --> 00:27:51,180 as a small investor. 641 00:27:51,180 --> 00:27:54,660 And so what I derived for you in the capital asset pricing model 642 00:27:54,660 --> 00:27:58,950 is a derivation that assumes each of us is small. 643 00:27:58,950 --> 00:28:02,250 We're not going to affect prices, or therefore, returns. 644 00:28:02,250 --> 00:28:05,906 And so, we can take returns as given. 645 00:28:05,906 --> 00:28:07,530 In other words, whether we're investing 646 00:28:07,530 --> 00:28:11,940 $100,000, or $200,000, or $15,000, or even a million, 647 00:28:11,940 --> 00:28:15,300 the analytics that derived are pretty reasonable 648 00:28:15,300 --> 00:28:16,950 approximations. 649 00:28:16,950 --> 00:28:19,470 That's very different from evaluating 650 00:28:19,470 --> 00:28:22,290 a particular investment opportunity for a division 651 00:28:22,290 --> 00:28:23,910 of a corporation. 652 00:28:23,910 --> 00:28:26,040 That's not the stock market. 653 00:28:26,040 --> 00:28:28,050 We use the stock market as a guide for computing 654 00:28:28,050 --> 00:28:29,380 the discount rate. 655 00:28:29,380 --> 00:28:33,240 But the bottom line analysis is how much of the investment 656 00:28:33,240 --> 00:28:36,490 can be supported by what you want to put into it. 657 00:28:36,490 --> 00:28:39,720 And as long as the NPV is looking good, 658 00:28:39,720 --> 00:28:41,040 you want to keep doing it. 659 00:28:41,040 --> 00:28:46,300 And to Remy's point, the more you do it, most likely, 660 00:28:46,300 --> 00:28:49,612 the less NPV will come out, eventually. 661 00:28:49,612 --> 00:28:51,070 And you're going to drive the thing 662 00:28:51,070 --> 00:28:52,736 into the ground in the sense that you're 663 00:28:52,736 --> 00:28:55,900 going to keep doing it until it stops being profitable. 664 00:28:55,900 --> 00:28:58,090 That's only human, it's only natural, 665 00:28:58,090 --> 00:29:00,504 it's only good business to drive it into the ground. 666 00:29:00,504 --> 00:29:02,920 Which is, by the way, what we did in the subprime mortgage 667 00:29:02,920 --> 00:29:04,310 market, right? 668 00:29:04,310 --> 00:29:06,310 That's why we're in the current crisis we're in. 669 00:29:06,310 --> 00:29:10,120 We basically drove that business into the ground and then some. 670 00:29:10,120 --> 00:29:13,000 But it's a natural phenomenon of business practice 671 00:29:13,000 --> 00:29:15,610 to constantly be coming up with new ideas. 672 00:29:15,610 --> 00:29:17,110 The ones that work well, we're going 673 00:29:17,110 --> 00:29:18,318 to keep on implementing them. 674 00:29:18,318 --> 00:29:20,350 We give them more capital until they 675 00:29:20,350 --> 00:29:22,210 start declining in their rates of return, 676 00:29:22,210 --> 00:29:23,680 then we take capital away. 677 00:29:23,680 --> 00:29:26,470 For the next year or so, we're going to be taking capital away 678 00:29:26,470 --> 00:29:27,678 from the real estate markets. 679 00:29:30,420 --> 00:29:32,677 Any questions about scale? 680 00:29:32,677 --> 00:29:35,260 That was a bit of a digression, but a useful one, in the sense 681 00:29:35,260 --> 00:29:38,170 that NPV is the right thing to do because it 682 00:29:38,170 --> 00:29:40,030 doesn't ignore scale. 683 00:29:40,030 --> 00:29:44,500 Whereas, for the small investor, ignoring scale 684 00:29:44,500 --> 00:29:45,850 makes perfect sense. 685 00:29:45,850 --> 00:29:48,340 Because then we are able to derive a theory that 686 00:29:48,340 --> 00:29:49,870 applies to most everybody. 687 00:29:49,870 --> 00:29:54,160 By the way, that theory doesn't apply to some 688 00:29:54,160 --> 00:29:56,470 of the largest investors today. 689 00:29:56,470 --> 00:29:59,530 For example, certain sovereign wealth funds, 690 00:29:59,530 --> 00:30:01,510 certain public pension funds, they 691 00:30:01,510 --> 00:30:05,410 can't invest according to the basics of portfolio theory. 692 00:30:05,410 --> 00:30:07,077 Because when they put money to work, 693 00:30:07,077 --> 00:30:09,160 they're looking to put a couple of billion dollars 694 00:30:09,160 --> 00:30:11,410 to work in a single investment. 695 00:30:11,410 --> 00:30:13,810 It's not worth their time to try to figure out 696 00:30:13,810 --> 00:30:16,790 how to allocate $5 million here, $10 million here, $20 million 697 00:30:16,790 --> 00:30:17,290 there. 698 00:30:17,290 --> 00:30:19,030 There's not enough hours in the day 699 00:30:19,030 --> 00:30:21,400 when they're managing a $250 billion 700 00:30:21,400 --> 00:30:23,870 portfolio to be able to do that. 701 00:30:23,870 --> 00:30:27,100 And so, when you're a large, large investor, 702 00:30:27,100 --> 00:30:29,930 the theory that we developed here in this class, 703 00:30:29,930 --> 00:30:31,000 it doesn't apply. 704 00:30:31,000 --> 00:30:33,790 You need to take 15 433 to understand 705 00:30:33,790 --> 00:30:37,390 how to deal with the issue of price impact and large scale 706 00:30:37,390 --> 00:30:37,990 investments. 707 00:30:37,990 --> 00:30:40,270 Fortunately, or unfortunately, that 708 00:30:40,270 --> 00:30:42,520 won't be a problem for most of us, 709 00:30:42,520 --> 00:30:44,620 so you have to keep that in mind. 710 00:30:44,620 --> 00:30:47,800 For most of us, the theory of investments 711 00:30:47,800 --> 00:30:52,120 that we developed in this class is perfectly appropriate. 712 00:30:52,120 --> 00:30:53,830 Except when we're talking about NPV. 713 00:30:53,830 --> 00:30:54,329 Yeah? 714 00:30:56,804 --> 00:30:59,149 AUDIENCE: Because of this lecture, 715 00:30:59,149 --> 00:31:02,198 will there be any indices or variables 716 00:31:02,198 --> 00:31:07,470 that we can use to determine the part of the initial returns 717 00:31:07,470 --> 00:31:10,010 for those sort of cash flows? 718 00:31:10,010 --> 00:31:12,260 ANDREW LO: In this particular context, no. 719 00:31:12,260 --> 00:31:16,012 You're going to learn about that in 402, as well as in 434, 720 00:31:16,012 --> 00:31:18,470 and some of the more advanced courses on capital budgeting. 721 00:31:18,470 --> 00:31:20,630 On how to scale an investment. 722 00:31:20,630 --> 00:31:22,910 But the basic principle, you, I think, 723 00:31:22,910 --> 00:31:25,370 already know because you've taken microeconomics. 724 00:31:25,370 --> 00:31:28,160 The basic principle of how much to invest 725 00:31:28,160 --> 00:31:30,560 is not to invest until you start losing money. 726 00:31:30,560 --> 00:31:33,470 That's actually typically how it's done in practice. 727 00:31:33,470 --> 00:31:36,800 That's not necessarily the best way of approaching it. 728 00:31:36,800 --> 00:31:39,140 According to an economist, the best way to invest 729 00:31:39,140 --> 00:31:43,970 is until the point at which the marginal benefits is actually 730 00:31:43,970 --> 00:31:46,350 equal to the marginal cost of the investment. 731 00:31:46,350 --> 00:31:48,540 So when you're trying to maximize profits, 732 00:31:48,540 --> 00:31:51,470 you're asking how much money should I invest 733 00:31:51,470 --> 00:31:53,330 in a particular division. 734 00:31:53,330 --> 00:31:55,340 You ought to keep investing until the point 735 00:31:55,340 --> 00:31:58,950 where the marginal benefit is equated to the marginal cost. 736 00:31:58,950 --> 00:32:03,100 In other words, where the profit maximizing point is, 737 00:32:03,100 --> 00:32:09,440 is where the marginal revenue is equated to the marginal cost 738 00:32:09,440 --> 00:32:10,400 of investment. 739 00:32:10,400 --> 00:32:14,260 That's true for any kind of an investment. 740 00:32:14,260 --> 00:32:16,960 The point is to be able to measure those things accurately 741 00:32:16,960 --> 00:32:19,150 enough to find that point. 742 00:32:19,150 --> 00:32:21,760 We don't do that in this course because, again, we're 743 00:32:21,760 --> 00:32:24,250 assuming that you're relatively small relative 744 00:32:24,250 --> 00:32:27,230 to the grand scheme of the investment universe. 745 00:32:27,230 --> 00:32:30,010 But as you get bigger, you need to develop other techniques 746 00:32:30,010 --> 00:32:31,280 to be able to deal with that. 747 00:32:31,280 --> 00:32:34,150 And one is this marginal benefit, marginal cost 748 00:32:34,150 --> 00:32:36,480 approximation. 749 00:32:36,480 --> 00:32:39,250 Other questions? 750 00:32:39,250 --> 00:32:42,370 So that's the profitability index. 751 00:32:42,370 --> 00:32:43,920 I just give you a couple of examples, 752 00:32:43,920 --> 00:32:46,420 so you can take a look at them at your leisure. 753 00:32:46,420 --> 00:32:48,260 It's pretty straightforward. 754 00:32:48,260 --> 00:32:48,760 All right. 755 00:32:48,760 --> 00:32:53,050 Now, let me talk about the last, and probably most important, 756 00:32:53,050 --> 00:32:55,575 alternative to NPV. 757 00:32:55,575 --> 00:32:56,950 This is something that's actually 758 00:32:56,950 --> 00:32:58,876 used in practice pretty commonly, 759 00:32:58,876 --> 00:33:00,250 and there are certain areas where 760 00:33:00,250 --> 00:33:02,450 it's used almost exclusively. 761 00:33:02,450 --> 00:33:04,180 So it's a very important idea that I 762 00:33:04,180 --> 00:33:07,360 want to go over in detail. 763 00:33:07,360 --> 00:33:10,660 The idea behind the IRR looks simple enough 764 00:33:10,660 --> 00:33:11,710 on the surface of it. 765 00:33:11,710 --> 00:33:14,260 And those of you who remember back to the lectures 766 00:33:14,260 --> 00:33:17,590 that we did on bond mathematics, you'll 767 00:33:17,590 --> 00:33:21,580 recognize the IRR as nothing more than the yield 768 00:33:21,580 --> 00:33:23,840 to maturity of a bond. 769 00:33:23,840 --> 00:33:28,480 So if you pretend that this is like a bond, where i sub 0 770 00:33:28,480 --> 00:33:33,352 is the market price of the bond, and the cf1 to cft 771 00:33:33,352 --> 00:33:36,760 are the coupons and principle payment of the bond, 772 00:33:36,760 --> 00:33:41,620 then the internal rate of return is nothing more than the yield 773 00:33:41,620 --> 00:33:44,180 to maturity of that bond. 774 00:33:44,180 --> 00:33:46,810 That's mathematically, formally what it is. 775 00:33:46,810 --> 00:33:48,940 But it's got a different interpretation here. 776 00:33:48,940 --> 00:33:53,170 The interpretation is that i sub 0 is the amount of money 777 00:33:53,170 --> 00:33:56,800 you're paying for this project. 