WEBVTT 00:00:00.090 --> 00:00:02.430 The following content is provided under a Creative 00:00:02.430 --> 00:00:03.820 Commons license. 00:00:03.820 --> 00:00:06.030 Your support will help MIT OpenCourseWare 00:00:06.030 --> 00:00:10.120 continue to offer high quality educational resources for free. 00:00:10.120 --> 00:00:12.690 To make a donation, or to view additional materials 00:00:12.690 --> 00:00:16.620 from hundreds of MIT courses, visit MIT OpenCourseWare 00:00:16.620 --> 00:00:17.830 at ocw.mit.edu. 00:00:27.109 --> 00:00:28.650 ANDREW LO: In today's lecture, I want 00:00:28.650 --> 00:00:33.300 to continue where we were last time in talking 00:00:33.300 --> 00:00:38.310 about applications of the net present value rule 00:00:38.310 --> 00:00:42.210 to capital budgeting and project financing. 00:00:42.210 --> 00:00:44.370 As promised, today what I'm going to do 00:00:44.370 --> 00:00:48.750 is to talk specifically about other alternatives 00:00:48.750 --> 00:00:53.550 to net present value that are not recommended, 00:00:53.550 --> 00:00:55.740 but which you need to know about simply 00:00:55.740 --> 00:00:59.790 because they actually are used in practice to some degree. 00:00:59.790 --> 00:01:02.880 And you have to be an intelligent consumer 00:01:02.880 --> 00:01:04.709 of all of these different ideas so 00:01:04.709 --> 00:01:06.120 that you can pick and choose. 00:01:06.120 --> 00:01:07.740 And actually, there are some instances 00:01:07.740 --> 00:01:09.780 where these other alternatives can 00:01:09.780 --> 00:01:13.050 shed some light on the particular problem 00:01:13.050 --> 00:01:15.030 and challenges at hand. 00:01:15.030 --> 00:01:18.120 I'll try to describe those as we go over them. 00:01:18.120 --> 00:01:21.000 Before I do, a student came up and asked me 00:01:21.000 --> 00:01:25.200 about a concept called adjusted present value. 00:01:25.200 --> 00:01:26.700 I wanted just to make a note of that 00:01:26.700 --> 00:01:29.670 because, so far, we've been talking about NPV. 00:01:29.670 --> 00:01:35.400 But in fact, both the textbook, as well as the best practices, 00:01:35.400 --> 00:01:37.380 would suggest that you use something 00:01:37.380 --> 00:01:40.020 called adjusted present value. 00:01:40.020 --> 00:01:41.910 Which basically makes adjustments 00:01:41.910 --> 00:01:45.480 for things like taxes, project interactions, 00:01:45.480 --> 00:01:50.880 strategic alternatives, optionality, and so on. 00:01:50.880 --> 00:01:53.400 I want to recommend that you first of all, keep in mind 00:01:53.400 --> 00:01:56.490 this notion of adjusted present value. 00:01:56.490 --> 00:02:00.030 That's what you'll be learning about in 402, and in more 00:02:00.030 --> 00:02:02.310 advanced courses on capital budgeting and project 00:02:02.310 --> 00:02:03.340 financing. 00:02:03.340 --> 00:02:06.670 So for now, NPV is the right answer, 00:02:06.670 --> 00:02:09.270 but when you learn more about how to make those adjustments, 00:02:09.270 --> 00:02:10.750 you're going to want to use them, 00:02:10.750 --> 00:02:15.780 and then we call the particular criterion APV instead of NPF. 00:02:15.780 --> 00:02:19.479 Just terminology that you should be aware of. 00:02:19.479 --> 00:02:21.520 All right, so what I want to do today, as I said, 00:02:21.520 --> 00:02:25.560 is to talk about three other approaches to capital budgeting 00:02:25.560 --> 00:02:29.190 that various professionals have used in the past, 00:02:29.190 --> 00:02:32.740 and which some are used to a great extent even today. 00:02:32.740 --> 00:02:36.570 And they are payback period and the discounted version of that 00:02:36.570 --> 00:02:39.300 called discounted payback. 00:02:39.300 --> 00:02:44.110 Second is the IRR, Internal Rate of Return, 00:02:44.110 --> 00:02:48.370 and the third is the profitability index. 00:02:48.370 --> 00:02:53.800 Each of these have its own particular uses, 00:02:53.800 --> 00:02:56.590 and I'm going to try to describe them to you very briefly. 00:02:56.590 --> 00:02:59.530 And then we're going to talk about different applications. 00:02:59.530 --> 00:03:02.050 The bottom line, just to be sure that there's 00:03:02.050 --> 00:03:08.240 no misunderstanding, NPV is always the right thing to do. 00:03:08.240 --> 00:03:12.190 So that's what we're recommending for any capital 00:03:12.190 --> 00:03:14.300 budgeting application. 00:03:14.300 --> 00:03:16.630 However, you should still understand 00:03:16.630 --> 00:03:18.610 what these three other alternatives are so 00:03:18.610 --> 00:03:21.010 that you can speak about them intelligently, talk 00:03:21.010 --> 00:03:25.020 about their advantages, and disadvantages. 00:03:25.020 --> 00:03:27.600 All right, so let's get started. 00:03:27.600 --> 00:03:28.980 Payback period-- oh, question. 00:03:28.980 --> 00:03:29.130 Yeah? 00:03:29.130 --> 00:03:30.558 AUDIENCE: Is this for [INAUDIBLE]? 00:03:30.558 --> 00:03:34.075 I mean you speak pretty firmly about NPV being better. 00:03:34.075 --> 00:03:34.700 ANDREW LO: Yes. 00:03:34.700 --> 00:03:39.370 So is it people using those other methods are wrong, 00:03:39.370 --> 00:03:46.600 or less intelligent, or is there anyway to kindly describe that? 00:03:46.600 --> 00:03:48.689 ANDREW LO: So the question is, why are they 00:03:48.689 --> 00:03:49.980 using these other alternatives? 00:03:49.980 --> 00:03:51.930 Let me get to that later, OK? 00:03:51.930 --> 00:03:54.420 I mean, one could argue that they're less intelligent. 00:03:54.420 --> 00:03:56.490 Not everybody is able to get into MIT 00:03:56.490 --> 00:03:59.490 and take this wonderful course. 00:03:59.490 --> 00:04:02.910 So by definition, they're less intelligent. 00:04:02.910 --> 00:04:07.350 But no, I don't want to make such a blanket statement. 00:04:07.350 --> 00:04:09.840 I think that, partly, you'll find 00:04:09.840 --> 00:04:11.880 that these other techniques have been 00:04:11.880 --> 00:04:16.709 used in practice both because of cultural inertia. 00:04:16.709 --> 00:04:19.200 They were the first to have come on the scene 00:04:19.200 --> 00:04:21.630 before NOV was fully worked out. 00:04:21.630 --> 00:04:24.039 So people are just used to doing things the way 00:04:24.039 --> 00:04:25.080 they're used to doing it. 00:04:25.080 --> 00:04:26.970 People don't like change, necessarily, 00:04:26.970 --> 00:04:29.520 when it's particularly forced upon them. 00:04:29.520 --> 00:04:34.200 But the second reason is that these other methods capture 00:04:34.200 --> 00:04:37.560 other aspects of risk that, in certain cases, 00:04:37.560 --> 00:04:40.950 may actually be more important for the particular individual 00:04:40.950 --> 00:04:41.730 decision makers. 00:04:41.730 --> 00:04:43.635 For example, we've talked about a lot 00:04:43.635 --> 00:04:44.760 of different kinds of risk. 00:04:44.760 --> 00:04:49.030 Market risk, estimation risk, credit risk. 00:04:49.030 --> 00:04:51.580 But what's the most important risk to all of you 00:04:51.580 --> 00:04:55.120 once you start working in your jobs? 00:04:55.120 --> 00:04:55.996 AUDIENCE: [INAUDIBLE] 00:04:55.996 --> 00:04:56.661 ANDREW LO: What? 00:04:56.661 --> 00:04:57.580 AUDIENCE: [INAUDIBLE] 00:04:57.580 --> 00:04:58.371 ANDREW LO: Exactly. 00:04:58.371 --> 00:04:59.410 Career risk. 00:04:59.410 --> 00:05:03.310 Career risk is probably the most important risk 00:05:03.310 --> 00:05:06.400 from the typical perspective of the decision maker. 00:05:06.400 --> 00:05:08.200 And frankly, some of these measures 00:05:08.200 --> 00:05:12.010 that I'm about to describe focus on career risk 00:05:12.010 --> 00:05:14.590 more than they do on the risk to the investor, 00:05:14.590 --> 00:05:15.940 or the shareholder. 00:05:15.940 --> 00:05:19.450 What I'd like you all to focus on in doing your jobs 00:05:19.450 --> 00:05:22.540 is to try to maximize the value of the company 00:05:22.540 --> 00:05:24.700 from the perspective of the owners of the company. 00:05:24.700 --> 00:05:27.010 You are agents of the owners, so therefore, you 00:05:27.010 --> 00:05:31.070 want to maximize the value to the shareholders. 00:05:31.070 --> 00:05:33.460 But in fact, the way people behave 00:05:33.460 --> 00:05:35.180 is often somewhat different. 00:05:35.180 --> 00:05:36.850 So we'll talk about that as we describe 00:05:36.850 --> 00:05:38.230 each of these measures. 00:05:38.230 --> 00:05:40.720 In fact, let's talk about the first measure as a way 00:05:40.720 --> 00:05:44.460 to illustrate the point about career risk. 00:05:44.460 --> 00:05:47.550 Payback period is a very simple concept. 00:05:47.550 --> 00:05:51.030 It is simply the minimum number of years 00:05:51.030 --> 00:05:54.420 that it requires for a particular investment 00:05:54.420 --> 00:05:56.800 to pay back. 00:05:56.800 --> 00:06:00.024 So if you invest a million dollars in a project, 00:06:00.024 --> 00:06:02.440 and it's going to generate some revenues, the question is, 00:06:02.440 --> 00:06:07.440 how long is it going to take before the project earns 00:06:07.440 --> 00:06:08.400 a million dollars? 00:06:08.400 --> 00:06:11.820 Namely, it pays back the original investment. 00:06:11.820 --> 00:06:14.620 So the definition, here, is simple. 00:06:14.620 --> 00:06:17.490 If you assume that cf1 through cfk 00:06:17.490 --> 00:06:19.740 are the cash flows to the project, 00:06:19.740 --> 00:06:21.590 and you invest a certain amount of cash, 00:06:21.590 --> 00:06:28.010 cf0, initially, then the question is, how long a period 00:06:28.010 --> 00:06:32.360 do you need so that the sum of the future cash flows 00:06:32.360 --> 00:06:34.140 exceeds the initial investment? 00:06:34.140 --> 00:06:38.670 What's the minimum number of periods for that to happen? 00:06:38.670 --> 00:06:43.470 And that minimum, k, is called the payback period. 