1

00:00:01,139 --> 00:00:01,990

welcome back

2
00:00:01,990 --> 00:00:03,889
our last topic in

3
00:00:03,889 --> 00:00:07,620
the chapter on the basic theory of
interest is the

4
00:00:07,620 --> 00:00:10,379
use of internal rate of return and

5
00:00:10,379 --> 00:00:15,869
uh... present value to rank different
investments

6
00:00:15,869 --> 00:00:20,659
to rank different invesments we can use
the net present value founded on the

7
00:00:20,659 --> 00:00:21,880
present value

8
00:00:21,880 --> 00:00:25,359
net present value simply is the present
value

9
00:00:25,359 --> 00:00:30,080
of the benefits minus the present value
of the costs

10
00:00:30,080 --> 00:00:31,319
of investment

11
00:00:31,319 --> 00:00:36,199
so that's simply to highlight the
fact that might be costs associated with

12
00:00:36,199 --> 00:00:39,450
investments that need to be taken into
account

13
00:00:39,450 --> 00:00:41,450
so it's also obvious that
14
00:00:41,450 --> 00:00:43,730
the greater a

15
00:00:43,730 --> 00:00:46,020
net present value, NPV,

16
00:00:46,020 --> 00:00:47,040
the better

17
00:00:47,040 --> 00:00:50,560
so we would prefer investments with the
greater

18
00:00:50,560 --> 00:00:52,980
net present value

19
00:00:52,980 --> 00:00:55,220
it's worth highlighting that

20
00:00:55,220 --> 00:01:00,910
we desire only projects where NPV exceeds

21
00:01:00,910 --> 00:01:03,100
uh... zero

22
00:01:03,100 --> 00:01:07,840
projects with NPV of less than
zero involve a loss of money

23
00:01:07,840 --> 00:01:10,850
and so are not desirable

24
00:01:10,850 --> 00:01:12,300
the NPV

25
00:01:12,300 --> 00:01:14,049
rule to rank

26
00:01:14,049 --> 00:01:16,960
an investment opportunity has

27
00:01:16,960 --> 00:01:20,390
several desirable properties
one of them is
28
00:01:20,390 --> 00:01:22,140
that's

29
00:01:22,140 --> 00:01:23,380
it is linear

30
00:01:23,380 --> 00:01:26,420
meaning that the NPV

31
00:01:26,420 --> 00:01:28,560
so the NPV of a sum of cash flows

32
00:01:28,560 --> 00:01:31,240
is equal to the sum

33
00:01:31,240 --> 00:01:35,790
of the NPVs of the individual
component cash flows so that is

34
00:01:35,790 --> 00:01:37,460
linearity property

35
00:01:37,460 --> 00:01:39,250
becomes very natural

36
00:01:39,250 --> 00:01:41,680
with pricing rule

37
00:01:41,680 --> 00:01:45,579
and we'll see later on if we
generalize the

38
00:01:45,579 --> 00:01:50,810
present value to a situation that
involves uncertainty if you talk about

39
00:01:50,810 --> 00:01:52,370
arbitrage then

40
00:01:52,370 --> 00:01:54,729
the linearity of

41
00:01:54,729 --> 00:01:56,509
the present value
42
00:01:56,509 --> 00:01:57,810
pricing rule

43
00:01:57,810 --> 00:02:01,890
will play an important
a fundamental role so

44
00:02:01,890 --> 00:02:03,250
linearity

45
00:02:03,250 --> 00:02:05,800
is a good property

46
00:02:05,800 --> 00:02:10,340
another property that is good is at
least in principle is that there's no

47
00:02:10,340 --> 00:02:13,680
ambiguity with the computation

48
00:02:13,680 --> 00:02:15,869
of the present value

49
00:02:15,869 --> 00:02:16,889
so

50
00:02:16,889 --> 00:02:18,049
uh...