778 00:33:56,800 --> 00:34:02,050 And cf1 through cft are the cash flows you're 779 00:34:02,050 --> 00:34:05,520 getting from the project. 780 00:34:05,520 --> 00:34:13,380 And the IRR is that yield, or that rate of return, 781 00:34:13,380 --> 00:34:17,810 such that it makes the project break-even. 782 00:34:17,810 --> 00:34:21,980 In other words, the present value of the future cash flows 783 00:34:21,980 --> 00:34:24,409 is actually equal to the amount of investment 784 00:34:24,409 --> 00:34:27,860 that you put into it at that IRR rate of return. 785 00:34:30,730 --> 00:34:33,489 Any questions about that definition? 786 00:34:33,489 --> 00:34:35,440 Now implicit in that definition are 787 00:34:35,440 --> 00:34:39,790 a couple of hidden assumptions that makes this work. 788 00:34:39,790 --> 00:34:42,820 One assumption is that the only investment 789 00:34:42,820 --> 00:34:45,340 that you're going to make in the project is upfront. 790 00:34:45,340 --> 00:34:47,817 You're going to pay i sub 0, and you're not 791 00:34:47,817 --> 00:34:49,650 going to pay anything more for that project. 792 00:34:49,650 --> 00:34:55,940 It requires no more cash inflows from you, the investor. 793 00:34:55,940 --> 00:34:57,710 The second assumption, which I guess 794 00:34:57,710 --> 00:34:59,480 is sort of the same as the first, 795 00:34:59,480 --> 00:35:03,660 is that all the cash flows are non-negative. 796 00:35:03,660 --> 00:35:05,520 They're either 0 or positive. 797 00:35:05,520 --> 00:35:08,650 You don't have any future negative cash flows. 798 00:35:08,650 --> 00:35:10,800 So once you invest in your certain amount 799 00:35:10,800 --> 00:35:14,040 today, then thereafter, you simply 800 00:35:14,040 --> 00:35:17,855 collect money from the project that comes in over t periods. 801 00:35:20,690 --> 00:35:23,570 If those two assumptions are satisfied, 802 00:35:23,570 --> 00:35:28,150 then this may be a reasonable approach. 803 00:35:28,150 --> 00:35:31,570 So just to be explicit, the way that IRR is used 804 00:35:31,570 --> 00:35:34,510 is for independent projects. 805 00:35:34,510 --> 00:35:39,510 Accept a project if the IRR's greater than some hurdle rate, 806 00:35:39,510 --> 00:35:41,010 some IRR star. 807 00:35:41,010 --> 00:35:44,100 You can think of that as your internal, 808 00:35:44,100 --> 00:35:46,900 or your required rate of return. 809 00:35:46,900 --> 00:35:53,730 So as long as the break-even IRR is equal to, or greater 810 00:35:53,730 --> 00:35:57,860 than that threshold, then you're OK. 811 00:35:57,860 --> 00:36:02,760 Second, if you've got mutually exclusive projects, 812 00:36:02,760 --> 00:36:06,495 then you pick the one that has the highest IRR. 813 00:36:10,268 --> 00:36:11,750 Yeah, [INAUDIBLE]? 814 00:36:11,750 --> 00:36:19,407 AUDIENCE: [INAUDIBLE] You could have 815 00:36:19,407 --> 00:36:22,651 an outflow in the first year, and you could 816 00:36:22,651 --> 00:36:26,050 have an increase [INAUDIBLE] 817 00:36:26,050 --> 00:36:27,550 ANDREW LO: I'll show you in a minute 818 00:36:27,550 --> 00:36:29,980 why you need that assumption, those two assumptions. 819 00:36:29,980 --> 00:36:31,504 In fact, when people use IRR, they 820 00:36:31,504 --> 00:36:32,920 don't bother with any assumptions. 821 00:36:32,920 --> 00:36:35,230 They just compute it. 822 00:36:35,230 --> 00:36:39,110 So the assumption is to give them the benefit of the doubt. 823 00:36:39,110 --> 00:36:41,590 I want to come up with conditions under which it might 824 00:36:41,590 --> 00:36:44,660 actually make sense to use this, and those are the conditions. 825 00:36:44,660 --> 00:36:48,460 But for now, let's forget about all conditions. 826 00:36:48,460 --> 00:36:53,040 And let me tell you what the problems are with IRR. 827 00:36:53,040 --> 00:36:58,180 There are certain situations where using IRR 828 00:36:58,180 --> 00:37:04,970 will lead to the same decisions as NPV, and there they are. 829 00:37:04,970 --> 00:37:08,480 There's only one cash outflow, which occurs at time 0. 830 00:37:08,480 --> 00:37:10,500 There's only one project under consideration, 831 00:37:10,500 --> 00:37:13,630 so you have multiple projects that you're comparing. 832 00:37:13,630 --> 00:37:15,450 Third, the opportunity cost of capital 833 00:37:15,450 --> 00:37:18,720 is the same for all periods. 834 00:37:18,720 --> 00:37:21,300 And the threshold rate that you use 835 00:37:21,300 --> 00:37:27,570 is set equal to the opportunity cost of capital. 836 00:37:27,570 --> 00:37:31,560 Now, the reason that you need all of these. 837 00:37:31,560 --> 00:37:34,130 I'm going to show you by way of counterexamples. 838 00:37:34,130 --> 00:37:36,230 But let me just tell you right now, up front, 839 00:37:36,230 --> 00:37:38,150 what the shortcomings are of IRR. 840 00:37:38,150 --> 00:37:41,930 Why you might want to think twice before using it. 841 00:37:41,930 --> 00:37:49,280 One is that in certain cases, the IRR may not exist. 842 00:37:49,280 --> 00:37:53,390 And in other cases, you may have multiple IRRs. 843 00:37:53,390 --> 00:37:55,820 I'm going to show you in a minute. 844 00:37:55,820 --> 00:38:01,550 Second, you're going to get incorrect rankings for IRRs 845 00:38:01,550 --> 00:38:05,540 where you're looking at loans, loans meaning you've 846 00:38:05,540 --> 00:38:08,330 got a negative cash flow starting today, 847 00:38:08,330 --> 00:38:11,240 and then positive cash flows tomorrow-- 848 00:38:11,240 --> 00:38:11,900 Excuse me. 849 00:38:11,900 --> 00:38:14,160 You have a positive cash inflow today, 850 00:38:14,160 --> 00:38:18,060 and negative cash going out tomorrow and the day after. 851 00:38:18,060 --> 00:38:18,890 Like a mortgage. 852 00:38:18,890 --> 00:38:20,750 A mortgage, you get money up front, 853 00:38:20,750 --> 00:38:22,880 and you're paying money out later on. 854 00:38:22,880 --> 00:38:24,530 If you do that, then you've actually 855 00:38:24,530 --> 00:38:28,190 got to flip around the ranking and take projects or loans 856 00:38:28,190 --> 00:38:31,760 with smaller IRRs, not higher IRRs. 857 00:38:31,760 --> 00:38:34,080 And finally, it also ignores scale 858 00:38:34,080 --> 00:38:35,330 because it's a rate of return. 859 00:38:35,330 --> 00:38:39,130 It doesn't look at dollars and cents. 860 00:38:39,130 --> 00:38:40,940 Zeke? 861 00:38:40,940 --> 00:38:43,370 AUDIENCE: I have no professional experience 862 00:38:43,370 --> 00:38:47,355 but there's something that simply bothers me. 863 00:38:47,355 --> 00:38:49,480 You told that for, example, that this model doesn't 864 00:38:49,480 --> 00:38:50,980 work if you have negative cash flows 865 00:38:50,980 --> 00:38:54,415 and that people can make mistakes and use negative cash 866 00:38:54,415 --> 00:38:55,876 flows in real life. 867 00:38:55,876 --> 00:38:57,824 How does this happen? 868 00:38:57,824 --> 00:38:59,772 Don't people have-- in this Excel sheet, 869 00:38:59,772 --> 00:39:01,233 it's a simple calculation. 870 00:39:01,233 --> 00:39:03,356 How is this allowed in professional-- 871 00:39:03,356 --> 00:39:05,480 ANDREW LO: Hold on for one second, let me show you. 872 00:39:05,480 --> 00:39:07,400 I'm going to show you by example. 873 00:39:07,400 --> 00:39:11,540 It's not as easy as you think. 874 00:39:11,540 --> 00:39:13,940 Let me give you some examples for incorrect rankings. 875 00:39:13,940 --> 00:39:16,820 This is one example where, as I said, with a loan 876 00:39:16,820 --> 00:39:19,520 you want to pick the project that's got a lower IRR, not 877 00:39:19,520 --> 00:39:20,960 a higher IRR. 878 00:39:20,960 --> 00:39:22,580 So that's one issue. 879 00:39:22,580 --> 00:39:26,950 But let me give you an idea of the nonexistence of an IRR. 880 00:39:26,950 --> 00:39:31,260 Project one has two negative cash flows. 881 00:39:31,260 --> 00:39:34,633 One in the first period, and another one in period two. 882 00:39:37,190 --> 00:39:39,800 Project two has only one negative cash flow, 883 00:39:39,800 --> 00:39:43,370 but it happens in period one, not in period zero 884 00:39:43,370 --> 00:39:45,530 or in period two. 885 00:39:45,530 --> 00:39:49,280 Both of these projects are not particularly weird. 886 00:39:49,280 --> 00:39:52,100 I know it's true that they don't have negative cash flows on day 887 00:39:52,100 --> 00:39:54,260 one and positive thereafter. 888 00:39:54,260 --> 00:39:56,540 But I don't think you would look at these 889 00:39:56,540 --> 00:39:59,390 and say that, gee this is really pathological, 890 00:39:59,390 --> 00:40:01,500 or perverse, in any way. 891 00:40:01,500 --> 00:40:03,320 It's just a different way of structuring 892 00:40:03,320 --> 00:40:07,160 your particular financing, or your cash flows. 893 00:40:07,160 --> 00:40:09,020 It turns out that in both of these cases, 894 00:40:09,020 --> 00:40:13,270 the IRR doesn't actually exist. 895 00:40:13,270 --> 00:40:15,640 Now by exist, what do I mean? 896 00:40:15,640 --> 00:40:19,480 Let's go back and look at exactly how to compute IRR. 897 00:40:19,480 --> 00:40:22,480 To compute an IRR, you have to find a number that 898 00:40:22,480 --> 00:40:23,840 satisfies this equation. 899 00:40:26,540 --> 00:40:32,250 And so with k period IRR calculation, 900 00:40:32,250 --> 00:40:37,330 we've got k cash flows over k years. 901 00:40:37,330 --> 00:40:39,140 What, in the end, are you trying to solve? 902 00:40:39,140 --> 00:40:40,181 What kind of an equation? 903 00:40:44,000 --> 00:40:45,441 Nobody on high school math teams? 904 00:40:45,441 --> 00:40:45,940 Andy? 905 00:40:45,940 --> 00:40:47,480 AUDIENCE: kth order polynomial. 906 00:40:47,480 --> 00:40:51,214 ANDREW LO: Yeah, a kth order polynomial. 907 00:40:51,214 --> 00:40:52,630 You all know what that is, I hope. 908 00:40:52,630 --> 00:40:54,260 Right? 909 00:40:54,260 --> 00:40:56,870 Second order polynomial's a quadratic. 910 00:40:56,870 --> 00:40:59,930 ax squared plus bx plus c equals 0. 911 00:40:59,930 --> 00:41:02,690 A third order polynomial has a cubed term, and so on. 912 00:41:02,690 --> 00:41:07,460 A kth order polynomial has powers of IRR 913 00:41:07,460 --> 00:41:08,870 that are up to order k. 914 00:41:12,390 --> 00:41:15,060 Anybody tell me how many solutions there 915 00:41:15,060 --> 00:41:18,040 are of a kth order polynomial? 916 00:41:18,040 --> 00:41:19,680 AUDIENCE: k [INAUDIBLE] 917 00:41:19,680 --> 00:41:23,340 ANDREW LO: Up to k solutions. 