00:06:43.470 --> 00:06:46.250 Now, right away you see that there's 00:06:46.250 --> 00:06:48.200 a problem because we're adding cash 00:06:48.200 --> 00:06:50.700 flows in different periods. 00:06:50.700 --> 00:06:54.050 So I hope by now, when you look at an expression like that, 00:06:54.050 --> 00:06:58.970 it causes you great cognitive dissonance and pain 00:06:58.970 --> 00:07:00.020 to look at that. 00:07:00.020 --> 00:07:01.730 It's like adding pounds to yen. 00:07:01.730 --> 00:07:03.950 Remember we did that the first day of class, right? 00:07:03.950 --> 00:07:07.190 Three pounds plus 25 yen is what? 00:07:07.190 --> 00:07:08.150 I don't know. 00:07:08.150 --> 00:07:10.100 So when you're adding these cash flows, 00:07:10.100 --> 00:07:13.670 it doesn't make sense because you're adding different units. 00:07:13.670 --> 00:07:15.170 But let's forget about that for now. 00:07:15.170 --> 00:07:16.795 Let's just look at the equation and try 00:07:16.795 --> 00:07:19.460 to divine what we mean from it. 00:07:19.460 --> 00:07:22.160 For independent projects, a criterion 00:07:22.160 --> 00:07:24.280 that you might construct using payback 00:07:24.280 --> 00:07:27.800 is to accept the project if k is less than 00:07:27.800 --> 00:07:31.160 or equal to some pre-specified threshold, t star. 00:07:31.160 --> 00:07:33.480 And for mutually exclusive projects, 00:07:33.480 --> 00:07:35.690 where you can only take one, pick the project 00:07:35.690 --> 00:07:38.900 that has the smallest payback period 00:07:38.900 --> 00:07:40.830 subject to that threshold t star. 00:07:43.580 --> 00:07:46.370 That's the typical approach to using payback. 00:07:46.370 --> 00:07:50.420 Clearly, this is a relatively shortsighted approach. 00:07:50.420 --> 00:07:53.500 It doesn't take into account scale, how much money you're 00:07:53.500 --> 00:07:54.650 going to make from this. 00:07:54.650 --> 00:07:57.140 It doesn't take into account risk, 00:07:57.140 --> 00:08:00.000 other than the risk of not getting paid back. 00:08:00.000 --> 00:08:03.740 So it's a very, very narrow focus 00:08:03.740 --> 00:08:07.520 in terms of what it's trying to accomplish. 00:08:07.520 --> 00:08:09.500 Now, we can try to fix this. 00:08:09.500 --> 00:08:13.260 And we can fix this by using discounted payback. 00:08:13.260 --> 00:08:17.270 So now at least, the cash flows are in the same units. 00:08:17.270 --> 00:08:20.180 So you can use discounted payback, 00:08:20.180 --> 00:08:25.140 but it still ignores the cash flows after the payback period. 00:08:25.140 --> 00:08:27.740 So in particular, you can have a project 00:08:27.740 --> 00:08:32.450 that requires cash inflow today, that then generates 00:08:32.450 --> 00:08:35.150 a bunch of positive cash flows thereafter, 00:08:35.150 --> 00:08:38.179 but then after the payback period, in some future date, 00:08:38.179 --> 00:08:40.730 it generates tremendously negative cash flows. 00:08:40.730 --> 00:08:43.970 Either because of some kind of liabilities that it incurs, 00:08:43.970 --> 00:08:45.890 or some other additional investments that it 00:08:45.890 --> 00:08:47.570 requires to keep it going. 00:08:47.570 --> 00:08:51.300 All of that stuff is ignored by payback. 00:08:51.300 --> 00:08:54.770 So in particular, this can have a negative NPV, 00:08:54.770 --> 00:08:56.810 but you might still want to take it 00:08:56.810 --> 00:09:00.320 because it pays back in a relatively 00:09:00.320 --> 00:09:01.940 short period of time. 00:09:01.940 --> 00:09:03.500 That's a mistake. 00:09:03.500 --> 00:09:05.390 But you can understand how something 00:09:05.390 --> 00:09:09.290 like this ended up getting put into practice, right? 00:09:09.290 --> 00:09:11.030 Career risk. 00:09:11.030 --> 00:09:13.130 If you're a manager of a division, 00:09:13.130 --> 00:09:17.180 and your job when you were hired is to turn it around and make 00:09:17.180 --> 00:09:20.420 it profitable, then it's very important 00:09:20.420 --> 00:09:24.260 that you take on projects with short payback periods. 00:09:24.260 --> 00:09:26.300 But that's not necessarily in the best interests 00:09:26.300 --> 00:09:31.010 of the company, or of the investors, or even of yourself 00:09:31.010 --> 00:09:34.370 if the incentives have been properly calibrated. 00:09:34.370 --> 00:09:37.430 In other words, if, as part of your compensation contract, 00:09:37.430 --> 00:09:40.340 they say, here, you get a bunch of stock in the company. 00:09:40.340 --> 00:09:42.980 We want you to maximize the value of the shareholders. 00:09:42.980 --> 00:09:45.920 Then what you ought to be doing is maximizing NPV. 00:09:45.920 --> 00:09:48.980 You're not supposed to be focusing on other aspects. 00:09:48.980 --> 00:09:52.220 But as a practical matter, people look at this. 00:09:52.220 --> 00:09:54.920 People want to know how long is it going to be 00:09:54.920 --> 00:09:56.810 before this thing pays back. 00:09:56.810 --> 00:10:00.470 Now, I don't want to argue that it's completely irrational. 00:10:00.470 --> 00:10:04.280 Can anybody give me a rationale for why payback is actually 00:10:04.280 --> 00:10:05.770 a sensible thing to consider? 00:10:05.770 --> 00:10:06.410 Yeah, David? 00:10:06.410 --> 00:10:08.334 AUDIENCE: The main thing that fueled 00:10:08.334 --> 00:10:10.739 this, in an NPV calculation, you're 00:10:10.739 --> 00:10:12.670 assuming that you know what cash flow's going 00:10:12.670 --> 00:10:13.840 to be way out in the future. 00:10:13.840 --> 00:10:14.350 ANDREW LO: Yeah, exactly. 00:10:14.350 --> 00:10:15.379 AUDIENCE: And if you have a big cash 00:10:15.379 --> 00:10:17.003 flow way out in the future end, there's 00:10:17.003 --> 00:10:19.440 so little certainty your career's attached to that-- 00:10:19.440 --> 00:10:20.440 ANDREW LO: That's right. 00:10:20.440 --> 00:10:23.821 AUDIENCE: --you'd want to weight effort more towards a calculus 00:10:23.821 --> 00:10:24.790 and-- 00:10:24.790 --> 00:10:25.790 ANDREW LO: That's right. 00:10:25.790 --> 00:10:28.000 So apart from the career risk, which you mentioned, 00:10:28.000 --> 00:10:30.220 but I want to downplay that because I 00:10:30.220 --> 00:10:33.610 want to argue that it is possible for payback 00:10:33.610 --> 00:10:35.620 to add value to shareholders. 00:10:35.620 --> 00:10:39.700 Simply because there is an implicit recognition for those 00:10:39.700 --> 00:10:42.970 who use payback that it's really hard to estimate 00:10:42.970 --> 00:10:45.160 what's going to happen in the distant future. 00:10:45.160 --> 00:10:48.790 So if you've got a project that pays back sooner rather 00:10:48.790 --> 00:10:52.120 than later, that's probably better 00:10:52.120 --> 00:10:54.760 because there's less certainty about what's 00:10:54.760 --> 00:10:56.960 going to happen in the future. 00:10:56.960 --> 00:11:01.150 Now there's a lot of if's in that statement, right? 00:11:01.150 --> 00:11:03.280 If really what you're concerned about 00:11:03.280 --> 00:11:06.640 is the growing uncertainty of the project, 00:11:06.640 --> 00:11:10.520 that ought to be reflected in the discount rates. 00:11:10.520 --> 00:11:13.630 So I'm not saying that you should ignore it. 00:11:13.630 --> 00:11:16.390 What I'm saying is that payback is not necessarily the best 00:11:16.390 --> 00:11:18.190 way of capturing it. 00:11:18.190 --> 00:11:20.380 Although I think we could acknowledge that it does 00:11:20.380 --> 00:11:22.120 serve a useful purpose in the sense 00:11:22.120 --> 00:11:25.990 that it is focusing your attention on the relatively 00:11:25.990 --> 00:11:29.410 recent periods of cash flows. 00:11:29.410 --> 00:11:31.210 But there may be better ways of taking care 00:11:31.210 --> 00:11:33.412 of that, if that's the issue. 00:11:33.412 --> 00:11:34.920 A question or comment? 00:11:34.920 --> 00:11:35.596 Yeah? 00:11:35.596 --> 00:11:36.550 AUDIENCE: Liquidity? 00:11:36.550 --> 00:11:37.216 ANDREW LO: Yeah? 00:11:37.216 --> 00:11:40.605 AUDIENCE: If you have a project that takes cash outflow up 00:11:40.605 --> 00:11:43.331 front, and then years and years out, 00:11:43.331 --> 00:11:47.273 it gives you a big cash inflow. 00:11:47.273 --> 00:11:51.060 From that time until the cash outflow, you get nothing? 00:11:51.060 --> 00:11:51.730 ANDREW LO: Yeah. 00:11:51.730 --> 00:11:53.235 AUDIENCE: That could even present some problems 00:11:53.235 --> 00:11:53.880 in finance. 00:11:53.880 --> 00:11:54.880 ANDREW LO: That's right. 00:11:54.880 --> 00:11:57.930 So another aspect of payback is this liquidity issue. 00:11:57.930 --> 00:11:59.550 In other words, projects that pay back 00:11:59.550 --> 00:12:02.970 in a shorter period of time require less liquidity 00:12:02.970 --> 00:12:04.830 over longer horizons. 00:12:04.830 --> 00:12:08.782 However, once again I'm going to say, if liquidity is the issue, 00:12:08.782 --> 00:12:10.740 you ought to take that into account explicitly, 00:12:10.740 --> 00:12:13.710 and understand what the term structure of your borrowing 00:12:13.710 --> 00:12:15.240 costs are over different periods. 00:12:15.240 --> 00:12:18.821 If you factor that in, then it should already be in there. 00:12:18.821 --> 00:12:19.320 If. 00:12:19.320 --> 00:12:21.270 AUDIENCE: Is that closer to a discount rate or something-- 00:12:21.270 --> 00:12:22.603 ANDREW LO: That's right, it can. 00:12:22.603 --> 00:12:24.900 It should certainly, because we know 00:12:24.900 --> 00:12:26.290 that there is a yield curve. 00:12:26.290 --> 00:12:28.890 The typical yield curve is upward sloping. 00:12:28.890 --> 00:12:30.600 Typical I say, not always. 00:12:30.600 --> 00:12:32.575 But the typical yield curve is upward sloping. 00:12:32.575 --> 00:12:34.200 What that's telling you is that there's 00:12:34.200 --> 00:12:37.470 a premium for borrowing longer. 