51
00:02:18,049 --> 00:02:21,959
i mentioned this since for the internal
rate of return

52
00:02:21,959 --> 00:02:24,190
there might be potential

53
00:02:24,190 --> 00:02:29,229
ambiguity with the computation
that arises in certain situations that are

54
00:02:29,229 --> 00:02:30,989
uncommon

55
00:02:30,989 --> 00:02:32,279
in finance however
56
00:02:32,279 --> 00:02:36,319
so it's not that i want to
overly emphasize the point that's

57
00:02:36,319 --> 00:02:39,859
a point that's more valid on
theoretical grounds

58
00:02:39,859 --> 00:02:43,109
a property that's less desirable is

59
00:02:43,109 --> 00:02:45,489
that the present value

60
00:02:45,489 --> 00:02:47,710
the computational of the net present value

61
00:02:47,710 --> 00:02:51,519
requires the concept, requires the
definition of

62
00:02:51,519 --> 00:02:52,870
an external

63
00:02:52,870 --> 00:02:55,229
benchmark interest rate r

64
00:02:55,229 --> 00:03:00,869
and in practice that benchmark rate
is not always easily defined

65
00:03:00,869 --> 00:03:05,759
now the internal rate of return is an alternative
criterion that we can use to rank

66
00:03:05,759 --> 00:03:08,139
different investments

67
00:03:08,139 --> 00:03:10,849
and it's also clear that we would prefer

68
00:03:10,849 --> 00:03:12,940
uh... streams that

69
00:03:12,940 --> 00:03:16,540
has a greater internal rate of return

70
00:03:16,540 --> 00:03:18,749
if that internal rate of return

71
00:03:18,749 --> 00:03:19,859
uh... is

72
00:03:19,859 --> 00:03:22,180
greater then

73
00:03:22,180 --> 00:03:25,430
benchmark rate - again

74
00:03:25,430 --> 00:03:27,150
we wish that we

75
00:03:27,150 --> 00:03:28,699
we get at least

76
00:03:28,699 --> 00:03:31,949
some excess return over
benchmark rate

77
00:03:31,949 --> 00:03:32,599
that

78
00:03:32,599 --> 00:03:34,180
we would get, say,

79
00:03:34,180 --> 00:03:38,389
by investing our funds into a simple
interest-bearing

80
00:03:38,389 --> 00:03:40,450
account

81
00:03:40,450 --> 00:03:44,469
so if we have the opportunity to, say,
earn three percent

82
00:03:44,469 --> 00:03:45,209
in a

83
00:03:45,209 --> 00:03:49,259
interest-bearing bank account with no
risk then

84
00:03:49,259 --> 00:03:50,069
uh...

85
00:03:50,069 --> 00:03:51,139
any

86
00:03:51,139 --> 00:03:56,980
investment should yield at least
those three percent to be worthwhile

87
00:03:56,980 --> 00:03:58,779
investments

88
00:03:58,779 --> 00:04:02,979
unlike the net present value, the
internal rate of return cannot be

89
00:04:02,979 --> 00:04:05,149
broken up into components

90
00:04:05,149 --> 00:04:06,259
so

91
00:04:06,259 --> 00:04:08,840
the internal rate of return is not

92
00:04:08,840 --> 00:04:12,339
linear as the present value

93
00:04:12,339 --> 00:04:13,599
who is

94
00:04:13,599 --> 00:04:14,469
um...

95
00:04:14,469 --> 00:04:15,530
we also

96
00:04:15,530 --> 00:04:19,019
discussed settings in which

97
00:04:19,019 --> 00:04:21,319
the internal rate of return problem

98
00:04:21,319 --> 00:04:23,620
may be ill-posed

99
00:04:23,620 --> 00:04:24,460
so

100
00:04:24,460 --> 00:04:30,110
although again this is not a
consideration in most situations there's