918 00:41:23,340 --> 00:41:25,110 Do you always have solutions? 919 00:41:25,110 --> 00:41:26,962 AUDIENCE: No. 920 00:41:26,962 --> 00:41:30,612 k is obvious. 921 00:41:30,612 --> 00:41:32,820 ANDREW LO: We're getting some different theories now. 922 00:41:32,820 --> 00:41:36,352 So some says yes, some says no, some says where k is odd. 923 00:41:36,352 --> 00:41:38,070 By odd I presume you mean not even, 924 00:41:38,070 --> 00:41:41,370 as opposed to weird, right? 925 00:41:41,370 --> 00:41:43,320 it actually turns out that you can 926 00:41:43,320 --> 00:41:47,126 construct a solution for every single kth order polynomial. 927 00:41:47,126 --> 00:41:48,750 But that's if you change the definition 928 00:41:48,750 --> 00:41:51,120 of what you mean by a solution. 929 00:41:51,120 --> 00:41:52,680 Right, exactly. 930 00:41:52,680 --> 00:41:54,840 If you introduce a new set of numbers 931 00:41:54,840 --> 00:41:58,470 called complex number, by that I mean numbers 932 00:41:58,470 --> 00:42:01,470 where the square root of negative 1 makes sense. 933 00:42:01,470 --> 00:42:03,390 If you will extend the number system 934 00:42:03,390 --> 00:42:06,790 to include these weird things called complex numbers, 935 00:42:06,790 --> 00:42:09,960 then it turns out that all polynomials, 936 00:42:09,960 --> 00:42:13,350 all kth order polynomials have exactly k solutions. 937 00:42:13,350 --> 00:42:15,010 How nice. 938 00:42:15,010 --> 00:42:16,740 The problem is that these solutions 939 00:42:16,740 --> 00:42:19,380 can involve complex numbers. 940 00:42:19,380 --> 00:42:21,192 And as far as we know, complex numbers 941 00:42:21,192 --> 00:42:22,650 don't have any ready interpretation 942 00:42:22,650 --> 00:42:24,610 in terms of interest and money. 943 00:42:24,610 --> 00:42:27,000 So in other words, the only solutions that matter for you 944 00:42:27,000 --> 00:42:29,130 and me, for practical purposes, is 945 00:42:29,130 --> 00:42:31,740 what are called real solutions. 946 00:42:31,740 --> 00:42:34,570 And in particular, not only do they have to be real, 947 00:42:34,570 --> 00:42:37,380 but it would sort of be nice if they were positive numbers. 948 00:42:37,380 --> 00:42:40,380 Because interest rates, again, although they can be negative, 949 00:42:40,380 --> 00:42:42,480 it's kind of hard to imagine what that implies 950 00:42:42,480 --> 00:42:45,280 over long periods of time. 951 00:42:45,280 --> 00:42:48,990 So when I say that a solution doesn't 952 00:42:48,990 --> 00:42:50,700 exist for these two cases, I don't mean 953 00:42:50,700 --> 00:42:52,770 that they don't exist, exist. 954 00:42:52,770 --> 00:42:55,050 Of course they exist, they have to exist. 955 00:42:55,050 --> 00:42:56,820 The problem is that the solutions-- these 956 00:42:56,820 --> 00:42:59,510 are two period cash flows. 957 00:42:59,510 --> 00:43:01,650 So we're talking about quadratics. 958 00:43:01,650 --> 00:43:05,760 We all know the solution to the quadratic equation of ax 959 00:43:05,760 --> 00:43:07,110 squared plus bx plus c equals 0. 960 00:43:07,110 --> 00:43:07,830 What's the solution? 961 00:43:07,830 --> 00:43:08,788 Anyway tell me quickly? 962 00:43:11,740 --> 00:43:13,770 Negative b plus or minus the square root of b 963 00:43:13,770 --> 00:43:15,120 squared minus 4ac over 2a. 964 00:43:15,120 --> 00:43:17,070 Remember that? 965 00:43:17,070 --> 00:43:22,020 It turns out that you don't get real solutions all the time. 966 00:43:22,020 --> 00:43:24,990 Meaning that, in certain cases, that formula 967 00:43:24,990 --> 00:43:27,825 will produce solutions that have the square root of negative 1 968 00:43:27,825 --> 00:43:29,250 in there. 969 00:43:29,250 --> 00:43:32,820 And that makes no sense from an economic perspective. 970 00:43:32,820 --> 00:43:34,840 It just so happens that in these two cases, 971 00:43:34,840 --> 00:43:38,610 you should go home and try it, and you'll see for yourself. 972 00:43:38,610 --> 00:43:41,460 When you come up with the two solutions that 973 00:43:41,460 --> 00:43:47,299 exist for both of these cases, they're complex numbers. 974 00:43:47,299 --> 00:43:49,590 So I challenge you to tell me what the right investment 975 00:43:49,590 --> 00:43:53,400 decision is by looking at those complex numbers. 976 00:43:53,400 --> 00:43:55,440 It can't be done. 977 00:43:55,440 --> 00:43:59,250 Which means that IRR doesn't always work. 978 00:43:59,250 --> 00:44:02,730 And here are two relatively reasonable examples 979 00:44:02,730 --> 00:44:06,020 that nobody should be expected to look at and say, 980 00:44:06,020 --> 00:44:06,930 ha, of course. 981 00:44:06,930 --> 00:44:08,820 You can't use IRR here. 982 00:44:08,820 --> 00:44:10,890 These are real life examples. 983 00:44:10,890 --> 00:44:12,600 And by the way, this is just two periods. 984 00:44:12,600 --> 00:44:16,770 If I had five periods, and I had some positives, some negatives, 985 00:44:16,770 --> 00:44:19,440 it gets even more complicated. 986 00:44:19,440 --> 00:44:21,630 So even within a spreadsheet, where 987 00:44:21,630 --> 00:44:23,880 you can see the positives and the negatives, 988 00:44:23,880 --> 00:44:25,020 and you can compute IRR-- 989 00:44:25,020 --> 00:44:26,850 you can do this in Excel. 990 00:44:26,850 --> 00:44:27,850 And you should do that. 991 00:44:27,850 --> 00:44:30,400 You'll get these weird symbols that come up, 992 00:44:30,400 --> 00:44:32,010 that will start spitting up blood 993 00:44:32,010 --> 00:44:35,530 and say that it can't handle this. 994 00:44:35,530 --> 00:44:37,150 Unfortunately, if you did it MATLAB, 995 00:44:37,150 --> 00:44:39,100 which I know a number of you are likely to do, 996 00:44:39,100 --> 00:44:40,330 you will get an answer. 997 00:44:40,330 --> 00:44:43,910 MATLAB has no problem with complex numbers. 998 00:44:43,910 --> 00:44:45,490 So that's one problem. 999 00:44:45,490 --> 00:44:48,820 Let me illustrate to you though, where the problem comes 1000 00:44:48,820 --> 00:44:51,080 with multiplicity of solutions. 1001 00:44:51,080 --> 00:44:54,580 So this is a graph of the polynomial. 1002 00:44:54,580 --> 00:44:57,850 In this case, the third order polynomial. 1003 00:44:57,850 --> 00:45:00,910 And so what I'm doing is I'm calculating 1004 00:45:00,910 --> 00:45:06,280 the NPV of project 1 and of project 2 1005 00:45:06,280 --> 00:45:10,300 as a function of the underlying interest rate. 1006 00:45:10,300 --> 00:45:12,820 And an IRR corresponds to a situation 1007 00:45:12,820 --> 00:45:16,390 where the NPV is equal to 0, the break-even point. 1008 00:45:16,390 --> 00:45:19,210 What you'll notice is that the 0's 1009 00:45:19,210 --> 00:45:23,547 are where this curve intersects the y-axis, or the x-axis, 1010 00:45:23,547 --> 00:45:24,680 sorry. 1011 00:45:24,680 --> 00:45:27,910 And so with the first project, you actually 1012 00:45:27,910 --> 00:45:29,320 get a unique solution. 1013 00:45:29,320 --> 00:45:32,680 It only crosses the x-axis once. 1014 00:45:32,680 --> 00:45:35,630 So you get a unique, real solution. 1015 00:45:35,630 --> 00:45:38,230 But if you take a look at project 2, 1016 00:45:38,230 --> 00:45:44,410 project 2 crosses the x-axis once, twice, three times. 1017 00:45:44,410 --> 00:45:45,880 You get three solutions. 1018 00:45:45,880 --> 00:45:47,830 They're all real, by the way. 1019 00:45:47,830 --> 00:45:50,500 You get three, real solutions. 1020 00:45:50,500 --> 00:45:52,350 Which one would you like? 1021 00:45:52,350 --> 00:45:53,990 Take your pick. 1022 00:45:53,990 --> 00:45:55,610 You pick the biggest one? 1023 00:45:55,610 --> 00:45:56,480 Or the smallest one? 1024 00:45:56,480 --> 00:45:58,280 Or maybe average them, or do something? 1025 00:45:58,280 --> 00:45:59,870 I don't know. 1026 00:45:59,870 --> 00:46:05,570 The problem is that with IRR, If the pattern of cash flows 1027 00:46:05,570 --> 00:46:08,630 is anything but strictly positive, 1028 00:46:08,630 --> 00:46:11,250 you get weird results. 1029 00:46:11,250 --> 00:46:16,320 Now, I told you before that IRR is used almost exclusively 1030 00:46:16,320 --> 00:46:19,167 in one particular sector, one particular segment, 1031 00:46:19,167 --> 00:46:20,250 of the financial industry. 1032 00:46:20,250 --> 00:46:22,614 Anybody know what that is? 1033 00:46:22,614 --> 00:46:23,674 AUDIENCE: Bonds? 1034 00:46:23,674 --> 00:46:24,340 ANDREW LO: Bond? 1035 00:46:24,340 --> 00:46:27,580 Well, that would be a good answer, you're right. 1036 00:46:27,580 --> 00:46:31,547 Yield to maturity is what IRR is in bonds. 1037 00:46:31,547 --> 00:46:33,130 That wasn't what I was thinking about, 1038 00:46:33,130 --> 00:46:34,450 but you're absolutely right. 1039 00:46:34,450 --> 00:46:38,200 IRR, in fact, is used all the time in bonds 1040 00:46:38,200 --> 00:46:39,700 because you quote yield to maturity. 1041 00:46:39,700 --> 00:46:42,700 And it's not surprising because with bonds, you only 1042 00:46:42,700 --> 00:46:45,700 have positive cash flows, and you only 1043 00:46:45,700 --> 00:46:48,620 have an initial payment upfront, which is the price of the bond. 1044 00:46:48,620 --> 00:46:52,300 So all of the criteria that I required in order 1045 00:46:52,300 --> 00:46:58,390 to make IRR equivalent to NPV holds for bonds. 1046 00:46:58,390 --> 00:47:01,000 But I'm thinking about something else. 1047 00:47:01,000 --> 00:47:04,150 What other part of the financial industry 1048 00:47:04,150 --> 00:47:06,790 uses IRR as a way of making investments? 1049 00:47:06,790 --> 00:47:11,080 And not only that, but of quoting performance. 1050 00:47:11,080 --> 00:47:11,650 What's that? 1051 00:47:11,650 --> 00:47:12,340 AUDIENCE: Private equity? 1052 00:47:12,340 --> 00:47:13,630 ANDREW LO: Private equity, exactly. 1053 00:47:13,630 --> 00:47:14,260 Private equity. 1054 00:47:14,260 --> 00:47:18,550 In private equity, almost every venture capitalist 1055 00:47:18,550 --> 00:47:23,470 will tell you what their IRR is of their portfolio. 1056 00:47:23,470 --> 00:47:26,470 And there are a couple of reasons for this practice. 1057 00:47:26,470 --> 00:47:31,060 One of course, is that for most private equity ventures, 1058 00:47:31,060 --> 00:47:34,690 it is all about cash up front, and then positive cash 1059 00:47:34,690 --> 00:47:37,590 flows thereafter. 