00:12:37.470 --> 00:12:40.140 So that basically gets at your liquidity issue. 00:12:40.140 --> 00:12:42.870 But if you have additional concerns above and beyond that, 00:12:42.870 --> 00:12:44.910 that should be reflected in your calculations. 00:12:44.910 --> 00:12:47.950 Payback is an inefficient way of capturing that. 00:12:47.950 --> 00:12:51.060 It's a very zero-one kind of an approach to dealing 00:12:51.060 --> 00:12:52.590 with that kind of an issue. 00:12:52.590 --> 00:12:53.237 Yeah? 00:12:53.237 --> 00:12:55.487 AUDIENCE: Think that people they lose the payback when 00:12:55.487 --> 00:12:58.204 they believe that the cash flow is 00:12:58.204 --> 00:13:00.180 the same all over the period. 00:13:00.180 --> 00:13:01.662 Which really makes sense. 00:13:01.662 --> 00:13:03.649 Like in multiple. 00:13:03.649 --> 00:13:05.940 ANDREW LO: So you're saying that it doesn't make sense. 00:13:05.940 --> 00:13:07.564 AUDIENCE: It makes sense, when the cash 00:13:07.564 --> 00:13:08.560 flow will be the same-- 00:13:08.560 --> 00:13:10.020 ANDREW LO: If the cash, yes, that's right. 00:13:10.020 --> 00:13:12.500 If the cash flow is going to be level, then it makes sense. 00:13:12.500 --> 00:13:12.780 You're right. 00:13:12.780 --> 00:13:13.686 AUDIENCE: Like multiple. 00:13:13.686 --> 00:13:15.519 You have a multiple for industry, you use it 00:13:15.519 --> 00:13:16.410 and you have it. 00:13:16.410 --> 00:13:18.030 ANDREW LO: That's right, that's right. 00:13:18.030 --> 00:13:20.520 There are conditions under which payback 00:13:20.520 --> 00:13:22.200 can give you sensible results. 00:13:22.200 --> 00:13:25.390 But think about how restrictive those conditions are. 00:13:25.390 --> 00:13:27.270 You need to have level cash flows, 00:13:27.270 --> 00:13:31.530 and moreover, you have to be comparing projects, all of whom 00:13:31.530 --> 00:13:34.620 have level cash flows and have comparable risks. 00:13:34.620 --> 00:13:37.527 If they have different risks, or different levels of cash flows, 00:13:37.527 --> 00:13:39.360 or different liquidity, all of those things, 00:13:39.360 --> 00:13:40.770 cannot be captured by payback. 00:13:43.450 --> 00:13:45.800 So I don't want to beat up too much on it. 00:13:45.800 --> 00:13:47.650 This is a relatively easy target. 00:13:47.650 --> 00:13:51.230 The point is that it provides some information, 00:13:51.230 --> 00:13:52.825 and you should know what it is. 00:13:52.825 --> 00:13:54.700 Regardless of whether you're going to use it. 00:13:54.700 --> 00:13:57.260 You ought to be able to have that at your fingertips 00:13:57.260 --> 00:13:59.770 so when somebody says, and undoubtedly somebody 00:13:59.770 --> 00:14:02.830 will say to you, when you're pushing a project, 00:14:02.830 --> 00:14:05.684 they're going to say, what's the payback period. 00:14:05.684 --> 00:14:06.850 You need to know the answer. 00:14:06.850 --> 00:14:08.380 It's not good enough for you to say, 00:14:08.380 --> 00:14:10.780 my 401 professor told me it doesn't make sense. 00:14:10.780 --> 00:14:12.820 You've got to basically have an answer, 00:14:12.820 --> 00:14:16.240 and then argue that while payback doesn't 00:14:16.240 --> 00:14:18.535 summarize all of the characteristics 00:14:18.535 --> 00:14:19.660 that we're concerned about. 00:14:22.870 --> 00:14:25.810 Second method, the profitability index. 00:14:25.810 --> 00:14:31.390 Now this one is another easy criterion to criticize, 00:14:31.390 --> 00:14:36.010 but it's so close to NPV that the only thing that really is 00:14:36.010 --> 00:14:38.510 an issue is the scale factor. 00:14:38.510 --> 00:14:39.940 So let me explain. 00:14:39.940 --> 00:14:46.652 Profitability index is simply the gross present value, as 00:14:46.652 --> 00:14:47.860 opposed to net present value. 00:14:47.860 --> 00:14:50.380 It's the gross present value, divided 00:14:50.380 --> 00:14:52.120 by the initial investment. 00:14:55.010 --> 00:14:58.030 So the present value is simply the present value 00:14:58.030 --> 00:15:02.450 of all the cash flows, divided by the initial investment. 00:15:02.450 --> 00:15:05.840 So you could think of it as a gross rate of return. 00:15:05.840 --> 00:15:08.390 In other words, 1 plus the net rate 00:15:08.390 --> 00:15:12.680 of return of your investment in this project. 00:15:12.680 --> 00:15:15.260 If the profitability index is greater than 1, 00:15:15.260 --> 00:15:16.830 take the project. 00:15:16.830 --> 00:15:19.550 If it's less than 1, don't take the project. 00:15:19.550 --> 00:15:23.150 And if you've got a bunch of mutually exclusive projects, 00:15:23.150 --> 00:15:26.270 pick the one that has the highest profitability index. 00:15:29.170 --> 00:15:31.980 That's the approach. 00:15:31.980 --> 00:15:33.886 Now what's wrong with this? 00:15:33.886 --> 00:15:36.280 It's not that far off from NPV. 00:15:36.280 --> 00:15:39.550 In fact, you could show that with a profitability 00:15:39.550 --> 00:15:43.420 index is greater than 1, you've got a positive NPV project. 00:15:43.420 --> 00:15:45.880 When the profitability index is less than 1, 00:15:45.880 --> 00:15:47.450 you've got a negative NPV project. 00:15:47.450 --> 00:15:51.640 So in terms of taking or not taking a project, 00:15:51.640 --> 00:15:53.479 it's actually the same as NPV. 00:15:53.479 --> 00:15:54.417 [INAUDIBLE]? 00:15:54.417 --> 00:15:56.996 AUDIENCE: The thing it doesn't tell you is how much they 00:15:56.996 --> 00:15:59.290 usually must have [INAUDIBLE]. 00:15:59.290 --> 00:16:01.486 It can be $1 or $1 billion. 00:16:01.486 --> 00:16:02.860 ANDREW LO: That's right, exactly. 00:16:02.860 --> 00:16:04.651 There's nothing that tells you about scale. 00:16:04.651 --> 00:16:09.990 So, if you guys give me $1 and I give you back $2, 00:16:09.990 --> 00:16:13.300 that's going to have a profitability index of 2. 00:16:13.300 --> 00:16:15.870 Which is going to look really good relative 00:16:15.870 --> 00:16:18.690 to an investment in Berkshire Hathaway 00:16:18.690 --> 00:16:22.220 20 years ago, because that may not have given you 00:16:22.220 --> 00:16:24.170 the same profitability index. 00:16:24.170 --> 00:16:26.090 But Warren Buffett has made a lot more money 00:16:26.090 --> 00:16:27.710 than just a dollar. 00:16:27.710 --> 00:16:29.930 So, this ignores scale and that's 00:16:29.930 --> 00:16:32.210 obviously something that you can't 00:16:32.210 --> 00:16:36.350 afford to do when you've got mutually exclusive projects 00:16:36.350 --> 00:16:37.589 where you're ranking them. 00:16:37.589 --> 00:16:40.130 You don't want to pick the one with the highest profitability 00:16:40.130 --> 00:16:40.629 index. 00:16:40.629 --> 00:16:42.680 What you want to do is to pick the one that 00:16:42.680 --> 00:16:45.470 is generating the most value for you, 00:16:45.470 --> 00:16:47.480 in terms of dollars and cents. 00:16:47.480 --> 00:16:49.190 In other words, NPV. 00:16:49.190 --> 00:16:53.825 So once again, NPV, although is very close to this, 00:16:53.825 --> 00:16:55.700 is actually preferred because you're actually 00:16:55.700 --> 00:17:01.700 getting a hard amount of dollars and cents as the bottom line. 00:17:01.700 --> 00:17:06.420 Any questions about profitability index? 00:17:06.420 --> 00:17:07.688 Yes? 00:17:07.688 --> 00:17:10.108 AUDIENCE: A lot of time, the money that you have 00:17:10.108 --> 00:17:13.788 in hand investment is limited. 00:17:13.788 --> 00:17:18.280 [INAUDIBLE] play into a role like when you have projects. 00:17:18.280 --> 00:17:22.130 ANDREW LO: Well, it does play a role. 00:17:22.130 --> 00:17:25.119 So the question is, if you have a limited amount of money 00:17:25.119 --> 00:17:27.700 to invest, does that play a role? 00:17:27.700 --> 00:17:29.650 It absolutely does play a role, but it 00:17:29.650 --> 00:17:34.420 plays a role that is contrary to what the profitability 00:17:34.420 --> 00:17:36.310 index wants to do for you. 00:17:36.310 --> 00:17:37.960 The profitability index is simply 00:17:37.960 --> 00:17:41.410 telling you whether something is a positive or negative NPV. 00:17:41.410 --> 00:17:43.219 It's not telling you how much NPV 00:17:43.219 --> 00:17:45.010 you're going to get for the amount of money 00:17:45.010 --> 00:17:46.750 you're going to invest. 00:17:46.750 --> 00:17:50.260 So what you need to do is to focus on the latter. 00:17:50.260 --> 00:17:52.390 In other words, how much cash are you 00:17:52.390 --> 00:17:55.450 going to be able to generate from a particular project? 00:17:55.450 --> 00:17:57.970 $50, or $50 million? 00:17:57.970 --> 00:17:59.810 That really makes a big difference. 00:17:59.810 --> 00:18:02.740 Particularly, if what you have is a limited amount of cash, 00:18:02.740 --> 00:18:06.760 scale is actually an important concept to you. 00:18:06.760 --> 00:18:09.310 The reason that economists and financial economists, 00:18:09.310 --> 00:18:13.030 by extension, focus on rates of return? 00:18:13.030 --> 00:18:16.900 Did that ever strike you as being rather odd? 00:18:16.900 --> 00:18:19.120 In other words, when you talk to business people, 00:18:19.120 --> 00:18:22.000 very often they'll speak in terms of dollar amounts. 00:18:22.000 --> 00:18:24.730 Like, a startup costs $15 million, 00:18:24.730 --> 00:18:29.320 or the profits for last quarter was a million and a half 00:18:29.320 --> 00:18:30.850 dollars. 00:18:30.850 --> 00:18:33.190 They won't talk always in rates of return. 00:18:33.190 --> 00:18:36.070 Whereas economists, particularly financial economists, 00:18:36.070 --> 00:18:38.114 they express everything in rates of return. 00:18:38.114 --> 00:18:40.030 I mean, that's what we've done in this course. 00:18:40.030 --> 00:18:44.920 We've spent most of our time focusing on r, not on v. v 00:18:44.920 --> 00:18:46.880 for value, r for return. 