101
00:04:30,110 --> 00:04:32,310
a possibility that exists

102
00:04:32,310 --> 00:04:34,770
uh... finally that's a good

103
00:04:34,770 --> 00:04:36,409
attribute

104
00:04:36,409 --> 00:04:39,330
that the internal rate of return does
not

105
00:04:39,330 --> 00:04:41,729
require the definition of an external
bank

106
00:04:41,729 --> 00:04:45,270
benchmark rate as the net
present value does. there's only

107
00:04:45,270 --> 00:04:46,129
one

108
00:04:46,129 --> 00:04:48,639
benchmark rate that we need to know to
decide

109
00:04:48,639 --> 00:04:50,180
whether

110
00:04:50,180 --> 00:04:54,710
the project whose internal rate of
return is computed is worthwhile

111
00:04:54,710 --> 00:04:58,979
to begin with namely is that
internal rate of return is actually

112
00:04:58,979 --> 00:05:01,969
exceeding some external

113
00:05:01,969 --> 00:05:03,449
bank

114
00:05:03,449 --> 00:05:07,479
say, deposit rate

115
00:05:07,479 --> 00:05:10,949
here's a simple example that's
somewhat contrived that

116
00:05:10,949 --> 00:05:12,710
that sort of

117
00:05:12,710 --> 00:05:16,289
gives you an idea of how these concepts
could be applied

118
00:05:16,289 --> 00:05:20,490
and that also highlights potential
difficulties

119
00:05:20,490 --> 00:05:21,900
with these concepts

120
00:05:21,900 --> 00:05:25,129
so it's an example that we'll call
"when to cut a tree"

121
00:05:25,129 --> 00:05:30,659
and you know physically you might think
off uh... a tree farm

122
00:05:30,659 --> 00:05:34,360
that could be run according to different
schemes

123
00:05:34,360 --> 00:05:40,120
and there are two alternative scheme here
that you need to evaluate

124
00:05:40,120 --> 00:05:41,790
the first scheme is a simple one

125
00:05:41,790 --> 00:05:43,770
it has the cash stream

126
00:05:43,770 --> 00:05:46,020
that's

127
00:05:46,020 --> 00:05:47,710
equal to

128
00:05:47,710 --> 00:05:52,469
hmm

129
00:05:52,469 --> 00:05:55,249
this one here. the highlighter
doesn't work anymore

130
00:05:55,249 --> 00:05:57,000
i don't know why

131
00:05:57,000 --> 00:06:01,529
i can't even clear the slides
now it works

132
00:06:01,529 --> 00:06:04,080
a cash stream is simply

133
00:06:04,080 --> 00:06:07,070
initial cash outflow of minus one

134
00:06:07,070 --> 00:06:10,330
and a payoff at the end of the period

135
00:06:10,330 --> 00:06:12,850
that is equal to two units

136
00:06:12,850 --> 00:06:15,799
the alternative is

137
00:06:15,799 --> 00:06:19,180
a different cash stream that also starts with
an initial

138
00:06:19,180 --> 00:06:22,599
you know investment that's required
of minus one

139
00:06:22,599 --> 00:06:24,220
then at the end of the

140
00:06:24,220 --> 00:06:28,030
first period there's zero cash flow
end of the second period

141
00:06:28,030 --> 00:06:30,509
there's cash flow equal to three

142
00:06:30,509 --> 00:06:32,830
now a simple exercise

143
00:06:32,830 --> 00:06:36,499
let's just try and fill in the gaps
in this table

144
00:06:36,499 --> 00:06:41,629
and come up with the decisions
so I'll leave you

145
00:06:41,629 --> 00:06:42,219
uh...