1060 00:47:37,590 --> 00:47:42,910 Unless of course, you require additional financing 1061 00:47:42,910 --> 00:47:44,440 like mezzanine financing. 1062 00:47:44,440 --> 00:47:47,110 In which case, now you have a hard time 1063 00:47:47,110 --> 00:47:49,030 using IRR for the whole thing. 1064 00:47:49,030 --> 00:47:52,510 You could use IRR for the separate tranches 1065 00:47:52,510 --> 00:47:55,480 of investments, and again, that's 1066 00:47:55,480 --> 00:47:57,370 kind of an accommodation. 1067 00:47:57,370 --> 00:48:02,050 It's a fix for trying to deal with the weaknesses of IRR. 1068 00:48:02,050 --> 00:48:04,120 If you focus just on the particular tranche 1069 00:48:04,120 --> 00:48:08,200 of an investment, you've got a tranche of investment going in, 1070 00:48:08,200 --> 00:48:14,920 cash flows going out, and it all satisfies the NPV criterion. 1071 00:48:14,920 --> 00:48:17,170 But the other reason for focusing on IRR 1072 00:48:17,170 --> 00:48:20,560 is because, again, this is an issue of scale. 1073 00:48:20,560 --> 00:48:22,510 You want to compare two investments, 1074 00:48:22,510 --> 00:48:25,612 and they may require different dollar amounts, 1075 00:48:25,612 --> 00:48:27,070 so you'd like to be able to compare 1076 00:48:27,070 --> 00:48:32,867 their performance in some way that doesn't include the scale. 1077 00:48:32,867 --> 00:48:34,450 Because you want to be able to compare 1078 00:48:34,450 --> 00:48:36,250 across a bunch of different investments 1079 00:48:36,250 --> 00:48:42,680 and see how each manager is doing per unit dollar invested. 1080 00:48:42,680 --> 00:48:45,560 However, the bottom line of a venture capitalist 1081 00:48:45,560 --> 00:48:47,579 is, I've got a billion dollars to invest. 1082 00:48:47,579 --> 00:48:49,370 I have to figure out where to put my money. 1083 00:48:49,370 --> 00:48:52,349 I can't afford to put my money in smaller investments that 1084 00:48:52,349 --> 00:48:54,140 are not going to give me the kind of return 1085 00:48:54,140 --> 00:48:55,460 that I need to have. 1086 00:48:55,460 --> 00:48:57,260 So in the end, a venture capitalist 1087 00:48:57,260 --> 00:48:59,960 is going to have to look at scale anyway. 1088 00:48:59,960 --> 00:49:03,080 But for historical and cultural reasons, 1089 00:49:03,080 --> 00:49:07,340 you actually have the venture capital community the only one 1090 00:49:07,340 --> 00:49:11,030 that really focuses almost exclusively on using IRR. 1091 00:49:11,030 --> 00:49:14,750 And for their applications, like the bond pricing example, 1092 00:49:14,750 --> 00:49:18,980 it's generally OK, but it may not be. 1093 00:49:18,980 --> 00:49:21,110 And so you should understand those conditions 1094 00:49:21,110 --> 00:49:22,910 under which it may not be. 1095 00:49:22,910 --> 00:49:26,630 So I want you to refer to these, and if you have a moment 1096 00:49:26,630 --> 00:49:28,730 during your holiday break and you're bored, 1097 00:49:28,730 --> 00:49:30,680 you might want to run a few of these in Excel. 1098 00:49:30,680 --> 00:49:34,910 Just literally try to compute the appropriate IRR in Excel. 1099 00:49:34,910 --> 00:49:37,010 And just prove to yourself that you 1100 00:49:37,010 --> 00:49:39,680 can't, that you get some weird results out of that. 1101 00:49:43,630 --> 00:49:48,130 Any questions about IRR? 1102 00:49:48,130 --> 00:49:50,350 By the way, again, there are no formulas 1103 00:49:50,350 --> 00:49:52,690 other than the quadratic for how to compute it. 1104 00:49:52,690 --> 00:49:55,030 So in most cases when you want to compute IRR, 1105 00:49:55,030 --> 00:49:56,530 you have to use numerical methods. 1106 00:49:56,530 --> 00:50:00,280 You have to basically solve a non-linear equation for a 0. 1107 00:50:00,280 --> 00:50:02,710 So effectively, you have to do this. 1108 00:50:02,710 --> 00:50:06,840 You have to find the 0's of these equations. 1109 00:50:06,840 --> 00:50:09,610 That could be a little bit of an exercise to do that. 1110 00:50:12,620 --> 00:50:15,200 There are other examples here where 1111 00:50:15,200 --> 00:50:17,090 I try to come up with ways to fix IRR, 1112 00:50:17,090 --> 00:50:19,730 maybe by looking at incremental cash flows, 1113 00:50:19,730 --> 00:50:22,880 or looking at different ranking methods. 1114 00:50:22,880 --> 00:50:26,420 But the bottom line is use NPV. 1115 00:50:26,420 --> 00:50:29,150 Be aware of how to compute an IRR, 1116 00:50:29,150 --> 00:50:31,670 but you should understand that IRR, 1117 00:50:31,670 --> 00:50:36,740 in the cases where it matters, either it agrees with NPV or it 1118 00:50:36,740 --> 00:50:37,262 doesn't. 1119 00:50:37,262 --> 00:50:38,720 And if it doesn't, you can't use it 1120 00:50:38,720 --> 00:50:41,690 because it's going to create all sorts of contradictions 1121 00:50:41,690 --> 00:50:42,515 and weird results. 1122 00:50:46,690 --> 00:50:49,810 I want to conclude this lecture on capital budgeting 1123 00:50:49,810 --> 00:50:53,860 by talking about what people actually do in practice, 1124 00:50:53,860 --> 00:50:56,410 and give you a little bit of a preview about what you're 1125 00:50:56,410 --> 00:51:01,060 going to learn in 402 as well as in 434 and other courses 1126 00:51:01,060 --> 00:51:04,300 on corporate financing and capital budgeting. 1127 00:51:04,300 --> 00:51:07,840 Right now, as of maybe five years ago 1128 00:51:07,840 --> 00:51:11,080 when this survey was done, for large US firms, 1129 00:51:11,080 --> 00:51:13,870 believe it or not, payback period 1130 00:51:13,870 --> 00:51:17,030 was probably the most popular. 1131 00:51:17,030 --> 00:51:19,010 It's the one that people focused on the most. 1132 00:51:19,010 --> 00:51:21,177 Again, not necessarily exclusively. 1133 00:51:21,177 --> 00:51:23,260 So it could well be that people use payback period 1134 00:51:23,260 --> 00:51:26,720 as one criterion, but they use many others as well. 1135 00:51:26,720 --> 00:51:31,530 But over 80% of the companies surveyed use payback period. 1136 00:51:31,530 --> 00:51:34,900 65% use IRR, which is quite a lot. 1137 00:51:34,900 --> 00:51:37,600 But again, a significant fraction of that 1138 00:51:37,600 --> 00:51:40,730 is private equity. 1139 00:51:40,730 --> 00:51:43,100 And by the way, for non-financial corporations that 1140 00:51:43,100 --> 00:51:46,910 have private equity operations within it, for example, 1141 00:51:46,910 --> 00:51:50,420 General Motors has a part of their pension fund devoted 1142 00:51:50,420 --> 00:51:51,950 to private equity investments. 1143 00:51:51,950 --> 00:51:54,560 They will use IRR as well, because other venture 1144 00:51:54,560 --> 00:51:56,960 capitalists use that. 1145 00:51:56,960 --> 00:52:00,410 NPV is actually gaining ground. 1146 00:52:00,410 --> 00:52:02,720 So it's now more popular than IRR. 1147 00:52:02,720 --> 00:52:06,380 If you surveyed multinationals and US corporations 1148 00:52:06,380 --> 00:52:09,110 20 years ago, it would have been flipped around. 1149 00:52:09,110 --> 00:52:12,500 IRR would have been way more popular than NPV, 1150 00:52:12,500 --> 00:52:16,200 but that's changed a lot just in the last 20 years. 1151 00:52:16,200 --> 00:52:18,500 However, when you look at multinationals, 1152 00:52:18,500 --> 00:52:22,460 you see that actually, IRR is still more popular. 1153 00:52:22,460 --> 00:52:25,250 So that's something to keep in mind. 1154 00:52:25,250 --> 00:52:27,140 When you're dealing with foreign companies, 1155 00:52:27,140 --> 00:52:30,170 they may be looking at investments 1156 00:52:30,170 --> 00:52:34,520 from a VC perspective, as opposed to from a pure net cash 1157 00:52:34,520 --> 00:52:36,500 flow NPV perspective. 1158 00:52:36,500 --> 00:52:39,530 So that's something that you'll want to be wary of. 1159 00:52:39,530 --> 00:52:41,750 And by the way, that's probably one area 1160 00:52:41,750 --> 00:52:46,305 where you can make real progress in terms of an impact 1161 00:52:46,305 --> 00:52:47,180 through your careers. 1162 00:52:50,090 --> 00:52:51,860 Historical comparison, this gives you 1163 00:52:51,860 --> 00:52:54,950 a little bit of a time series of how 1164 00:52:54,950 --> 00:52:56,730 things have changed over time. 1165 00:52:56,730 --> 00:53:01,250 So back in 1959, payback period, IRR, 1166 00:53:01,250 --> 00:53:03,020 was quite a bit more popular. 1167 00:53:03,020 --> 00:53:06,860 Over time, that's declined, and over time, IRR 1168 00:53:06,860 --> 00:53:08,540 has gained more ground. 1169 00:53:08,540 --> 00:53:13,280 But NPV, as of 1981, was lagging far behind. 1170 00:53:13,280 --> 00:53:17,060 And within the last 20 years, we see this chart where 1171 00:53:17,060 --> 00:53:19,460 NPV has caught up a great deal. 1172 00:53:19,460 --> 00:53:21,020 A large part of that, if you want 1173 00:53:21,020 --> 00:53:23,103 to know where that came from, a large part of that 1174 00:53:23,103 --> 00:53:25,910 was thanks to Brealey and Myers. 1175 00:53:25,910 --> 00:53:27,680 The textbook that you're using now 1176 00:53:27,680 --> 00:53:31,010 was probably the first major corporate finance textbook ever 1177 00:53:31,010 --> 00:53:33,980 written, way back in the 1980s. 1178 00:53:33,980 --> 00:53:38,330 And Stu Myers and Dick Brealey wrote the book really 1179 00:53:38,330 --> 00:53:39,980 because there was nothing else that 1180 00:53:39,980 --> 00:53:43,310 was out there that corresponded to these kind of modern finance 1181 00:53:43,310 --> 00:53:44,390 principles. 1182 00:53:44,390 --> 00:53:47,420 And so Stu and Dick have a lot to do 1183 00:53:47,420 --> 00:53:49,940 with these numbers as of today. 1184 00:53:54,830 --> 00:53:57,570 Other issues that we were not able to take on in this course, 1185 00:53:57,570 --> 00:54:00,950 but which you will see in 402 and 434, 1186 00:54:00,950 --> 00:54:06,050 is how to deal with other aspects of the capital 1187 00:54:06,050 --> 00:54:07,100 budgeting process. 1188 00:54:07,100 --> 00:54:09,740 For example, competitive response. 1189 00:54:09,740 --> 00:54:11,960 When we think about making investments in projects, 1190 00:54:11,960 --> 00:54:16,532 we are assuming everything else as given. 1191 00:54:16,532 --> 00:54:18,740 This is sort of like putting money in a stock market. 1192 00:54:18,740 --> 00:54:20,573 When you put your money in the stock market, 1193 00:54:20,573 --> 00:54:24,470 you're assuming that the means and the variances are given. 