00:18:46.880 --> 00:18:48.610 Anybody know why that is? 00:18:48.610 --> 00:18:49.273 Yeah? 00:18:49.273 --> 00:18:51.245 AUDIENCE: We always look about opportunity 00:18:51.245 --> 00:18:54.696 that we miss so maybe we can change the direction 00:18:54.696 --> 00:18:57.670 of our money [INAUDIBLE]. 00:18:57.670 --> 00:18:59.110 ANDREW LO: Well, that's true. 00:18:59.110 --> 00:19:01.734 But why focus on return as opposed to dollars? 00:19:01.734 --> 00:19:03.400 I mean, if we're thinking about changing 00:19:03.400 --> 00:19:05.230 the direction of our portfolio, you 00:19:05.230 --> 00:19:06.940 might think about investing, instead 00:19:06.940 --> 00:19:09.670 of a hundred thousand dollars in high tech stocks, 00:19:09.670 --> 00:19:12.370 take that money and invest a hundred thousand dollars 00:19:12.370 --> 00:19:13.660 in manufacturing. 00:19:13.660 --> 00:19:15.730 It's still about dollars and cents, isn't it? 00:19:15.730 --> 00:19:18.169 When you think about your portfolio, at some point, 00:19:18.169 --> 00:19:20.210 you've got to look at how much money do you have, 00:19:20.210 --> 00:19:22.501 how much money did you have, and is the current greater 00:19:22.501 --> 00:19:23.230 than the latter. 00:19:23.230 --> 00:19:25.840 You want to know whether or not you've made money. 00:19:25.840 --> 00:19:29.811 Why the focus on r in this course? 00:19:29.811 --> 00:19:30.310 Yeah, Zeke? 00:19:30.310 --> 00:19:32.260 AUDIENCE: Could be to get rid of the units. 00:19:32.260 --> 00:19:33.760 ANDREW LO: I know, it is to get rid of units. 00:19:33.760 --> 00:19:35.551 But why do we want to get rid of the units? 00:19:35.551 --> 00:19:37.262 AUDIENCE: Compared to their numbers? 00:19:37.262 --> 00:19:38.470 ANDREW LO: But wait a minute. 00:19:38.470 --> 00:19:41.085 Why can't you compare dollars to dollars? 00:19:41.085 --> 00:19:42.460 I mean, you're right that you can 00:19:42.460 --> 00:19:45.100 compare a 3% increase in General Motors 00:19:45.100 --> 00:19:47.320 to a 2% decline in Microsoft. 00:19:47.320 --> 00:19:49.400 But you could also compare a hundred thousand 00:19:49.400 --> 00:19:51.910 dollar increase in your portfolio in General Motors, 00:19:51.910 --> 00:19:56.840 versus a $50,000 loss in Microsoft. 00:19:56.840 --> 00:19:57.520 Yeah, Courtney? 00:19:57.520 --> 00:20:00.894 AUDIENCE: It goes back to scale because it's 00:20:00.894 --> 00:20:04.200 a $50,000 [INAUDIBLE] for that company, 00:20:04.200 --> 00:20:08.225 but it could be your entire company's profit. 00:20:08.225 --> 00:20:12.230 So it shows a return on an individualized basis. 00:20:12.230 --> 00:20:14.850 ANDREW LO: It shows the return on an individualized basis, 00:20:14.850 --> 00:20:16.070 and it gets rid of the scale. 00:20:16.070 --> 00:20:16.580 That's true. 00:20:16.580 --> 00:20:21.030 So you're able to compare the scale for different companies, 00:20:21.030 --> 00:20:24.200 but what's wrong with using dollars to do that? 00:20:24.200 --> 00:20:25.490 I mean, if you're an investor. 00:20:25.490 --> 00:20:27.470 So from the investor's perspective, 00:20:27.470 --> 00:20:29.810 if you're looking at an investment in General Electric 00:20:29.810 --> 00:20:33.230 versus Microsoft, wouldn't dollars make more sense? 00:20:33.230 --> 00:20:35.750 Rather than returns? 00:20:35.750 --> 00:20:37.540 Because you can still compare them, right? 00:20:37.540 --> 00:20:38.040 Yeah? 00:20:38.040 --> 00:20:39.964 AUDIENCE: If you're going to invest 00:20:39.964 --> 00:20:43.331 x amount in both companies, it might create a greater impact 00:20:43.331 --> 00:20:44.293 on one. 00:20:44.293 --> 00:20:47.660 And you want to see where your money is going to be or-- 00:20:47.660 --> 00:20:50.130 ANDREW LO: OK, you're on the right idea. 00:20:50.130 --> 00:20:53.570 You have the right elements, but you haven't put it together. 00:20:53.570 --> 00:20:55.780 It's true that scale is the issue, 00:20:55.780 --> 00:20:58.220 so you've got your finger on the right concept. 00:20:58.220 --> 00:21:00.230 But what about scale is the issue here? 00:21:00.230 --> 00:21:00.800 [INAUDIBLE]? 00:21:00.800 --> 00:21:03.205 AUDIENCE: I think you want to develop a theory that says 00:21:03.205 --> 00:21:06.172 [INAUDIBLE], that basically you can tell them 00:21:06.172 --> 00:21:08.932 what's your return in terms of percentages 00:21:08.932 --> 00:21:10.890 and then they can decide I want to invest $100, 00:21:10.890 --> 00:21:12.770 I want to invest a million dollars. 00:21:12.770 --> 00:21:13.436 ANDREW LO: Good. 00:21:13.436 --> 00:21:15.140 So that's following in Courtney's point 00:21:15.140 --> 00:21:17.820 that we want to develop a theory that suits all investors, 00:21:17.820 --> 00:21:20.700 so it's not focused on scale. 00:21:20.700 --> 00:21:22.970 But implicit in not focusing on scale, 00:21:22.970 --> 00:21:26.176 we're making another assumption. 00:21:26.176 --> 00:21:27.050 What are we assuming? 00:21:27.050 --> 00:21:27.550 Mike? 00:21:27.550 --> 00:21:29.889 AUDIENCE: In terms of focusing on the marginal dollar, 00:21:29.889 --> 00:21:33.826 you should actually take the highest return. 00:21:33.826 --> 00:21:36.246 If someone's going to triple that $3 investment, 00:21:36.246 --> 00:21:38.302 you should at least put your first $3 in that. 00:21:38.302 --> 00:21:39.625 Give them bang for your buck. 00:21:39.625 --> 00:21:42.040 And then go down until you're getting 00:21:42.040 --> 00:21:44.570 to a lower marginal return on larger investments. 00:21:44.570 --> 00:21:46.460 ANDREW LO: And why should you do that? 00:21:46.460 --> 00:21:50.624 Why should you go down the line in that manner? 00:21:50.624 --> 00:21:53.972 AUDIENCE: Because that will maximize your overall return. 00:21:53.972 --> 00:21:55.180 ANDREW LO: But wait a minute. 00:21:55.180 --> 00:21:57.480 I thought that if we put our money across all 00:21:57.480 --> 00:21:59.670 of these various different projects in proportion 00:21:59.670 --> 00:22:03.900 to the standard portfolio theory, the tangency portfolio, 00:22:03.900 --> 00:22:07.920 we get the biggest bang per unit risk. 00:22:07.920 --> 00:22:11.730 So, are you saying we ought to deviate from that? 00:22:11.730 --> 00:22:14.340 What about the theory that we developed 00:22:14.340 --> 00:22:18.900 requires us to focus on returns, rather than on dollars 00:22:18.900 --> 00:22:20.370 invested. 00:22:20.370 --> 00:22:23.100 You've all been very patient in not bringing up this issue. 00:22:23.100 --> 00:22:26.160 You've just taken it as given that I'm telling you the truth 00:22:26.160 --> 00:22:27.690 about focusing on returns. 00:22:27.690 --> 00:22:31.950 Why not focus on the actual dollars that you invest? 00:22:31.950 --> 00:22:32.469 Remy. 00:22:32.469 --> 00:22:34.427 AUDIENCE: Focusing on return is the easiest way 00:22:34.427 --> 00:22:37.990 to weigh it versus the risk. 00:22:37.990 --> 00:22:39.730 ANDREW LO: That's true, it does make 00:22:39.730 --> 00:22:41.590 it easy to weigh it against the risk. 00:22:41.590 --> 00:22:44.440 But in the end, don't you care about what your dollars at risk 00:22:44.440 --> 00:22:45.135 are? 00:22:45.135 --> 00:22:46.676 AUDIENCE: You can't check out what it 00:22:46.676 --> 00:22:50.670 is on the tangency portfolio. 00:22:50.670 --> 00:22:54.180 ANDREW LO: Well, I could rewrite the tangency portfolio in terms 00:22:54.180 --> 00:22:56.100 of dollars, instead of return. 00:22:56.100 --> 00:22:57.600 AUDIENCE: You don't want to do that. 00:22:57.600 --> 00:22:59.641 ANDREW LO: I don't want to do that, you're right. 00:22:59.641 --> 00:23:00.810 Why don't I want to do that? 00:23:00.810 --> 00:23:02.580 Aside from the fact that the fonts are not 00:23:02.580 --> 00:23:05.190 going to fit on that axis. 00:23:05.190 --> 00:23:06.820 Well you're on the right track. 00:23:06.820 --> 00:23:07.320 All of you. 00:23:07.320 --> 00:23:09.207 I think you sense what I'm getting at, 00:23:09.207 --> 00:23:10.790 but you haven't put your finger on it. 00:23:10.790 --> 00:23:12.450 Let me tie it all together, and tell you 00:23:12.450 --> 00:23:14.449 where you're getting, because I think that we're 00:23:14.449 --> 00:23:16.315 going to get there eventually. 00:23:16.315 --> 00:23:18.690 The idea is that we want to come up with a framework that 00:23:18.690 --> 00:23:19.830 applies to all investors. 00:23:19.830 --> 00:23:21.070 That's true. 00:23:21.070 --> 00:23:23.160 And so, it would be really convenient for us 00:23:23.160 --> 00:23:26.110 to be able to use returns and units of risk 00:23:26.110 --> 00:23:28.350 so that whatever dollars you have, 00:23:28.350 --> 00:23:30.330 you can simply apply the theory and find out 00:23:30.330 --> 00:23:31.957 where you are on that frontier. 00:23:31.957 --> 00:23:34.290 And just simply multiply by the initial amount of wealth 00:23:34.290 --> 00:23:38.190 to figure out all your dollar investments. 00:23:38.190 --> 00:23:43.700 Underlying that approach is a belief. 00:23:43.700 --> 00:23:44.720 And here's the belief. 00:23:44.720 --> 00:23:51.450 The belief is that we can invest however much money we want, 00:23:51.450 --> 00:23:54.070 and get these kind of returns. 00:23:54.070 --> 00:23:56.770 That's the key that all of you are groping at. 00:23:56.770 --> 00:23:59.180 Implicitly, I think you understood this, 00:23:59.180 --> 00:24:01.870 but you haven't articulated it. 00:24:01.870 --> 00:24:04.330 What we're assuming, when we put down 00:24:04.330 --> 00:24:06.640 all these equations in returns, is 00:24:06.640 --> 00:24:11.440 that scale doesn't matter in the sense that no matter 00:24:11.440 --> 00:24:13.550 whether we're investing a hundred dollars, 00:24:13.550 --> 00:24:17.650 or a hundred million dollars, or a hundred billion dollars. 