146
00:06:42,219 --> 00:06:45,460
alone for a moment please stop the movie
and try to

147
00:06:45,460 --> 00:06:52,460
uh... perform these computations

148
00:06:52,509 --> 00:06:53,620
so you all

149
00:06:53,620 --> 00:06:55,889
have been able to complete

150
00:06:55,889 --> 00:06:57,740
that little exercise here
151
00:06:57,740 --> 00:06:58,770
at least you

152
00:06:58,770 --> 00:07:03,850
should have been able to compute
this number in the table here

153
00:07:03,850 --> 00:07:05,300
that's

154
00:07:05,300 --> 00:07:07,069
fairly obvious

155
00:07:07,069 --> 00:07:11,800
given that we have this cash flow
stream here

156
00:07:11,800 --> 00:07:16,560
we start with an initial cash outflow
of one

157
00:07:16,560 --> 00:07:18,520
and we get a return

158
00:07:18,520 --> 00:07:21,300
of two at the end of the period so
that's

159
00:07:21,300 --> 00:07:23,639
a hundred percent growth

160
00:07:23,639 --> 00:07:24,999
of capital

161
00:07:24,999 --> 00:07:27,960
now we gonna get this number here

162
00:07:27,960 --> 00:07:33,020
so the internal rate of return
formula is simple: let zero be equal to

163
00:07:33,020 --> 00:07:34,490
the present value

164
00:07:34,490 --> 00:07:37,659
which is minus one

165
00:07:37,659 --> 00:07:41,209
for that second alternative here
for this one here

166
00:07:41,209 --> 00:07:43,499
minus one, plus

167
00:07:43,499 --> 00:07:44,680
uh... zero

168
00:07:44,680 --> 00:07:48,380
that's the end of term one cash flow
plus

169
00:07:48,380 --> 00:07:49,289
three

170
00:07:49,289 --> 00:07:50,400
at end of

171
00:07:50,400 --> 00:07:52,629
term two cash flow

172
00:07:52,629 --> 00:07:55,009
over one plus r raised

173
00:07:55,009 --> 00:07:56,680
to the power of two

174
00:07:56,680 --> 00:07:59,249
now in other words

175
00:07:59,249 --> 00:08:00,940
we can wrtie it as one

176
00:08:00,940 --> 00:08:03,739
is equal to

177
00:08:03,739 --> 00:08:05,649
three

178
00:08:05,649 --> 00:08:07,979
over one plus r

179
00:08:07,979 --> 00:08:09,840
squared, so that's

180
00:08:09,840 --> 00:08:12,860
could lead to one plus r

181
00:08:12,860 --> 00:08:19,600
squared is equal to three
so in other words

182
00:08:19,600 --> 00:08:21,330
r is equal to

183
00:08:21,330 --> 00:08:25,520
minus one plus square root of 3

184
00:08:25,520 --> 00:08:26,439
that that's

185
00:08:26,439 --> 00:08:28,479
the solution and we have

186
00:08:28,479 --> 00:08:35,479
over here and for the other two
numbers we just apply

187
00:08:35,850 --> 00:08:40,290
present value formula
more importantly what we see is that

188
00:08:40,290 --> 00:08:41,320
uh... the

189
00:08:41,320 --> 00:08:44,149
criteria did give us indifferent

190
00:08:44,149 --> 00:08:47,579
different uh... recommendations: the
internal rate of return criteria would

191
00:08:47,579 --> 00:08:50,920
suggest that we cut early, in other words

192
00:08:50,920 --> 00:08:55,640
pursue this alternative here that will
be internal rate of return

193
00:08:55,640 --> 00:08:57,950
whereas the NPV is

194
00:08:57,950 --> 00:09:02,170
greater for the "cut later"
alternative so the NPV

195
00:09:02,170 --> 00:09:02,930
rule

196
00:09:02,930 --> 00:09:05,830
would suggest to cut late

197
00:09:05,830 --> 00:09:11,040
uh... we in the situation that we cannot
easily resolve with uh... the criteria

198
00:09:11,040 --> 00:09:13,430
that we have at hand

199
00:09:13,430 --> 00:09:15,880
and the question is uh...