1194 00:54:24,470 --> 00:54:26,780 That your investment has no impact 1195 00:54:26,780 --> 00:54:28,940 on the market as a whole. 1196 00:54:28,940 --> 00:54:32,900 For specific kinds of projects, that's not true at all. 1197 00:54:32,900 --> 00:54:34,820 The perfect market's assumption that we 1198 00:54:34,820 --> 00:54:38,660 make from the perspective of a small investor investing 1199 00:54:38,660 --> 00:54:40,880 in the entire market, those set of assumptions 1200 00:54:40,880 --> 00:54:44,060 don't work for you making a decision 1201 00:54:44,060 --> 00:54:46,430 about whether to invest in a new technology 1202 00:54:46,430 --> 00:54:47,960 in your particular industry. 1203 00:54:47,960 --> 00:54:50,510 Because most likely, that new technology 1204 00:54:50,510 --> 00:54:54,470 will have a very significant impact on that industry 1205 00:54:54,470 --> 00:54:55,610 if it's any good. 1206 00:54:55,610 --> 00:54:57,026 So therefore, you're going to have 1207 00:54:57,026 --> 00:54:59,990 to deal with competitors and the competitive response. 1208 00:54:59,990 --> 00:55:02,270 Things are going to change because of the way 1209 00:55:02,270 --> 00:55:03,800 you make your investments. 1210 00:55:03,800 --> 00:55:06,230 So that's something you'll have to take into account. 1211 00:55:06,230 --> 00:55:08,600 Capital rationing, which means you 1212 00:55:08,600 --> 00:55:10,249 don't have all the money in the world. 1213 00:55:10,249 --> 00:55:12,290 There's a limit to how much money you can invest, 1214 00:55:12,290 --> 00:55:15,500 so now, given that there are limits to how much money you 1215 00:55:15,500 --> 00:55:19,670 have, you've got to pick your opportunities more carefully. 1216 00:55:19,670 --> 00:55:24,290 And some of these capital rationing requirements 1217 00:55:24,290 --> 00:55:26,610 are implemented over multi-year periods. 1218 00:55:26,610 --> 00:55:28,730 So for example, you might have a three year 1219 00:55:28,730 --> 00:55:32,750 budget of $100 million to make investments in new technology. 1220 00:55:32,750 --> 00:55:35,679 Over three years, you can use up to $100 million. 1221 00:55:35,679 --> 00:55:37,220 So now, not only do you have to think 1222 00:55:37,220 --> 00:55:41,840 about how to spread your money over opportunities this year, 1223 00:55:41,840 --> 00:55:43,670 you've got to think about a spread it out 1224 00:55:43,670 --> 00:55:44,817 over a three year period. 1225 00:55:44,817 --> 00:55:47,150 And you have to think about spreading it out to projects 1226 00:55:47,150 --> 00:55:49,430 that you don't even know exist right now. 1227 00:55:49,430 --> 00:55:52,500 So the problems, the challenges, become much, 1228 00:55:52,500 --> 00:55:55,100 much more complex as you start making 1229 00:55:55,100 --> 00:55:57,600 the assumptions more realistic. 1230 00:55:57,600 --> 00:55:59,600 You've got now, the very basics to understand 1231 00:55:59,600 --> 00:56:02,810 how to do this for the very, very simple cases. 1232 00:56:02,810 --> 00:56:05,570 But the more advanced courses will, one by one, 1233 00:56:05,570 --> 00:56:07,760 relax these assumptions and give you 1234 00:56:07,760 --> 00:56:11,840 more tools to be able to handle more complex situations. 1235 00:56:11,840 --> 00:56:13,610 The examples that I give in this slide 1236 00:56:13,610 --> 00:56:18,170 are looking at short run versus the long run, 1237 00:56:18,170 --> 00:56:20,990 as well as dealing with general noise. 1238 00:56:20,990 --> 00:56:23,699 In other words, you may be taking in lots of data, 1239 00:56:23,699 --> 00:56:25,490 not all of that data is equally meaningful. 1240 00:56:25,490 --> 00:56:29,397 So you need to know what to ignore, and what to focus on. 1241 00:56:29,397 --> 00:56:30,980 That will be part of those challenges. 1242 00:56:30,980 --> 00:56:37,210 You'll get that in 402, and more in 434. 1243 00:56:37,210 --> 00:56:43,720 So to summarize, we are now done with pretty much all 1244 00:56:43,720 --> 00:56:46,510 of the finance theory that we need 1245 00:56:46,510 --> 00:56:51,310 to value and to make decisions on virtually any kind 1246 00:56:51,310 --> 00:56:54,680 of investment that's out there. 1247 00:56:54,680 --> 00:56:56,530 The key points for capital budgeting 1248 00:56:56,530 --> 00:57:00,220 is use NPV, or in the case of more advanced kinds 1249 00:57:00,220 --> 00:57:03,580 of concepts, APV. 1250 00:57:03,580 --> 00:57:06,790 Take all projects that are positive NPV, and if they're 1251 00:57:06,790 --> 00:57:10,090 mutually exclusive, take the one with the biggest NPV. 1252 00:57:10,090 --> 00:57:12,250 Consider project interactions separately. 1253 00:57:12,250 --> 00:57:14,530 So consider the project on a standalone basis, 1254 00:57:14,530 --> 00:57:17,260 then consider any interaction effects 1255 00:57:17,260 --> 00:57:18,850 that may or may not exist. 1256 00:57:18,850 --> 00:57:21,130 You can evaluate them separately, and add them 1257 00:57:21,130 --> 00:57:23,230 together at the end. 1258 00:57:23,230 --> 00:57:26,020 Use after tax cash flows for the NPV calculations, 1259 00:57:26,020 --> 00:57:27,670 not accounting earnings. 1260 00:57:27,670 --> 00:57:31,881 And when you need discount rate, use the capital asset pricing 1261 00:57:31,881 --> 00:57:32,380 model. 1262 00:57:32,380 --> 00:57:35,440 The capital asset pricing model provides you 1263 00:57:35,440 --> 00:57:41,320 with a risk adjustment for the required rate of return. 1264 00:57:41,320 --> 00:57:44,710 And be wary about risks that change over time. 1265 00:57:44,710 --> 00:57:48,460 So every single year you use your cost of capital, 1266 00:57:48,460 --> 00:57:52,060 make sure you can justify the particular risk associated 1267 00:57:52,060 --> 00:57:52,840 with that year. 1268 00:57:52,840 --> 00:57:55,630 Remember the example of drilling for oil 1269 00:57:55,630 --> 00:57:57,940 and how the risks change dramatically 1270 00:57:57,940 --> 00:58:01,900 as you go from oil exploration to oil production. 1271 00:58:01,900 --> 00:58:04,660 Those are two different activities. 1272 00:58:04,660 --> 00:58:09,160 Finally, think about all the other alternatives to NPV. 1273 00:58:09,160 --> 00:58:11,740 And you don't have to be a snob about it. 1274 00:58:11,740 --> 00:58:14,170 Don't tell people, NPV's the only way to go. 1275 00:58:14,170 --> 00:58:16,150 It's either my way or the highway. 1276 00:58:16,150 --> 00:58:19,900 You recognize that there are other elements of risk 1277 00:58:19,900 --> 00:58:22,990 and reward that may be captured by payback, 1278 00:58:22,990 --> 00:58:26,590 by internal rate of return, by the profitability index. 1279 00:58:26,590 --> 00:58:28,240 But in the end, what you're going 1280 00:58:28,240 --> 00:58:31,360 to want to base your decision on is primarily 1281 00:58:31,360 --> 00:58:34,570 NPV considerations, with these other factors 1282 00:58:34,570 --> 00:58:37,580 thrown in as well. 1283 00:58:37,580 --> 00:58:40,910 I'll conclude with one last comment about capital 1284 00:58:40,910 --> 00:58:44,462 budgeting, which is something that is completely 1285 00:58:44,462 --> 00:58:45,920 outside the purview of this course, 1286 00:58:45,920 --> 00:58:48,947 but it's not outside the purview of your MBA. 1287 00:58:48,947 --> 00:58:50,530 And that is that why I've been talking 1288 00:58:50,530 --> 00:58:53,800 about for the exclusion of everything else in this course 1289 00:58:53,800 --> 00:58:58,300 is the economic and financial considerations. 1290 00:58:58,300 --> 00:59:00,910 Obviously, when you're engaged in trying 1291 00:59:00,910 --> 00:59:06,262 to get a project approved, or making a decision on a project, 1292 00:59:06,262 --> 00:59:07,720 there are many other considerations 1293 00:59:07,720 --> 00:59:09,280 that you should not forget about. 1294 00:59:09,280 --> 00:59:13,210 Considerations like political, social, cultural, 1295 00:59:13,210 --> 00:59:17,440 implementation, all sorts of practical aspects 1296 00:59:17,440 --> 00:59:19,640 that you need to put together. 1297 00:59:19,640 --> 00:59:21,970 And so all of the other courses that you've been taking 1298 00:59:21,970 --> 00:59:24,580 are designed to try to get you to think about that. 1299 00:59:24,580 --> 00:59:28,180 But unfortunately, or maybe inevitably, 1300 00:59:28,180 --> 00:59:32,470 in a curriculum like the MBA, we pick apart 1301 00:59:32,470 --> 00:59:34,780 all of the various aspects of a decision 1302 00:59:34,780 --> 00:59:36,850 and then study it to death, and try 1303 00:59:36,850 --> 00:59:40,000 to come up with the very best possible approaches for each 1304 00:59:40,000 --> 00:59:42,820 of those particular silos. 1305 00:59:42,820 --> 00:59:46,276 It's your job, ultimately, to put all of that together. 1306 00:59:46,276 --> 00:59:47,650 And you will do that, you will be 1307 00:59:47,650 --> 00:59:49,540 asked to do that, whether you know it or not, 1308 00:59:49,540 --> 00:59:50,920 when you start working. 1309 00:59:50,920 --> 00:59:53,830 So what I've been focused on exclusively 1310 00:59:53,830 --> 00:59:56,080 is the financial and economic considerations. 1311 00:59:56,080 --> 00:59:58,240 And I believe you now have the tools 1312 00:59:58,240 --> 01:00:00,100 to be able to analyze any project, 1313 01:00:00,100 --> 01:00:03,640 at least to get a starting point for an intellectually 1314 01:00:03,640 --> 01:00:05,352 consistent way of looking at it. 1315 01:00:05,352 --> 01:00:07,810 But don't for a moment think that those are the only things 1316 01:00:07,810 --> 01:00:09,270 that are important. 1317 01:00:09,270 --> 01:00:13,090 The political, social, cultural ramifications 1318 01:00:13,090 --> 01:00:15,460 are going to be extraordinarily critical, 1319 01:00:15,460 --> 01:00:17,380 and only you will be able to figure out 1320 01:00:17,380 --> 01:00:19,120 how to put that all together. 1321 01:00:19,120 --> 01:00:21,670 So hopefully in this particular course, 1322 01:00:21,670 --> 01:00:24,130 you've learned something valuable from that one aspect. 1323 01:00:24,130 --> 01:00:26,140 But just keep in mind, it is only one aspect, 1324 01:00:26,140 --> 01:00:27,281 one perspective. 1325 01:00:27,281 --> 01:00:29,530 And there are others that you will have to incorporate 1326 01:00:29,530 --> 01:00:30,910 into your way of thinking. 