00:24:17.650 --> 00:24:20.290 We're going to get the same returns. 00:24:20.290 --> 00:24:23.110 And the fact of the matter is that's just not true. 00:24:23.110 --> 00:24:27.500 Scale absolutely does matter. 00:24:27.500 --> 00:24:29.590 It matters because the more money 00:24:29.590 --> 00:24:32.260 you put into certain kinds of investments, 00:24:32.260 --> 00:24:35.560 the harder it will be for those investments 00:24:35.560 --> 00:24:38.870 to maintain the same level of return. 00:24:38.870 --> 00:24:41.140 Now, that has a very different impact 00:24:41.140 --> 00:24:44.860 among different industries and among different investments. 00:24:44.860 --> 00:24:48.760 For example, right now, nanotechnology 00:24:48.760 --> 00:24:51.140 is just beginning to take off. 00:24:51.140 --> 00:24:56.815 And so, if you end up putting a couple of extra billion dollars 00:24:56.815 --> 00:24:59.620 in nanotechnology, it's unlikely you're 00:24:59.620 --> 00:25:02.650 going to really affect the returns because the technology 00:25:02.650 --> 00:25:04.180 is still emerging. 00:25:04.180 --> 00:25:08.410 But if you take a very highly capacity constrained strategy 00:25:08.410 --> 00:25:11.540 and try to implement that same idea, 00:25:11.540 --> 00:25:14.800 you're going to have a very hard time doing it. 00:25:14.800 --> 00:25:19.480 If you decide that you want to focus on middle level software 00:25:19.480 --> 00:25:22.220 for dealing with file server control mechanisms, 00:25:22.220 --> 00:25:25.090 it's a relatively narrow sector in the technology sector. 00:25:25.090 --> 00:25:28.420 And you want to put $2 billion of extra money in that sector 00:25:28.420 --> 00:25:30.160 this month. 00:25:30.160 --> 00:25:31.390 Good luck. 00:25:31.390 --> 00:25:33.247 You'll have a very hard time doing it. 00:25:33.247 --> 00:25:35.080 Not to say that people won't take the money. 00:25:35.080 --> 00:25:37.540 I'm sure you can find people, yeah, sure give me the money. 00:25:37.540 --> 00:25:40.206 But they're not going to be able to produce the returns that you 00:25:40.206 --> 00:25:44.020 would expect from that very narrow slice of the economy. 00:25:44.020 --> 00:25:47.700 So all of what we've done in this course 00:25:47.700 --> 00:25:51.360 ignores scale from the perspective of risk and reward, 00:25:51.360 --> 00:25:56.454 but the one area where scale absolutely matters is NPV. 00:25:56.454 --> 00:25:58.620 In other words, when you're a project manager trying 00:25:58.620 --> 00:26:02.250 to figure out should I take Project A, or take Project B, 00:26:02.250 --> 00:26:03.840 scale matters. 00:26:03.840 --> 00:26:06.100 As Dee pointed out, in certain cases, 00:26:06.100 --> 00:26:09.270 you don't have more money to put into a particular project. 00:26:09.270 --> 00:26:11.250 In other cases, you have too much money 00:26:11.250 --> 00:26:14.070 that is not suitable for a certain project. 00:26:14.070 --> 00:26:17.850 But the bottom line in both cases is NPV. 00:26:17.850 --> 00:26:18.570 Dollars. 00:26:18.570 --> 00:26:20.524 Actual dollars and cents. 00:26:20.524 --> 00:26:23.190 That's what you want to focus on from the perspective of capital 00:26:23.190 --> 00:26:24.450 budgeting or corporate finance. 00:26:24.450 --> 00:26:24.950 Mike? 00:26:24.950 --> 00:26:27.432 AUDIENCE: If the NPV is really, really good, 00:26:27.432 --> 00:26:30.420 and the return is good, you should go get more capital-- 00:26:30.420 --> 00:26:32.130 ANDREW LO: That's right, that's right. 00:26:32.130 --> 00:26:34.950 If the NPV is really, really good, first of all, 00:26:34.950 --> 00:26:36.600 you're going to take the project. 00:26:36.600 --> 00:26:38.280 But secondly, what you're going to do 00:26:38.280 --> 00:26:40.050 is you're going to try to figure how to scale the heck out 00:26:40.050 --> 00:26:41.870 of the project and take as much of it as you want. 00:26:41.870 --> 00:26:42.510 Why? 00:26:42.510 --> 00:26:45.330 Because more money is preferred to less money. 00:26:45.330 --> 00:26:46.620 Simple as that. 00:26:46.620 --> 00:26:49.620 And again, anybody that violates that, see me after class. 00:26:49.620 --> 00:26:50.940 Be happy to help you. 00:26:50.940 --> 00:26:51.568 Yeah? 00:26:51.568 --> 00:26:53.760 AUDIENCE: If you did that it would go back to your-- 00:26:53.760 --> 00:26:55.190 ANDREW LO: Exactly, it would. 00:26:55.190 --> 00:26:56.531 AUDIENCE: Or, it would change r. 00:26:56.531 --> 00:26:58.540 ANDREW LO: It would change r, that's the point. 00:26:58.540 --> 00:27:01.320 That's why you shouldn't focus on r from the perspective 00:27:01.320 --> 00:27:02.430 of capital budgeting. 00:27:02.430 --> 00:27:04.650 From an investor's point of view, 00:27:04.650 --> 00:27:08.200 from a point of view of you and me, investing in the market, 00:27:08.200 --> 00:27:09.390 we're not going to affect r. 00:27:09.390 --> 00:27:12.160 I mean, I hate to depress all of you, but most of you, 00:27:12.160 --> 00:27:14.760 if you put your entire wealth into the market, 00:27:14.760 --> 00:27:18.480 you probably won't move the market by a whole lot. 00:27:18.480 --> 00:27:20.340 That's not true of everybody, and it's not 00:27:20.340 --> 00:27:21.579 true of all assets. 00:27:21.579 --> 00:27:23.620 But it's certainly true of the market as a whole. 00:27:23.620 --> 00:27:26.340 In other words, if we put all of our collective wealth 00:27:26.340 --> 00:27:29.370 into the S&P 500, we're not going to move it by a lot. 00:27:31.890 --> 00:27:34.050 But if you're a corporation, and you 00:27:34.050 --> 00:27:37.950 put all of your corporate wealth in one particular division 00:27:37.950 --> 00:27:40.050 of the particular company you're in, 00:27:40.050 --> 00:27:42.376 that could have dramatic consequences for the rate 00:27:42.376 --> 00:27:43.500 of return for that project. 00:27:43.500 --> 00:27:47.100 So scale matters for capital budgeting. 00:27:47.100 --> 00:27:50.070 It doesn't matter if you're thinking about each of us 00:27:50.070 --> 00:27:51.180 as a small investor. 00:27:51.180 --> 00:27:54.660 And so what I derived for you in the capital asset pricing model 00:27:54.660 --> 00:27:58.950 is a derivation that assumes each of us is small. 00:27:58.950 --> 00:28:02.250 We're not going to affect prices, or therefore, returns. 00:28:02.250 --> 00:28:05.906 And so, we can take returns as given. 00:28:05.906 --> 00:28:07.530 In other words, whether we're investing 00:28:07.530 --> 00:28:11.940 $100,000, or $200,000, or $15,000, or even a million, 00:28:11.940 --> 00:28:15.300 the analytics that derived are pretty reasonable 00:28:15.300 --> 00:28:16.950 approximations. 00:28:16.950 --> 00:28:19.470 That's very different from evaluating 00:28:19.470 --> 00:28:22.290 a particular investment opportunity for a division 00:28:22.290 --> 00:28:23.910 of a corporation. 00:28:23.910 --> 00:28:26.040 That's not the stock market. 00:28:26.040 --> 00:28:28.050 We use the stock market as a guide for computing 00:28:28.050 --> 00:28:29.380 the discount rate. 00:28:29.380 --> 00:28:33.240 But the bottom line analysis is how much of the investment 00:28:33.240 --> 00:28:36.490 can be supported by what you want to put into it. 00:28:36.490 --> 00:28:39.720 And as long as the NPV is looking good, 00:28:39.720 --> 00:28:41.040 you want to keep doing it. 00:28:41.040 --> 00:28:46.300 And to Remy's point, the more you do it, most likely, 00:28:46.300 --> 00:28:49.612 the less NPV will come out, eventually. 00:28:49.612 --> 00:28:51.070 And you're going to drive the thing 00:28:51.070 --> 00:28:52.736 into the ground in the sense that you're 00:28:52.736 --> 00:28:55.900 going to keep doing it until it stops being profitable. 00:28:55.900 --> 00:28:58.090 That's only human, it's only natural, 00:28:58.090 --> 00:29:00.504 it's only good business to drive it into the ground. 00:29:00.504 --> 00:29:02.920 Which is, by the way, what we did in the subprime mortgage 00:29:02.920 --> 00:29:04.310 market, right? 00:29:04.310 --> 00:29:06.310 That's why we're in the current crisis we're in. 00:29:06.310 --> 00:29:10.120 We basically drove that business into the ground and then some. 00:29:10.120 --> 00:29:13.000 But it's a natural phenomenon of business practice 00:29:13.000 --> 00:29:15.610 to constantly be coming up with new ideas. 00:29:15.610 --> 00:29:17.110 The ones that work well, we're going 00:29:17.110 --> 00:29:18.318 to keep on implementing them. 00:29:18.318 --> 00:29:20.350 We give them more capital until they 00:29:20.350 --> 00:29:22.210 start declining in their rates of return, 00:29:22.210 --> 00:29:23.680 then we take capital away. 00:29:23.680 --> 00:29:26.470 For the next year or so, we're going to be taking capital away 00:29:26.470 --> 00:29:27.678 from the real estate markets. 00:29:30.420 --> 00:29:32.677 Any questions about scale? 00:29:32.677 --> 00:29:35.260 That was a bit of a digression, but a useful one, in the sense 00:29:35.260 --> 00:29:38.170 that NPV is the right thing to do because it 00:29:38.170 --> 00:29:40.030 doesn't ignore scale. 00:29:40.030 --> 00:29:44.500 Whereas, for the small investor, ignoring scale 00:29:44.500 --> 00:29:45.850 makes perfect sense. 00:29:45.850 --> 00:29:48.340 Because then we are able to derive a theory that 00:29:48.340 --> 00:29:49.870 applies to most everybody. 00:29:49.870 --> 00:29:54.160 By the way, that theory doesn't apply to some 00:29:54.160 --> 00:29:56.470 of the largest investors today. 00:29:56.470 --> 00:29:59.530 For example, certain sovereign wealth funds, 00:29:59.530 --> 00:30:01.510 certain public pension funds, they 00:30:01.510 --> 00:30:05.410 can't invest according to the basics of portfolio theory. 