200
00:09:15,880 --> 00:09:17,300
what are we going to do

201
00:09:17,300 --> 00:09:23,150
well the problem here with this
particular example is simply that

202
00:09:23,150 --> 00:09:24,839
the cash streams

203
00:09:24,839 --> 00:09:26,720
do not have equal length

204
00:09:26,720 --> 00:09:27,920
right so if you

205
00:09:27,920 --> 00:09:30,590
look at the first alternative it's just a
one
206
00:09:30,590 --> 00:09:33,520
period investment whereas

207
00:09:33,520 --> 00:09:37,680
the second alternative, the "cut late"
alternative is a

208
00:09:37,680 --> 00:09:38,870
two period

209
00:09:38,870 --> 00:09:40,350
uh... cash stream

210
00:09:40,350 --> 00:09:43,120
and if the equalize

211
00:09:43,120 --> 00:09:44,790
the horizon

212
00:09:44,790 --> 00:09:47,440
uh... assuming that we can repeat

213
00:09:47,440 --> 00:09:49,530
these two cash flows

214
00:09:49,530 --> 00:09:53,170
uh... streams of these investments
associated with these cash flow

215
00:09:53,170 --> 00:09:54,840
streams then we'll

216
00:09:54,840 --> 00:09:58,270
more easily see that the

217
00:09:58,270 --> 00:10:00,880
criteria that we've discussed provide

218
00:10:00,880 --> 00:10:03,800
consistent investment recommendations

219
00:10:03,800 --> 00:10:07,350
now here's a table, it's clear that
220
00:10:07,350 --> 00:10:11,230
even if you repeat the investment,
the internal rate of return

221
00:10:11,230 --> 00:10:13,270
isn't going to change

222
00:10:13,270 --> 00:10:16,840
so internal rate of return still

223
00:10:16,840 --> 00:10:18,549
is going to suggest the

224
00:10:18,549 --> 00:10:20,480
"cut early" alternative

225
00:10:20,480 --> 00:10:24,349
whereas the net present value criterion

226
00:10:24,349 --> 00:10:29,240
now is going to change since new cash
flows

227
00:10:29,240 --> 00:10:31,920
are added to the original sequence

228
00:10:31,920 --> 00:10:34,720
and we see that also

229
00:10:34,720 --> 00:10:37,679
the NPV criterion

230
00:10:37,679 --> 00:10:39,690
would suggest to cut early

231
00:10:39,690 --> 00:10:45,580
so this simple contrived
example we were actually able to

232
00:10:45,580 --> 00:10:46,630
you know resolve

233
00:10:46,630 --> 00:10:50,070
the conflicting recommendations by
equalizing
234
00:10:50,070 --> 00:10:52,830
the investment horizon

235
00:10:52,830 --> 00:10:56,570
there's other examples in practice and
practice of course is much more

236
00:10:56,570 --> 00:10:59,590
messy and complex to apply these

237
00:10:59,590 --> 00:11:00,990
criteria

238
00:11:00,990 --> 00:11:05,570
but there's other examples in
practice that really cannot easily

239
00:11:05,570 --> 00:11:08,900
resolve those types of uh...
conflicting

240
00:11:08,900 --> 00:11:10,059
recommendations

241
00:11:10,059 --> 00:11:13,600
so in those cases you really need to
have a conviction as to

242
00:11:13,600 --> 00:11:15,500
what the concept is

243
00:11:15,500 --> 00:11:18,390
that you

244
00:11:18,390 --> 00:11:19,240
favor

245
00:11:19,240 --> 00:11:20,519
so

246
00:11:20,519 --> 00:11:21,940
in theory

247
00:11:21,940 --> 00:11:25,180
most people would use

248
00:11:25,180 --> 00:11:29,750
the NPV concept and that's because
the NPV

249
00:11:29,750 --> 00:11:32,820
really forms the basis for

250
00:11:32,820 --> 00:11:35,090
a lot of theory in finance

251
00:11:35,090 --> 00:11:36,879
as we'll see later on

252
00:11:36,879 --> 00:11:40,850
this formula can be generalized to a
situation of uncertainty