1327 01:00:33,850 --> 01:00:36,650 That's it for capital budgeting. 1328 01:00:36,650 --> 01:00:38,560 Any final questions before we move 1329 01:00:38,560 --> 01:00:42,021 on to the final lecture of this course? 1330 01:00:42,021 --> 01:00:42,520 Yes? 1331 01:00:42,520 --> 01:00:46,454 AUDIENCE: I just have one small question on IRR again. 1332 01:00:46,454 --> 01:00:50,927 In the examples you showed, the cash flows in the out years 1333 01:00:50,927 --> 01:00:56,269 and years [INAUDIBLE] were more, they 1334 01:00:56,269 --> 01:01:00,060 were the opposite direction from the initial year cash flow, 1335 01:01:00,060 --> 01:01:02,290 but greater than the [INAUDIBLE] cash flow. 1336 01:01:02,290 --> 01:01:04,900 Does it matter that that's not the case that can happen? 1337 01:01:04,900 --> 01:01:08,110 ANDREW LO: Well, I guess the answer is, it depends. 1338 01:01:08,110 --> 01:01:10,420 In other words, what you detected 1339 01:01:10,420 --> 01:01:14,110 was not a universal pattern that can be systematized 1340 01:01:14,110 --> 01:01:16,390 and then incorporated into IRR. 1341 01:01:16,390 --> 01:01:19,300 In other words, if I had a longer period of time 1342 01:01:19,300 --> 01:01:21,520 to be able to play with changes of sine 1343 01:01:21,520 --> 01:01:24,807 and changes of magnitude, I can get any kind of pattern 1344 01:01:24,807 --> 01:01:25,390 that you want. 1345 01:01:25,390 --> 01:01:28,870 For example, in the dotted line curve, 1346 01:01:28,870 --> 01:01:31,870 I can have this curve flip around the other way 1347 01:01:31,870 --> 01:01:33,790 so that it starts negative, goes positive, 1348 01:01:33,790 --> 01:01:34,870 and it goes up like that. 1349 01:01:34,870 --> 01:01:38,020 Just by changing the sign patterns to something else. 1350 01:01:38,020 --> 01:01:39,970 If I had a quartic term in there, 1351 01:01:39,970 --> 01:01:41,960 I can make it even more complicated. 1352 01:01:41,960 --> 01:01:44,770 So the longer the number of periods, the more number 1353 01:01:44,770 --> 01:01:46,870 of periods that I have to play with, the more 1354 01:01:46,870 --> 01:01:49,300 patterns that you can create so that it would be really 1355 01:01:49,300 --> 01:01:53,380 impossible to reduce it to a systematic 1356 01:01:53,380 --> 01:01:58,440 set other than this proscription here. 1357 01:01:58,440 --> 01:02:01,010 If these four conditions are satisfied, 1358 01:02:01,010 --> 01:02:04,810 then you're OK with using this as opposed to NPV. 1359 01:02:04,810 --> 01:02:07,570 But that's the only simple case where you 1360 01:02:07,570 --> 01:02:10,090 can say something meaningful. 1361 01:02:10,090 --> 01:02:14,350 By the way, the number of 0's and the nature of the 0's 1362 01:02:14,350 --> 01:02:19,790 of polynomials, that turns out to be related to a very, very, 1363 01:02:19,790 --> 01:02:23,920 very famous and hard unsolved problem in mathematics known 1364 01:02:23,920 --> 01:02:25,479 as the Riemann zeta hypothesis. 1365 01:02:25,479 --> 01:02:27,520 We're not going to talk about that in this class, 1366 01:02:27,520 --> 01:02:28,103 unfortunately. 1367 01:02:28,103 --> 01:02:30,430 It is beyond the scope of the school. 1368 01:02:33,790 --> 01:02:36,430 But I just want to let you know that there is something 1369 01:02:36,430 --> 01:02:40,180 inherently extraordinarily deep about 1370 01:02:40,180 --> 01:02:43,644 the underlying contradictions that get generated by IRR. 1371 01:02:43,644 --> 01:02:45,310 You don't have to solve the Riemann zeta 1372 01:02:45,310 --> 01:02:49,510 hypothesis to understand it, but you can get very, very complex, 1373 01:02:49,510 --> 01:02:55,000 very quickly by looking at these kinds of patterns. 1374 01:02:55,000 --> 01:02:57,940 In fact, it would be bad news for us 1375 01:02:57,940 --> 01:03:01,000 if these patterns actually mattered for investing. 1376 01:03:01,000 --> 01:03:02,170 The fact is they don't. 1377 01:03:02,170 --> 01:03:04,330 The bottom line is NPV. 1378 01:03:04,330 --> 01:03:06,280 How much money are you generating 1379 01:03:06,280 --> 01:03:08,270 from this investment, period. 1380 01:03:08,270 --> 01:03:10,180 And if you focus on that, you're not 1381 01:03:10,180 --> 01:03:12,130 likely to make a lot of mistakes. 1382 01:03:12,130 --> 01:03:15,650 But you should at least be aware about these other techniques. 1383 01:03:15,650 --> 01:03:17,200 So that's why I went over them. 1384 01:03:17,200 --> 01:03:18,054 Yeah, David? 1385 01:03:18,054 --> 01:03:19,720 AUDIENCE: Can you talk a little bit more 1386 01:03:19,720 --> 01:03:24,780 about social, political, and cultural risks. 1387 01:03:24,780 --> 01:03:29,346 From the perspective of the CFO of a company for example, 1388 01:03:29,346 --> 01:03:32,490 who has to make a decision on whether and where to invest. 1389 01:03:32,490 --> 01:03:37,170 It makes sense that there will be some political implications 1390 01:03:37,170 --> 01:03:39,900 that cannot be captured by every model. 1391 01:03:39,900 --> 01:03:42,570 But if I'm a private investor and I 1392 01:03:42,570 --> 01:03:45,660 invest in a company that is listed in a stock exchange, 1393 01:03:45,660 --> 01:03:49,320 I would expect all these considerations to be captured 1394 01:03:49,320 --> 01:03:52,800 already in the stock price. 1395 01:03:52,800 --> 01:03:55,410 ANDREW LO: Well, yes and no. 1396 01:03:55,410 --> 01:03:57,802 Let me give you an example that is 1397 01:03:57,802 --> 01:03:59,010 a somewhat controversial one. 1398 01:03:59,010 --> 01:04:00,660 I don't really know the answer to it, 1399 01:04:00,660 --> 01:04:02,034 but at least we can talk about it 1400 01:04:02,034 --> 01:04:03,660 in the context of current events. 1401 01:04:06,022 --> 01:04:07,480 If you take a look at what happened 1402 01:04:07,480 --> 01:04:12,340 with Bear Stearns versus what happened with Lehman Brothers. 1403 01:04:12,340 --> 01:04:17,560 It's kind of hard to understand why what happened, happened. 1404 01:04:17,560 --> 01:04:20,350 Bear Stearns was deemed too big to fail. 1405 01:04:20,350 --> 01:04:25,600 And so it was navigated to a soft landing with JP Morgan. 1406 01:04:25,600 --> 01:04:28,450 Lehman on the other hand, which in certain respects 1407 01:04:28,450 --> 01:04:30,940 was even bigger and even more broadly 1408 01:04:30,940 --> 01:04:37,100 intertwined in our financial system, was allowed to fail. 1409 01:04:37,100 --> 01:04:40,140 I don't understand that from an economic perspective. 1410 01:04:40,140 --> 01:04:43,790 In fact, I'm not sure there is an economic perspective to why 1411 01:04:43,790 --> 01:04:46,100 it failed. 1412 01:04:46,100 --> 01:04:48,530 But there may be a political dimension. 1413 01:04:48,530 --> 01:04:51,950 For example, and again this is pure speculation, 1414 01:04:51,950 --> 01:04:55,910 so asking me for my views on political elements, 1415 01:04:55,910 --> 01:04:56,990 I'm happy to provide. 1416 01:04:56,990 --> 01:05:00,560 But it's like asking Roger Federer what 1417 01:05:00,560 --> 01:05:02,460 he thinks about the S&P 500. 1418 01:05:02,460 --> 01:05:06,410 Not that I'm Roger Federer, but it's 1419 01:05:06,410 --> 01:05:08,690 asking somebody who's a professional in one area what 1420 01:05:08,690 --> 01:05:10,023 they think about something else. 1421 01:05:10,023 --> 01:05:12,290 I'm not sure it's a good idea. 1422 01:05:12,290 --> 01:05:14,690 But the point is that my conjecture 1423 01:05:14,690 --> 01:05:18,230 is that the reason Lehman Brothers was left to fail 1424 01:05:18,230 --> 01:05:21,620 was because there was so much criticism and backlash 1425 01:05:21,620 --> 01:05:26,720 from the Bear Stearns event that both Treasury and the Federal 1426 01:05:26,720 --> 01:05:31,100 Reserve thought that it was politically untenable for them 1427 01:05:31,100 --> 01:05:32,420 to do it again. 1428 01:05:32,420 --> 01:05:34,670 Because if they did it again, then they 1429 01:05:34,670 --> 01:05:36,290 would be expected to do it again, 1430 01:05:36,290 --> 01:05:37,650 and again, and again, and again. 1431 01:05:37,650 --> 01:05:40,520 In which case, all the firms would be in line 1432 01:05:40,520 --> 01:05:42,520 to try to get a bailout. 1433 01:05:42,520 --> 01:05:45,380 And they are. 1434 01:05:45,380 --> 01:05:48,600 However, to highlight the complexity, 1435 01:05:48,600 --> 01:05:51,860 to highlight the complexity of the political dimension, 1436 01:05:51,860 --> 01:05:55,940 now that Lehman did fail and it caused 1437 01:05:55,940 --> 01:06:00,980 such disastrous consequences, now maybe it's truly impossible 1438 01:06:00,980 --> 01:06:02,637 to let any company fail. 1439 01:06:02,637 --> 01:06:04,970 Because people will say, oh you remember Lehman Brothers 1440 01:06:04,970 --> 01:06:05,970 and what happened there? 1441 01:06:05,970 --> 01:06:07,670 You better not do that again. 1442 01:06:07,670 --> 01:06:11,060 So I don't know the answer to the question about what 1443 01:06:11,060 --> 01:06:14,750 the political landscape is going to look like a year from now, 1444 01:06:14,750 --> 01:06:17,010 or even six months from now. 1445 01:06:17,010 --> 01:06:19,010 So I don't know whether or not it's 1446 01:06:19,010 --> 01:06:21,620 significant in terms of what will happen, 1447 01:06:21,620 --> 01:06:25,220 but surely in the past, politics has played a very big role, 1448 01:06:25,220 --> 01:06:26,714 even for private investors. 1449 01:06:26,714 --> 01:06:29,130 But that actually wasn't the politics I was talking about. 1450 01:06:29,130 --> 01:06:31,217 That certainly matters a great deal now, 1451 01:06:31,217 --> 01:06:33,050 but the kind of politics I was talking about 1452 01:06:33,050 --> 01:06:35,070 was more within a company. 1453 01:06:35,070 --> 01:06:37,340 So I'll give you an example. 1454 01:06:37,340 --> 01:06:38,930 You're a new division manager that 1455 01:06:38,930 --> 01:06:43,970 was specifically hired by the CEO to turn around a division. 1456 01:06:43,970 --> 01:06:47,270 And in your first quarter on the job, 1457 01:06:47,270 --> 01:06:50,720 you propose a very specific restructuring 1458 01:06:50,720 --> 01:06:53,210 for that division. 1459 01:06:53,210 --> 01:06:56,950 Chances are the CEO is going to agree with you. 1460 01:06:56,950 --> 01:06:58,700 Knowing nothing about whether the proposal 1461 01:06:58,700 --> 01:07:01,992 is smart, or stupid, or good, or bad, 1462 01:07:01,992 --> 01:07:03,950 most likely, the CEO's going to agree with you. 1463 01:07:03,950 --> 01:07:04,730 Why is that? 1464 01:07:04,730 --> 01:07:05,630 You know why, right? 