00:30:05.410 --> 00:30:07.077 Because when they put money to work, 00:30:07.077 --> 00:30:09.160 they're looking to put a couple of billion dollars 00:30:09.160 --> 00:30:11.410 to work in a single investment. 00:30:11.410 --> 00:30:13.810 It's not worth their time to try to figure out 00:30:13.810 --> 00:30:16.790 how to allocate $5 million here, $10 million here, $20 million 00:30:16.790 --> 00:30:17.290 there. 00:30:17.290 --> 00:30:19.030 There's not enough hours in the day 00:30:19.030 --> 00:30:21.400 when they're managing a $250 billion 00:30:21.400 --> 00:30:23.870 portfolio to be able to do that. 00:30:23.870 --> 00:30:27.100 And so, when you're a large, large investor, 00:30:27.100 --> 00:30:29.930 the theory that we developed here in this class, 00:30:29.930 --> 00:30:31.000 it doesn't apply. 00:30:31.000 --> 00:30:33.790 You need to take 15 433 to understand 00:30:33.790 --> 00:30:37.390 how to deal with the issue of price impact and large scale 00:30:37.390 --> 00:30:37.990 investments. 00:30:37.990 --> 00:30:40.270 Fortunately, or unfortunately, that 00:30:40.270 --> 00:30:42.520 won't be a problem for most of us, 00:30:42.520 --> 00:30:44.620 so you have to keep that in mind. 00:30:44.620 --> 00:30:47.800 For most of us, the theory of investments 00:30:47.800 --> 00:30:52.120 that we developed in this class is perfectly appropriate. 00:30:52.120 --> 00:30:53.830 Except when we're talking about NPV. 00:30:53.830 --> 00:30:54.329 Yeah? 00:30:56.804 --> 00:30:59.149 AUDIENCE: Because of this lecture, 00:30:59.149 --> 00:31:02.198 will there be any indices or variables 00:31:02.198 --> 00:31:07.470 that we can use to determine the part of the initial returns 00:31:07.470 --> 00:31:10.010 for those sort of cash flows? 00:31:10.010 --> 00:31:12.260 ANDREW LO: In this particular context, no. 00:31:12.260 --> 00:31:16.012 You're going to learn about that in 402, as well as in 434, 00:31:16.012 --> 00:31:18.470 and some of the more advanced courses on capital budgeting. 00:31:18.470 --> 00:31:20.630 On how to scale an investment. 00:31:20.630 --> 00:31:22.910 But the basic principle, you, I think, 00:31:22.910 --> 00:31:25.370 already know because you've taken microeconomics. 00:31:25.370 --> 00:31:28.160 The basic principle of how much to invest 00:31:28.160 --> 00:31:30.560 is not to invest until you start losing money. 00:31:30.560 --> 00:31:33.470 That's actually typically how it's done in practice. 00:31:33.470 --> 00:31:36.800 That's not necessarily the best way of approaching it. 00:31:36.800 --> 00:31:39.140 According to an economist, the best way to invest 00:31:39.140 --> 00:31:43.970 is until the point at which the marginal benefits is actually 00:31:43.970 --> 00:31:46.350 equal to the marginal cost of the investment. 00:31:46.350 --> 00:31:48.540 So when you're trying to maximize profits, 00:31:48.540 --> 00:31:51.470 you're asking how much money should I invest 00:31:51.470 --> 00:31:53.330 in a particular division. 00:31:53.330 --> 00:31:55.340 You ought to keep investing until the point 00:31:55.340 --> 00:31:58.950 where the marginal benefit is equated to the marginal cost. 00:31:58.950 --> 00:32:03.100 In other words, where the profit maximizing point is, 00:32:03.100 --> 00:32:09.440 is where the marginal revenue is equated to the marginal cost 00:32:09.440 --> 00:32:10.400 of investment. 00:32:10.400 --> 00:32:14.260 That's true for any kind of an investment. 00:32:14.260 --> 00:32:16.960 The point is to be able to measure those things accurately 00:32:16.960 --> 00:32:19.150 enough to find that point. 00:32:19.150 --> 00:32:21.760 We don't do that in this course because, again, we're 00:32:21.760 --> 00:32:24.250 assuming that you're relatively small relative 00:32:24.250 --> 00:32:27.230 to the grand scheme of the investment universe. 00:32:27.230 --> 00:32:30.010 But as you get bigger, you need to develop other techniques 00:32:30.010 --> 00:32:31.280 to be able to deal with that. 00:32:31.280 --> 00:32:34.150 And one is this marginal benefit, marginal cost 00:32:34.150 --> 00:32:36.480 approximation. 00:32:36.480 --> 00:32:39.250 Other questions? 00:32:39.250 --> 00:32:42.370 So that's the profitability index. 00:32:42.370 --> 00:32:43.920 I just give you a couple of examples, 00:32:43.920 --> 00:32:46.420 so you can take a look at them at your leisure. 00:32:46.420 --> 00:32:48.260 It's pretty straightforward. 00:32:48.260 --> 00:32:48.760 All right. 00:32:48.760 --> 00:32:53.050 Now, let me talk about the last, and probably most important, 00:32:53.050 --> 00:32:55.575 alternative to NPV. 00:32:55.575 --> 00:32:56.950 This is something that's actually 00:32:56.950 --> 00:32:58.876 used in practice pretty commonly, 00:32:58.876 --> 00:33:00.250 and there are certain areas where 00:33:00.250 --> 00:33:02.450 it's used almost exclusively. 00:33:02.450 --> 00:33:04.180 So it's a very important idea that I 00:33:04.180 --> 00:33:07.360 want to go over in detail. 00:33:07.360 --> 00:33:10.660 The idea behind the IRR looks simple enough 00:33:10.660 --> 00:33:11.710 on the surface of it. 00:33:11.710 --> 00:33:14.260 And those of you who remember back to the lectures 00:33:14.260 --> 00:33:17.590 that we did on bond mathematics, you'll 00:33:17.590 --> 00:33:21.580 recognize the IRR as nothing more than the yield 00:33:21.580 --> 00:33:23.840 to maturity of a bond. 00:33:23.840 --> 00:33:28.480 So if you pretend that this is like a bond, where i sub 0 00:33:28.480 --> 00:33:33.352 is the market price of the bond, and the cf1 to cft 00:33:33.352 --> 00:33:36.760 are the coupons and principle payment of the bond, 00:33:36.760 --> 00:33:41.620 then the internal rate of return is nothing more than the yield 00:33:41.620 --> 00:33:44.180 to maturity of that bond. 00:33:44.180 --> 00:33:46.810 That's mathematically, formally what it is. 00:33:46.810 --> 00:33:48.940 But it's got a different interpretation here. 00:33:48.940 --> 00:33:53.170 The interpretation is that i sub 0 is the amount of money 00:33:53.170 --> 00:33:56.800 you're paying for this project. 00:33:56.800 --> 00:34:02.050 And cf1 through cft are the cash flows you're 00:34:02.050 --> 00:34:05.520 getting from the project. 00:34:05.520 --> 00:34:13.380 And the IRR is that yield, or that rate of return, 00:34:13.380 --> 00:34:17.810 such that it makes the project break-even. 00:34:17.810 --> 00:34:21.980 In other words, the present value of the future cash flows 00:34:21.980 --> 00:34:24.409 is actually equal to the amount of investment 00:34:24.409 --> 00:34:27.860 that you put into it at that IRR rate of return. 00:34:30.730 --> 00:34:33.489 Any questions about that definition? 00:34:33.489 --> 00:34:35.440 Now implicit in that definition are 00:34:35.440 --> 00:34:39.790 a couple of hidden assumptions that makes this work. 00:34:39.790 --> 00:34:42.820 One assumption is that the only investment 00:34:42.820 --> 00:34:45.340 that you're going to make in the project is upfront. 00:34:45.340 --> 00:34:47.817 You're going to pay i sub 0, and you're not 00:34:47.817 --> 00:34:49.650 going to pay anything more for that project. 00:34:49.650 --> 00:34:55.940 It requires no more cash inflows from you, the investor. 00:34:55.940 --> 00:34:57.710 The second assumption, which I guess 00:34:57.710 --> 00:34:59.480 is sort of the same as the first, 00:34:59.480 --> 00:35:03.660 is that all the cash flows are non-negative. 00:35:03.660 --> 00:35:05.520 They're either 0 or positive. 00:35:05.520 --> 00:35:08.650 You don't have any future negative cash flows. 00:35:08.650 --> 00:35:10.800 So once you invest in your certain amount 00:35:10.800 --> 00:35:14.040 today, then thereafter, you simply 00:35:14.040 --> 00:35:17.855 collect money from the project that comes in over t periods. 00:35:20.690 --> 00:35:23.570 If those two assumptions are satisfied, 00:35:23.570 --> 00:35:28.150 then this may be a reasonable approach. 00:35:28.150 --> 00:35:31.570 So just to be explicit, the way that IRR is used 00:35:31.570 --> 00:35:34.510 is for independent projects. 00:35:34.510 --> 00:35:39.510 Accept a project if the IRR's greater than some hurdle rate, 00:35:39.510 --> 00:35:41.010 some IRR star. 00:35:41.010 --> 00:35:44.100 You can think of that as your internal, 00:35:44.100 --> 00:35:46.900 or your required rate of return. 00:35:46.900 --> 00:35:53.730 So as long as the break-even IRR is equal to, or greater 00:35:53.730 --> 00:35:57.860 than that threshold, then you're OK. 00:35:57.860 --> 00:36:02.760 Second, if you've got mutually exclusive projects, 00:36:02.760 --> 00:36:06.495 then you pick the one that has the highest IRR. 00:36:10.268 --> 00:36:11.750 Yeah, [INAUDIBLE]? 00:36:11.750 --> 00:36:19.407 AUDIENCE: [INAUDIBLE] You could have 00:36:19.407 --> 00:36:22.651 an outflow in the first year, and you could 00:36:22.651 --> 00:36:26.050 have an increase [INAUDIBLE] 00:36:26.050 --> 00:36:27.550 ANDREW LO: I'll show you in a minute 00:36:27.550 --> 00:36:29.980 why you need that assumption, those two assumptions. 00:36:29.980 --> 00:36:31.504 In fact, when people use IRR, they 00:36:31.504 --> 00:36:32.920 don't bother with any assumptions. 00:36:32.920 --> 00:36:35.230 They just compute it. 00:36:35.230 --> 00:36:39.110 So the assumption is to give them the benefit of the doubt. 00:36:39.110 --> 00:36:41.590 I want to come up with conditions under which it might 00:36:41.590 --> 00:36:44.660 actually make sense to use this, and those are the conditions. 00:36:44.660 --> 00:36:48.460 But for now, let's forget about all conditions. 00:36:48.460 --> 00:36:53.040 And let me tell you what the problems are with IRR. 00:36:53.040 --> 00:36:58.180 There are certain situations where using IRR 00:36:58.180 --> 00:37:04.970 will lead to the same decisions as NPV, and there they are. 00:37:04.970 --> 00:37:08.480 There's only one cash outflow, which occurs at time 0. 