253
00:11:40,850 --> 00:11:42,680
we can

254
00:11:42,680 --> 00:11:45,540
discuss in a comprehensive way

255
00:11:45,540 --> 00:11:46,339
the

256
00:11:46,339 --> 00:11:47,749
existence

257
00:11:47,749 --> 00:11:50,990
of arbitrage opportunities and how that

258
00:11:50,990 --> 00:11:52,770
determines the pricing

259
00:11:52,770 --> 00:11:54,259
of financial assets

260
00:11:54,259 --> 00:11:56,139
so the NPV

261
00:11:56,139 --> 00:12:01,440
really is a building block,
a stepping stone

262
00:12:01,440 --> 00:12:06,380
uh... four much theory in finance and
most theorists will actually prefer

263
00:12:06,380 --> 00:12:07,210
that

264
00:12:07,210 --> 00:12:09,730
NPV criterion over

265
00:12:09,730 --> 00:12:11,310
internal rate of return

266
00:12:11,310 --> 00:12:12,350
criteria

267
00:12:12,350 --> 00:12:14,889
but the way i view it is really

268
00:12:14,889 --> 00:12:15,540
about

269
00:12:15,540 --> 00:12:17,140
the

270
00:12:17,140 --> 00:12:21,550
type of view that you have, if
you're looking for return on capital if

271
00:12:21,550 --> 00:12:22,400
that's

272
00:12:22,400 --> 00:12:26,830
your ultimate goal then you
would use the internal rate of return to

273
00:12:26,830 --> 00:12:28,200
make your decision

274
00:12:28,200 --> 00:12:32,290
if you're looking at dollar values of an
investment then it will be

275
00:12:32,290 --> 00:12:35,780
the uh... net present value that you

276
00:12:35,780 --> 00:12:37,440
uh... would be looking at

277
00:12:37,440 --> 00:12:40,079
so it really depends on your fundamental

278
00:12:40,079 --> 00:12:43,060
perspective what kind of criterion

279
00:12:43,060 --> 00:12:44,380
you are using

280
00:12:44,380 --> 00:12:45,870
to rank

281
00:12:45,870 --> 00:12:51,430
investment alternatives

282
00:12:51,430 --> 00:12:54,830
one final comments is on

283
00:12:54,830 --> 00:12:55,750
the

284
00:12:55,750 --> 00:12:57,750
uh... computation

285
00:12:57,750 --> 00:13:01,080
of the net present value and an internal
rate of return in the presence of

286
00:13:01,080 --> 00:13:02,280
taxes

287
00:13:02,280 --> 00:13:02,989
so

288
00:13:02,989 --> 00:13:07,830
one thing uh... one with a good
property is that's

289
00:13:07,830 --> 00:13:08,910
if the

290
00:13:08,910 --> 00:13:11,270
tax rate is uniform

291
00:13:11,270 --> 00:13:17,100
uniformly applied to revenues and
expenses of a project then the ranking

292
00:13:17,100 --> 00:13:19,960
that's suggested by the internal rate of
return

293
00:13:19,960 --> 00:13:23,650
and the net present value isn't going to
change

294
00:13:23,650 --> 00:13:28,280
uh... that's because the NPV of an
individual investment changes by factor

295
00:13:28,280 --> 00:13:30,460
of one minus the tax rate

296
00:13:30,460 --> 00:13:32,780
and the internal rate of return

297
00:13:32,780 --> 00:13:34,770
really doesn't change at all

298
00:13:34,770 --> 00:13:37,550
so uh... taxes really don't

299
00:13:37,550 --> 00:13:39,900
pose a serious problem

300
00:13:39,900 --> 00:13:42,440
when computing

301
00:13:42,440 --> 00:13:45,800
these criteria and they
won't change

302
00:13:45,800 --> 00:13:48,310
the ranking implied by those
303
00:13:48,310 --> 00:13:48,880
criteria