1465 01:07:05,630 --> 01:07:07,340 You guys agree with me. 1466 01:07:07,340 --> 01:07:10,004 If you agree with me, that means that you understand something 1467 01:07:10,004 --> 01:07:11,420 about the political situation that 1468 01:07:11,420 --> 01:07:14,720 has nothing to do with P&L, nothing to do with NPV, nothing 1469 01:07:14,720 --> 01:07:17,060 to do with cost of capital or risk adjustment. 1470 01:07:17,060 --> 01:07:19,160 Somebody just hired you to do a job 1471 01:07:19,160 --> 01:07:21,419 and they're going to have to give you 1472 01:07:21,419 --> 01:07:23,210 the benefit of the doubt for a little while 1473 01:07:23,210 --> 01:07:25,550 before they can pull in the reins. 1474 01:07:25,550 --> 01:07:27,830 That's what I mean by political considerations. 1475 01:07:27,830 --> 01:07:30,080 So when you're thinking about capital budgeting, 1476 01:07:30,080 --> 01:07:33,157 you've got to factor in all of these considerations. 1477 01:07:33,157 --> 01:07:33,740 Which is hard. 1478 01:07:33,740 --> 01:07:37,280 It's what makes business both an art and a science. 1479 01:07:37,280 --> 01:07:40,220 You need to have both of those elements represented. 1480 01:07:40,220 --> 01:07:41,810 And I just wanted to bring that up 1481 01:07:41,810 --> 01:07:45,770 to remind you not to forget about those elements. 1482 01:07:45,770 --> 01:07:48,740 Economists have a very bad habit, myself included. 1483 01:07:48,740 --> 01:07:51,950 We think that everything is economic. 1484 01:07:51,950 --> 01:07:54,840 Someone said that to a person that owns a hammer, 1485 01:07:54,840 --> 01:07:57,140 everything looks like a nail. 1486 01:07:57,140 --> 01:07:57,942 And I agree. 1487 01:07:57,942 --> 01:07:59,400 As an economist, I have these tools 1488 01:07:59,400 --> 01:08:01,230 that I think apply to everything. 1489 01:08:01,230 --> 01:08:03,860 And there's a danger that as an economist, 1490 01:08:03,860 --> 01:08:06,640 I see everything from the economic perspective. 1491 01:08:06,640 --> 01:08:08,660 And it's only after you've been hit 1492 01:08:08,660 --> 01:08:11,591 over the head with a bunch of failures of your theories 1493 01:08:11,591 --> 01:08:13,340 that you'll begin to realize maybe there's 1494 01:08:13,340 --> 01:08:15,950 something else out there that's explaining behavior. 1495 01:08:15,950 --> 01:08:18,149 Which I'm going to talk about next. 1496 01:08:18,149 --> 01:08:21,229 But the traditional approach of economists 1497 01:08:21,229 --> 01:08:23,490 is to assume that everybody is rational, 1498 01:08:23,490 --> 01:08:26,510 everybody's maximizing NPV, the markets work efficiently. 1499 01:08:26,510 --> 01:08:28,350 And by the way, if that's the case, 1500 01:08:28,350 --> 01:08:30,540 then your job is really easy. 1501 01:08:30,540 --> 01:08:34,100 What makes it hard, and I would argue fun and challenging, 1502 01:08:34,100 --> 01:08:35,810 is all the other stuff that makes 1503 01:08:35,810 --> 01:08:38,930 this stuff not work the way it's supposed to all the time. 1504 01:08:38,930 --> 01:08:42,319 You have to know when to use these methods 1505 01:08:42,319 --> 01:08:44,149 and when to use other methods in order 1506 01:08:44,149 --> 01:08:47,420 to be able to advance your particular objectives. 1507 01:08:47,420 --> 01:08:49,640 And ultimately, you have to understand exactly 1508 01:08:49,640 --> 01:08:52,200 what kind of objectives you want to achieve. 1509 01:08:52,200 --> 01:08:54,200 So that's going to actually be the topic 1510 01:08:54,200 --> 01:08:57,680 of the latter part of the next lecture, is objectives. 1511 01:08:57,680 --> 01:09:00,350 I've told you up until now that the objective for most 1512 01:09:00,350 --> 01:09:05,000 shareholders and most corporate managers is to maximize NPV. 1513 01:09:05,000 --> 01:09:08,970 That is an approximation to a much more complex reality. 1514 01:09:08,970 --> 01:09:12,500 So I'm about to change your view of that reality 1515 01:09:12,500 --> 01:09:16,590 over the next lecture and a half. 1516 01:09:16,590 --> 01:09:18,380 Any other questions? 1517 01:09:22,069 --> 01:09:25,490 This concludes our lecture on capital budgeting, 1518 01:09:25,490 --> 01:09:28,760 and what I want to turn to now is the last lecture 1519 01:09:28,760 --> 01:09:34,080 of the course, which is efficient markets, lecture 21. 1520 01:09:34,080 --> 01:09:37,529 I'm going to get started on this just very briefly 1521 01:09:37,529 --> 01:09:40,569 today, because we're almost out of time. 1522 01:09:40,569 --> 01:09:43,710 We've got about another 10 minutes or so. 1523 01:09:43,710 --> 01:09:46,890 I want to give you an overview of where we're going 1524 01:09:46,890 --> 01:09:49,680 and why we're going to do this lecture. 1525 01:09:49,680 --> 01:09:52,680 Typically, efficient markets is a lecture 1526 01:09:52,680 --> 01:09:56,370 that is given in most corporate finance and Introductory 1527 01:09:56,370 --> 01:09:59,732 finance courses at the beginning of the course. 1528 01:09:59,732 --> 01:10:01,440 And the reason it's done at the beginning 1529 01:10:01,440 --> 01:10:05,550 is because actually, we need this efficient markets 1530 01:10:05,550 --> 01:10:09,450 hypothesis to justify most of what I taught you 1531 01:10:09,450 --> 01:10:12,960 over the last 13 weeks. 1532 01:10:12,960 --> 01:10:16,130 Let me explain why that is. 1533 01:10:16,130 --> 01:10:18,460 For the longest time now in this course, 1534 01:10:18,460 --> 01:10:21,860 I've kept repeating that when we need a discount rate, when 1535 01:10:21,860 --> 01:10:25,790 we need a price, when we need a value, where do we go? 1536 01:10:25,790 --> 01:10:26,510 To the market. 1537 01:10:26,510 --> 01:10:27,500 All of you, right? 1538 01:10:27,500 --> 01:10:28,190 And we did that. 1539 01:10:28,190 --> 01:10:31,310 The first day of class, I auctioned off certain items 1540 01:10:31,310 --> 01:10:34,770 and we engaged in price discovery. 1541 01:10:34,770 --> 01:10:38,190 That's an enormous benefit, this wisdom of crowds 1542 01:10:38,190 --> 01:10:39,750 that we relied on. 1543 01:10:39,750 --> 01:10:41,670 And that's why at the very beginning of most 1544 01:10:41,670 --> 01:10:44,970 of these finance courses, we typically teach our students 1545 01:10:44,970 --> 01:10:46,860 to trust in the market. 1546 01:10:46,860 --> 01:10:48,480 Now I didn't do that in this course 1547 01:10:48,480 --> 01:10:50,760 because I don't want you to trust the market. 1548 01:10:50,760 --> 01:10:53,550 I want you to learn from experience when to trust 1549 01:10:53,550 --> 01:10:55,710 the market, and when not to. 1550 01:10:55,710 --> 01:10:59,610 But the fact of the matter is the theories that we rely on, 1551 01:10:59,610 --> 01:11:03,370 this notion of risk adjustment, this cost of capital, 1552 01:11:03,370 --> 01:11:04,770 this CAPM. 1553 01:11:04,770 --> 01:11:07,920 All of that relies on people being rational. 1554 01:11:07,920 --> 01:11:10,800 It relies on all of you in this room wanting 1555 01:11:10,800 --> 01:11:13,320 to hold the tangency portfolio. 1556 01:11:13,320 --> 01:11:16,620 It relies on supply equaling demand. 1557 01:11:16,620 --> 01:11:22,320 And unless we have that kind of behavior, a lot of our results 1558 01:11:22,320 --> 01:11:24,340 go out the window. 1559 01:11:24,340 --> 01:11:27,700 So I want to talk about the justification 1560 01:11:27,700 --> 01:11:30,760 for that assumption in this particular lecture. 1561 01:11:30,760 --> 01:11:32,920 I told you that I'm going to tie together 1562 01:11:32,920 --> 01:11:34,570 all the various different loose strands 1563 01:11:34,570 --> 01:11:36,970 of the course in this one lecture, 1564 01:11:36,970 --> 01:11:38,800 and I do mean to do that. 1565 01:11:38,800 --> 01:11:40,874 What I'm going to do is first of all, 1566 01:11:40,874 --> 01:11:42,540 make an argument for why it is you ought 1567 01:11:42,540 --> 01:11:43,780 to trust in market prices. 1568 01:11:43,780 --> 01:11:49,320 Why the wisdom of crowds is very wise, most of the time. 1569 01:11:49,320 --> 01:11:52,290 But then I want to spend the bulk of this lecture telling 1570 01:11:52,290 --> 01:11:54,079 you why it can break down. 1571 01:11:54,079 --> 01:11:55,620 Now, I don't think I need to tell you 1572 01:11:55,620 --> 01:11:57,090 that after the last 13 weeks. 1573 01:11:57,090 --> 01:11:59,910 You've sort of seen that in real time. 1574 01:11:59,910 --> 01:12:04,140 But I want to give you an understanding of what happened. 1575 01:12:04,140 --> 01:12:07,170 And actually, I'm going to be able to provide you 1576 01:12:07,170 --> 01:12:10,530 with a complete and satisfactory theory that 1577 01:12:10,530 --> 01:12:13,560 makes sense of everything that has happened over the last 13 1578 01:12:13,560 --> 01:12:14,340 weeks. 1579 01:12:14,340 --> 01:12:17,940 You may be skeptical about that, but I promise you, 1580 01:12:17,940 --> 01:12:20,040 it will be true. 1581 01:12:20,040 --> 01:12:23,310 I have a theory, which is not generally accepted. 1582 01:12:23,310 --> 01:12:25,329 So I've got to start with that disclaimer. 1583 01:12:25,329 --> 01:12:27,120 This is a theory that I'm going to tell you 1584 01:12:27,120 --> 01:12:31,020 that is my own pet theory, it's not in any textbook 1585 01:12:31,020 --> 01:12:33,514 because it's relatively new. 1586 01:12:33,514 --> 01:12:35,430 And if you do a search for it on the internet, 1587 01:12:35,430 --> 01:12:38,070 my name was the only name that's going to come up. 1588 01:12:38,070 --> 01:12:39,830 So that's both good and bad. 1589 01:12:39,830 --> 01:12:41,661 You're hearing it from the horse's mouth, 1590 01:12:41,661 --> 01:12:43,410 but it is a horse that's telling you this. 1591 01:12:46,577 --> 01:12:48,660 I'm going to start by first explaining to you what 1592 01:12:48,660 --> 01:12:50,430 efficient markets is. 1593 01:12:50,430 --> 01:12:51,930 I think you already know, right? 1594 01:12:51,930 --> 01:12:53,460 You can trust the market prices. 