00:37:08.480 --> 00:37:10.500 There's only one project under consideration, 00:37:10.500 --> 00:37:13.630 so you have multiple projects that you're comparing. 00:37:13.630 --> 00:37:15.450 Third, the opportunity cost of capital 00:37:15.450 --> 00:37:18.720 is the same for all periods. 00:37:18.720 --> 00:37:21.300 And the threshold rate that you use 00:37:21.300 --> 00:37:27.570 is set equal to the opportunity cost of capital. 00:37:27.570 --> 00:37:31.560 Now, the reason that you need all of these. 00:37:31.560 --> 00:37:34.130 I'm going to show you by way of counterexamples. 00:37:34.130 --> 00:37:36.230 But let me just tell you right now, up front, 00:37:36.230 --> 00:37:38.150 what the shortcomings are of IRR. 00:37:38.150 --> 00:37:41.930 Why you might want to think twice before using it. 00:37:41.930 --> 00:37:49.280 One is that in certain cases, the IRR may not exist. 00:37:49.280 --> 00:37:53.390 And in other cases, you may have multiple IRRs. 00:37:53.390 --> 00:37:55.820 I'm going to show you in a minute. 00:37:55.820 --> 00:38:01.550 Second, you're going to get incorrect rankings for IRRs 00:38:01.550 --> 00:38:05.540 where you're looking at loans, loans meaning you've 00:38:05.540 --> 00:38:08.330 got a negative cash flow starting today, 00:38:08.330 --> 00:38:11.240 and then positive cash flows tomorrow-- 00:38:11.240 --> 00:38:11.900 Excuse me. 00:38:11.900 --> 00:38:14.160 You have a positive cash inflow today, 00:38:14.160 --> 00:38:18.060 and negative cash going out tomorrow and the day after. 00:38:18.060 --> 00:38:18.890 Like a mortgage. 00:38:18.890 --> 00:38:20.750 A mortgage, you get money up front, 00:38:20.750 --> 00:38:22.880 and you're paying money out later on. 00:38:22.880 --> 00:38:24.530 If you do that, then you've actually 00:38:24.530 --> 00:38:28.190 got to flip around the ranking and take projects or loans 00:38:28.190 --> 00:38:31.760 with smaller IRRs, not higher IRRs. 00:38:31.760 --> 00:38:34.080 And finally, it also ignores scale 00:38:34.080 --> 00:38:35.330 because it's a rate of return. 00:38:35.330 --> 00:38:39.130 It doesn't look at dollars and cents. 00:38:39.130 --> 00:38:40.940 Zeke? 00:38:40.940 --> 00:38:43.370 AUDIENCE: I have no professional experience 00:38:43.370 --> 00:38:47.355 but there's something that simply bothers me. 00:38:47.355 --> 00:38:49.480 You told that for, example, that this model doesn't 00:38:49.480 --> 00:38:50.980 work if you have negative cash flows 00:38:50.980 --> 00:38:54.415 and that people can make mistakes and use negative cash 00:38:54.415 --> 00:38:55.876 flows in real life. 00:38:55.876 --> 00:38:57.824 How does this happen? 00:38:57.824 --> 00:38:59.772 Don't people have-- in this Excel sheet, 00:38:59.772 --> 00:39:01.233 it's a simple calculation. 00:39:01.233 --> 00:39:03.356 How is this allowed in professional-- 00:39:03.356 --> 00:39:05.480 ANDREW LO: Hold on for one second, let me show you. 00:39:05.480 --> 00:39:07.400 I'm going to show you by example. 00:39:07.400 --> 00:39:11.540 It's not as easy as you think. 00:39:11.540 --> 00:39:13.940 Let me give you some examples for incorrect rankings. 00:39:13.940 --> 00:39:16.820 This is one example where, as I said, with a loan 00:39:16.820 --> 00:39:19.520 you want to pick the project that's got a lower IRR, not 00:39:19.520 --> 00:39:20.960 a higher IRR. 00:39:20.960 --> 00:39:22.580 So that's one issue. 00:39:22.580 --> 00:39:26.950 But let me give you an idea of the nonexistence of an IRR. 00:39:26.950 --> 00:39:31.260 Project one has two negative cash flows. 00:39:31.260 --> 00:39:34.633 One in the first period, and another one in period two. 00:39:37.190 --> 00:39:39.800 Project two has only one negative cash flow, 00:39:39.800 --> 00:39:43.370 but it happens in period one, not in period zero 00:39:43.370 --> 00:39:45.530 or in period two. 00:39:45.530 --> 00:39:49.280 Both of these projects are not particularly weird. 00:39:49.280 --> 00:39:52.100 I know it's true that they don't have negative cash flows on day 00:39:52.100 --> 00:39:54.260 one and positive thereafter. 00:39:54.260 --> 00:39:56.540 But I don't think you would look at these 00:39:56.540 --> 00:39:59.390 and say that, gee this is really pathological, 00:39:59.390 --> 00:40:01.500 or perverse, in any way. 00:40:01.500 --> 00:40:03.320 It's just a different way of structuring 00:40:03.320 --> 00:40:07.160 your particular financing, or your cash flows. 00:40:07.160 --> 00:40:09.020 It turns out that in both of these cases, 00:40:09.020 --> 00:40:13.270 the IRR doesn't actually exist. 00:40:13.270 --> 00:40:15.640 Now by exist, what do I mean? 00:40:15.640 --> 00:40:19.480 Let's go back and look at exactly how to compute IRR. 00:40:19.480 --> 00:40:22.480 To compute an IRR, you have to find a number that 00:40:22.480 --> 00:40:23.840 satisfies this equation. 00:40:26.540 --> 00:40:32.250 And so with k period IRR calculation, 00:40:32.250 --> 00:40:37.330 we've got k cash flows over k years. 00:40:37.330 --> 00:40:39.140 What, in the end, are you trying to solve? 00:40:39.140 --> 00:40:40.181 What kind of an equation? 00:40:44.000 --> 00:40:45.441 Nobody on high school math teams? 00:40:45.441 --> 00:40:45.940 Andy? 00:40:45.940 --> 00:40:47.480 AUDIENCE: kth order polynomial. 00:40:47.480 --> 00:40:51.214 ANDREW LO: Yeah, a kth order polynomial. 00:40:51.214 --> 00:40:52.630 You all know what that is, I hope. 00:40:52.630 --> 00:40:54.260 Right? 00:40:54.260 --> 00:40:56.870 Second order polynomial's a quadratic. 00:40:56.870 --> 00:40:59.930 ax squared plus bx plus c equals 0. 00:40:59.930 --> 00:41:02.690 A third order polynomial has a cubed term, and so on. 00:41:02.690 --> 00:41:07.460 A kth order polynomial has powers of IRR 00:41:07.460 --> 00:41:08.870 that are up to order k. 00:41:12.390 --> 00:41:15.060 Anybody tell me how many solutions there 00:41:15.060 --> 00:41:18.040 are of a kth order polynomial? 00:41:18.040 --> 00:41:19.680 AUDIENCE: k [INAUDIBLE] 00:41:19.680 --> 00:41:23.340 ANDREW LO: Up to k solutions. 00:41:23.340 --> 00:41:25.110 Do you always have solutions? 00:41:25.110 --> 00:41:26.962 AUDIENCE: No. 00:41:26.962 --> 00:41:30.612 k is obvious. 00:41:30.612 --> 00:41:32.820 ANDREW LO: We're getting some different theories now. 00:41:32.820 --> 00:41:36.352 So some says yes, some says no, some says where k is odd. 00:41:36.352 --> 00:41:38.070 By odd I presume you mean not even, 00:41:38.070 --> 00:41:41.370 as opposed to weird, right? 00:41:41.370 --> 00:41:43.320 it actually turns out that you can 00:41:43.320 --> 00:41:47.126 construct a solution for every single kth order polynomial. 00:41:47.126 --> 00:41:48.750 But that's if you change the definition 00:41:48.750 --> 00:41:51.120 of what you mean by a solution. 00:41:51.120 --> 00:41:52.680 Right, exactly. 00:41:52.680 --> 00:41:54.840 If you introduce a new set of numbers 00:41:54.840 --> 00:41:58.470 called complex number, by that I mean numbers 00:41:58.470 --> 00:42:01.470 where the square root of negative 1 makes sense. 00:42:01.470 --> 00:42:03.390 If you will extend the number system 00:42:03.390 --> 00:42:06.790 to include these weird things called complex numbers, 00:42:06.790 --> 00:42:09.960 then it turns out that all polynomials, 00:42:09.960 --> 00:42:13.350 all kth order polynomials have exactly k solutions. 00:42:13.350 --> 00:42:15.010 How nice. 00:42:15.010 --> 00:42:16.740 The problem is that these solutions 00:42:16.740 --> 00:42:19.380 can involve complex numbers. 00:42:19.380 --> 00:42:21.192 And as far as we know, complex numbers 00:42:21.192 --> 00:42:22.650 don't have any ready interpretation 00:42:22.650 --> 00:42:24.610 in terms of interest and money. 00:42:24.610 --> 00:42:27.000 So in other words, the only solutions that matter for you 00:42:27.000 --> 00:42:29.130 and me, for practical purposes, is 00:42:29.130 --> 00:42:31.740 what are called real solutions. 00:42:31.740 --> 00:42:34.570 And in particular, not only do they have to be real, 00:42:34.570 --> 00:42:37.380 but it would sort of be nice if they were positive numbers. 00:42:37.380 --> 00:42:40.380 Because interest rates, again, although they can be negative, 00:42:40.380 --> 00:42:42.480 it's kind of hard to imagine what that implies 00:42:42.480 --> 00:42:45.280 over long periods of time. 00:42:45.280 --> 00:42:48.990 So when I say that a solution doesn't 00:42:48.990 --> 00:42:50.700 exist for these two cases, I don't mean 00:42:50.700 --> 00:42:52.770 that they don't exist, exist. 00:42:52.770 --> 00:42:55.050 Of course they exist, they have to exist. 00:42:55.050 --> 00:42:56.820 The problem is that the solutions-- these 00:42:56.820 --> 00:42:59.510 are two period cash flows. 00:42:59.510 --> 00:43:01.650 So we're talking about quadratics. 00:43:01.650 --> 00:43:05.760 We all know the solution to the quadratic equation of ax 00:43:05.760 --> 00:43:07.110 squared plus bx plus c equals 0. 00:43:07.110 --> 00:43:07.830 What's the solution? 00:43:07.830 --> 00:43:08.788 Anyway tell me quickly? 00:43:11.740 --> 00:43:13.770 Negative b plus or minus the square root of b 00:43:13.770 --> 00:43:15.120 squared minus 4ac over 2a. 00:43:15.120 --> 00:43:17.070 Remember that? 00:43:17.070 --> 00:43:22.020 It turns out that you don't get real solutions all the time. 00:43:22.020 --> 00:43:24.990 Meaning that, in certain cases, that formula 00:43:24.990 --> 00:43:27.825 will produce solutions that have the square root of negative 1 00:43:27.825 --> 00:43:29.250 in there. 00:43:29.250 --> 00:43:32.820 And that makes no sense from an economic perspective. 00:43:32.820 --> 00:43:34.840 It just so happens that in these two cases, 00:43:34.840 --> 00:43:38.610 you should go home and try it, and you'll see for yourself. 