1595 01:12:53,460 --> 01:12:57,030 The market price tells you what you need to know. 1596 01:12:57,030 --> 01:12:59,730 And after I make that argument, I'm 1597 01:12:59,730 --> 01:13:01,260 going to then turn around and take 1598 01:13:01,260 --> 01:13:03,090 the other side of the debate, and give you 1599 01:13:03,090 --> 01:13:07,380 all the reasons why people are irrational, silly, mistaken, 1600 01:13:07,380 --> 01:13:11,160 stupid, all of the reasons that psychologists tell us markets 1601 01:13:11,160 --> 01:13:14,379 are crazy, and you should never trust in market prices. 1602 01:13:14,379 --> 01:13:16,170 And then I'm going to try to bring together 1603 01:13:16,170 --> 01:13:18,240 the two sides of the debate using 1604 01:13:18,240 --> 01:13:21,510 some recent research from the cognitive neurosciences. 1605 01:13:21,510 --> 01:13:24,240 So I'm going to actually talk a bit about the neurophysiology 1606 01:13:24,240 --> 01:13:26,312 of the brain, and it turns out that that research 1607 01:13:26,312 --> 01:13:28,770 is going to be directly relevant to how we interpret what's 1608 01:13:28,770 --> 01:13:33,570 been going on over the last 13 weeks, over the last 130 years. 1609 01:13:33,570 --> 01:13:38,010 Let me start with that argument about efficient markets. 1610 01:13:38,010 --> 01:13:42,300 Market efficiency says that there's no free lunch, 1611 01:13:42,300 --> 01:13:44,730 there's no arbitrage, you don't get something for nothing, 1612 01:13:44,730 --> 01:13:47,370 prices fully reflect all available information, 1613 01:13:47,370 --> 01:13:50,940 and there's no way to make money in the marketplace. 1614 01:13:50,940 --> 01:13:55,080 Active management does not add any value. 1615 01:13:55,080 --> 01:13:59,130 Now, if you really believe this, why are you here? 1616 01:13:59,130 --> 01:14:00,800 Why are you taking finance? 1617 01:14:00,800 --> 01:14:03,410 Well, it turns out that there is a reason for taking finance 1618 01:14:03,410 --> 01:14:05,700 even if this is true, which is that finance 1619 01:14:05,700 --> 01:14:09,620 is the language by which you conduct discussion and analysis 1620 01:14:09,620 --> 01:14:11,570 in business negotiations. 1621 01:14:11,570 --> 01:14:15,860 But even apart from this, I would argue that most of you 1622 01:14:15,860 --> 01:14:18,230 are probably thinking you can beat 1623 01:14:18,230 --> 01:14:20,060 the market if you work hard enough 1624 01:14:20,060 --> 01:14:21,620 and if you're smart enough. 1625 01:14:21,620 --> 01:14:24,170 That's not the perspective of modern finance theory. 1626 01:14:24,170 --> 01:14:26,420 So remember I was telling you the difference to Warren 1627 01:14:26,420 --> 01:14:28,130 Buffett and modern finance. 1628 01:14:28,130 --> 01:14:29,480 They do part company. 1629 01:14:29,480 --> 01:14:31,340 Warren Buffett literally believes 1630 01:14:31,340 --> 01:14:34,780 that he can pick stocks better than you and I can. 1631 01:14:34,780 --> 01:14:37,150 And what academics would have you believe 1632 01:14:37,150 --> 01:14:40,060 is that nobody can pick stocks, that it's all luck, 1633 01:14:40,060 --> 01:14:41,710 and what you ought to do is simply buy 1634 01:14:41,710 --> 01:14:43,300 the tangency portfolio. 1635 01:14:43,300 --> 01:14:45,550 It's going to turn out that both of these perspectives 1636 01:14:45,550 --> 01:14:48,610 are wrong, and they're right in very specific ways, 1637 01:14:48,610 --> 01:14:51,730 and I'm going to show you how to put it together. 1638 01:14:51,730 --> 01:14:53,230 But let me first start by motivating 1639 01:14:53,230 --> 01:14:54,970 this idea of efficient markets. 1640 01:14:54,970 --> 01:14:59,320 Why you cannot make money, why all information is incorporated 1641 01:14:59,320 --> 01:15:00,310 into market prices. 1642 01:15:00,310 --> 01:15:02,920 And to do that, I'm going to tell you about a research 1643 01:15:02,920 --> 01:15:06,550 paper that was published in 2003 by two economists, Michael 1644 01:15:06,550 --> 01:15:10,294 Maloney and Herold Mulhearn, titled the complexity 1645 01:15:10,294 --> 01:15:12,460 of price discovery in an efficient market, the stock 1646 01:15:12,460 --> 01:15:16,891 market reaction to the Challenger crash. 1647 01:15:16,891 --> 01:15:19,190 Now this is a rather somber subject. 1648 01:15:19,190 --> 01:15:23,570 It has to do with an event that occurred on January 28, 1986, 1649 01:15:23,570 --> 01:15:26,270 at 11:39 AM. 1650 01:15:26,270 --> 01:15:29,540 At that time, the Challenger space shuttle 1651 01:15:29,540 --> 01:15:32,810 exploded before our very eyes. 1652 01:15:32,810 --> 01:15:35,570 Apparently, one of the booster rockets 1653 01:15:35,570 --> 01:15:39,590 ignited and destroyed the space shuttle. 1654 01:15:39,590 --> 01:15:43,340 11: 47, the space shuttle was reported to have exploded. 1655 01:15:43,340 --> 01:15:49,400 It came across the news wire 12:17, Lockheed, 1656 01:15:49,400 --> 01:15:51,920 which is one of the contractors that built the shuttle, 1657 01:15:51,920 --> 01:15:53,390 had no comment. 1658 01:15:53,390 --> 01:15:57,080 12:52, Rockwell International, another one of the vendors 1659 01:15:57,080 --> 01:16:00,050 that built parts for the space shuttle, they had no comment. 1660 01:16:00,050 --> 01:16:02,820 This is all through the news wire. 1661 01:16:02,820 --> 01:16:06,750 And over the course of the next several months, 1662 01:16:06,750 --> 01:16:10,620 a presidential commission was impaneled 1663 01:16:10,620 --> 01:16:15,270 to study what happened with the space shuttle explosion. 1664 01:16:15,270 --> 01:16:17,220 And many of you know, the physicist 1665 01:16:17,220 --> 01:16:19,410 Richard Feynman was on that panel 1666 01:16:19,410 --> 01:16:22,980 and wrote a dissenting opinion about what happened. 1667 01:16:22,980 --> 01:16:25,560 But the bottom line, after all the dust settled, 1668 01:16:25,560 --> 01:16:30,120 was that in June of that year, so about six months later, 1669 01:16:30,120 --> 01:16:32,280 there was a report that was produced 1670 01:16:32,280 --> 01:16:36,570 that showed that it was an O-ring, a piece of rubber, 1671 01:16:36,570 --> 01:16:40,920 around a booster rocket that ended up becoming brittle. 1672 01:16:40,920 --> 01:16:43,520 And because it became brittle in the cold weather, 1673 01:16:43,520 --> 01:16:46,230 there were gases that leaked from that booster rocket, 1674 01:16:46,230 --> 01:16:49,150 and those gases ignited after take off. 1675 01:16:49,150 --> 01:16:51,450 And so in the end, after all of this analysis, 1676 01:16:51,450 --> 01:16:55,320 it was determined that the O-ring was at fault. 1677 01:16:55,320 --> 01:16:58,020 And who produced this O-ring and the rocket? 1678 01:16:58,020 --> 01:16:59,020 It was Morton Thiokol. 1679 01:17:01,620 --> 01:17:04,920 They were the culprit, or the weak link in all of this, 1680 01:17:04,920 --> 01:17:06,210 according to this study. 1681 01:17:08,790 --> 01:17:14,560 Now, this was on June 9, 1986. 1682 01:17:14,560 --> 01:17:19,510 Let me show you what happened to the stock prices of all 1683 01:17:19,510 --> 01:17:23,930 of the different vendors for space shuttle parts, 1684 01:17:23,930 --> 01:17:27,380 right after the explosion on January the 28th, 1685 01:17:27,380 --> 01:17:30,580 six months earlier. 1686 01:17:30,580 --> 01:17:32,350 Let me show you a graph. 1687 01:17:32,350 --> 01:17:34,960 There are four vendors. 1688 01:17:34,960 --> 01:17:40,220 Lockheed, Martin Marietta, Rockwell, and Martin Thiokol. 1689 01:17:40,220 --> 01:17:46,010 And these are the tick-by-tick price changes, all normalized 1690 01:17:46,010 --> 01:17:51,530 to start at $1 at the very beginning of the sample, which 1691 01:17:51,530 --> 01:17:57,380 was at 11 o'clock, or 11:39, when the shuttle exploded. 1692 01:17:57,380 --> 01:17:58,880 So this is where we start, we all 1693 01:17:58,880 --> 01:18:02,420 start with them at a dollar. 1694 01:18:02,420 --> 01:18:06,890 Within minutes of the explosion, I'm talking minutes now, 1695 01:18:06,890 --> 01:18:08,450 not nine months or six months. 1696 01:18:08,450 --> 01:18:13,670 Within minutes, we see that the stock price that gets 1697 01:18:13,670 --> 01:18:18,770 hit the hardest is Morton Thiokol. 1698 01:18:18,770 --> 01:18:20,390 All of them get hit. 1699 01:18:20,390 --> 01:18:23,630 But by 1 o'clock, Morton Thiokol's price 1700 01:18:23,630 --> 01:18:25,012 is down below all the others. 1701 01:18:25,012 --> 01:18:27,470 And this is all normalized so that they all start off at 1. 1702 01:18:27,470 --> 01:18:30,560 So it's not difference of scale, I've rescaled them. 1703 01:18:30,560 --> 01:18:33,440 And moreover, at the close of trading 1704 01:18:33,440 --> 01:18:39,140 on that day, the only stock that was down significantly, 1705 01:18:39,140 --> 01:18:42,370 the only one, was Morton Thiokol. 1706 01:18:42,370 --> 01:18:44,020 They had to stop trading in that stock 1707 01:18:44,020 --> 01:18:45,145 because it was down so far. 1708 01:18:47,560 --> 01:18:52,250 This happened in less than six hours. 1709 01:18:52,250 --> 01:18:55,190 It took the commission six months 1710 01:18:55,190 --> 01:18:57,750 to come up with the O-ring and Morton Thiokol. 1711 01:18:57,750 --> 01:19:01,910 Now, if you look at this, you don't see an O-ring. 1712 01:19:01,910 --> 01:19:03,920 But you see Morton Thiokol. 1713 01:19:03,920 --> 01:19:06,909 Plain and simple, like a sore thumb. 1714 01:19:06,909 --> 01:19:08,200 This is what I'm talking about. 1715 01:19:08,200 --> 01:19:11,037 This is the wisdom of crowds. 1716 01:19:11,037 --> 01:19:12,870 This is why, when you look at market prices, 1717 01:19:12,870 --> 01:19:15,036 you should look at them with a certain degree of awe 1718 01:19:15,036 --> 01:19:16,230 and respect. 1719 01:19:16,230 --> 01:19:18,750 It's because it aggregates information 1720 01:19:18,750 --> 01:19:20,340 like you wouldn't believe. 1721 01:19:20,340 --> 01:19:21,840 It's phenomenal. 1722 01:19:21,840 --> 01:19:24,240 So this is what economists like to trot out 1723 01:19:24,240 --> 01:19:26,370 and say, see I told you so. 1724 01:19:26,370 --> 01:19:28,211 This is what we're good at. 1725 01:19:28,211 --> 01:19:30,210 What I'm going to talk to you about on Wednesday 1726 01:19:30,210 --> 01:19:33,750 is all of the other examples of where this fails. 1727 01:19:33,750 --> 01:19:35,012 So this is the good news. 1728 01:19:35,012 --> 01:19:37,220 On Wednesday, we're going to talk about the bad news. 1729 01:19:37,220 --> 01:19:39,360 OK, see you then.