00:43:38.610 --> 00:43:41.460 When you come up with the two solutions that 00:43:41.460 --> 00:43:47.299 exist for both of these cases, they're complex numbers. 00:43:47.299 --> 00:43:49.590 So I challenge you to tell me what the right investment 00:43:49.590 --> 00:43:53.400 decision is by looking at those complex numbers. 00:43:53.400 --> 00:43:55.440 It can't be done. 00:43:55.440 --> 00:43:59.250 Which means that IRR doesn't always work. 00:43:59.250 --> 00:44:02.730 And here are two relatively reasonable examples 00:44:02.730 --> 00:44:06.020 that nobody should be expected to look at and say, 00:44:06.020 --> 00:44:06.930 ha, of course. 00:44:06.930 --> 00:44:08.820 You can't use IRR here. 00:44:08.820 --> 00:44:10.890 These are real life examples. 00:44:10.890 --> 00:44:12.600 And by the way, this is just two periods. 00:44:12.600 --> 00:44:16.770 If I had five periods, and I had some positives, some negatives, 00:44:16.770 --> 00:44:19.440 it gets even more complicated. 00:44:19.440 --> 00:44:21.630 So even within a spreadsheet, where 00:44:21.630 --> 00:44:23.880 you can see the positives and the negatives, 00:44:23.880 --> 00:44:25.020 and you can compute IRR-- 00:44:25.020 --> 00:44:26.850 you can do this in Excel. 00:44:26.850 --> 00:44:27.850 And you should do that. 00:44:27.850 --> 00:44:30.400 You'll get these weird symbols that come up, 00:44:30.400 --> 00:44:32.010 that will start spitting up blood 00:44:32.010 --> 00:44:35.530 and say that it can't handle this. 00:44:35.530 --> 00:44:37.150 Unfortunately, if you did it MATLAB, 00:44:37.150 --> 00:44:39.100 which I know a number of you are likely to do, 00:44:39.100 --> 00:44:40.330 you will get an answer. 00:44:40.330 --> 00:44:43.910 MATLAB has no problem with complex numbers. 00:44:43.910 --> 00:44:45.490 So that's one problem. 00:44:45.490 --> 00:44:48.820 Let me illustrate to you though, where the problem comes 00:44:48.820 --> 00:44:51.080 with multiplicity of solutions. 00:44:51.080 --> 00:44:54.580 So this is a graph of the polynomial. 00:44:54.580 --> 00:44:57.850 In this case, the third order polynomial. 00:44:57.850 --> 00:45:00.910 And so what I'm doing is I'm calculating 00:45:00.910 --> 00:45:06.280 the NPV of project 1 and of project 2 00:45:06.280 --> 00:45:10.300 as a function of the underlying interest rate. 00:45:10.300 --> 00:45:12.820 And an IRR corresponds to a situation 00:45:12.820 --> 00:45:16.390 where the NPV is equal to 0, the break-even point. 00:45:16.390 --> 00:45:19.210 What you'll notice is that the 0's 00:45:19.210 --> 00:45:23.547 are where this curve intersects the y-axis, or the x-axis, 00:45:23.547 --> 00:45:24.680 sorry. 00:45:24.680 --> 00:45:27.910 And so with the first project, you actually 00:45:27.910 --> 00:45:29.320 get a unique solution. 00:45:29.320 --> 00:45:32.680 It only crosses the x-axis once. 00:45:32.680 --> 00:45:35.630 So you get a unique, real solution. 00:45:35.630 --> 00:45:38.230 But if you take a look at project 2, 00:45:38.230 --> 00:45:44.410 project 2 crosses the x-axis once, twice, three times. 00:45:44.410 --> 00:45:45.880 You get three solutions. 00:45:45.880 --> 00:45:47.830 They're all real, by the way. 00:45:47.830 --> 00:45:50.500 You get three, real solutions. 00:45:50.500 --> 00:45:52.350 Which one would you like? 00:45:52.350 --> 00:45:53.990 Take your pick. 00:45:53.990 --> 00:45:55.610 You pick the biggest one? 00:45:55.610 --> 00:45:56.480 Or the smallest one? 00:45:56.480 --> 00:45:58.280 Or maybe average them, or do something? 00:45:58.280 --> 00:45:59.870 I don't know. 00:45:59.870 --> 00:46:05.570 The problem is that with IRR, If the pattern of cash flows 00:46:05.570 --> 00:46:08.630 is anything but strictly positive, 00:46:08.630 --> 00:46:11.250 you get weird results. 00:46:11.250 --> 00:46:16.320 Now, I told you before that IRR is used almost exclusively 00:46:16.320 --> 00:46:19.167 in one particular sector, one particular segment, 00:46:19.167 --> 00:46:20.250 of the financial industry. 00:46:20.250 --> 00:46:22.614 Anybody know what that is? 00:46:22.614 --> 00:46:23.674 AUDIENCE: Bonds? 00:46:23.674 --> 00:46:24.340 ANDREW LO: Bond? 00:46:24.340 --> 00:46:27.580 Well, that would be a good answer, you're right. 00:46:27.580 --> 00:46:31.547 Yield to maturity is what IRR is in bonds. 00:46:31.547 --> 00:46:33.130 That wasn't what I was thinking about, 00:46:33.130 --> 00:46:34.450 but you're absolutely right. 00:46:34.450 --> 00:46:38.200 IRR, in fact, is used all the time in bonds 00:46:38.200 --> 00:46:39.700 because you quote yield to maturity. 00:46:39.700 --> 00:46:42.700 And it's not surprising because with bonds, you only 00:46:42.700 --> 00:46:45.700 have positive cash flows, and you only 00:46:45.700 --> 00:46:48.620 have an initial payment upfront, which is the price of the bond. 00:46:48.620 --> 00:46:52.300 So all of the criteria that I required in order 00:46:52.300 --> 00:46:58.390 to make IRR equivalent to NPV holds for bonds. 00:46:58.390 --> 00:47:01.000 But I'm thinking about something else. 00:47:01.000 --> 00:47:04.150 What other part of the financial industry 00:47:04.150 --> 00:47:06.790 uses IRR as a way of making investments? 00:47:06.790 --> 00:47:11.080 And not only that, but of quoting performance. 00:47:11.080 --> 00:47:11.650 What's that? 00:47:11.650 --> 00:47:12.340 AUDIENCE: Private equity? 00:47:12.340 --> 00:47:13.630 ANDREW LO: Private equity, exactly. 00:47:13.630 --> 00:47:14.260 Private equity. 00:47:14.260 --> 00:47:18.550 In private equity, almost every venture capitalist 00:47:18.550 --> 00:47:23.470 will tell you what their IRR is of their portfolio. 00:47:23.470 --> 00:47:26.470 And there are a couple of reasons for this practice. 00:47:26.470 --> 00:47:31.060 One of course, is that for most private equity ventures, 00:47:31.060 --> 00:47:34.690 it is all about cash up front, and then positive cash 00:47:34.690 --> 00:47:37.590 flows thereafter. 00:47:37.590 --> 00:47:42.910 Unless of course, you require additional financing 00:47:42.910 --> 00:47:44.440 like mezzanine financing. 00:47:44.440 --> 00:47:47.110 In which case, now you have a hard time 00:47:47.110 --> 00:47:49.030 using IRR for the whole thing. 00:47:49.030 --> 00:47:52.510 You could use IRR for the separate tranches 00:47:52.510 --> 00:47:55.480 of investments, and again, that's 00:47:55.480 --> 00:47:57.370 kind of an accommodation. 00:47:57.370 --> 00:48:02.050 It's a fix for trying to deal with the weaknesses of IRR. 00:48:02.050 --> 00:48:04.120 If you focus just on the particular tranche 00:48:04.120 --> 00:48:08.200 of an investment, you've got a tranche of investment going in, 00:48:08.200 --> 00:48:14.920 cash flows going out, and it all satisfies the NPV criterion. 00:48:14.920 --> 00:48:17.170 But the other reason for focusing on IRR 00:48:17.170 --> 00:48:20.560 is because, again, this is an issue of scale. 00:48:20.560 --> 00:48:22.510 You want to compare two investments, 00:48:22.510 --> 00:48:25.612 and they may require different dollar amounts, 00:48:25.612 --> 00:48:27.070 so you'd like to be able to compare 00:48:27.070 --> 00:48:32.867 their performance in some way that doesn't include the scale. 00:48:32.867 --> 00:48:34.450 Because you want to be able to compare 00:48:34.450 --> 00:48:36.250 across a bunch of different investments 00:48:36.250 --> 00:48:42.680 and see how each manager is doing per unit dollar invested. 00:48:42.680 --> 00:48:45.560 However, the bottom line of a venture capitalist 00:48:45.560 --> 00:48:47.579 is, I've got a billion dollars to invest. 00:48:47.579 --> 00:48:49.370 I have to figure out where to put my money. 00:48:49.370 --> 00:48:52.349 I can't afford to put my money in smaller investments that 00:48:52.349 --> 00:48:54.140 are not going to give me the kind of return 00:48:54.140 --> 00:48:55.460 that I need to have. 00:48:55.460 --> 00:48:57.260 So in the end, a venture capitalist 00:48:57.260 --> 00:48:59.960 is going to have to look at scale anyway. 00:48:59.960 --> 00:49:03.080 But for historical and cultural reasons, 00:49:03.080 --> 00:49:07.340 you actually have the venture capital community the only one 00:49:07.340 --> 00:49:11.030 that really focuses almost exclusively on using IRR. 00:49:11.030 --> 00:49:14.750 And for their applications, like the bond pricing example, 00:49:14.750 --> 00:49:18.980 it's generally OK, but it may not be. 00:49:18.980 --> 00:49:21.110 And so you should understand those conditions 00:49:21.110 --> 00:49:22.910 under which it may not be. 00:49:22.910 --> 00:49:26.630 So I want you to refer to these, and if you have a moment 00:49:26.630 --> 00:49:28.730 during your holiday break and you're bored, 00:49:28.730 --> 00:49:30.680 you might want to run a few of these in Excel. 00:49:30.680 --> 00:49:34.910 Just literally try to compute the appropriate IRR in Excel. 00:49:34.910 --> 00:49:37.010 And just prove to yourself that you 00:49:37.010 --> 00:49:39.680 can't, that you get some weird results out of that. 00:49:43.630 --> 00:49:48.130 Any questions about IRR? 00:49:48.130 --> 00:49:50.350 By the way, again, there are no formulas 00:49:50.350 --> 00:49:52.690 other than the quadratic for how to compute it. 00:49:52.690 --> 00:49:55.030 So in most cases when you want to compute IRR, 00:49:55.030 --> 00:49:56.530 you have to use numerical methods. 00:49:56.530 --> 00:50:00.280 You have to basically solve a non-linear equation for a 0. 00:50:00.280 --> 00:50:02.710 So effectively, you have to do this. 00:50:02.710 --> 00:50:06.840 You have to find the 0's of these equations. 00:50:06.840 --> 00:50:09.610 That could be a little bit of an exercise to do that. 00:50:12.620 --> 00:50:15.200 There are other examples here where 00:50:15.200 --> 00:50:17.090 I try to come up with ways to fix IRR, 00:50:17.090 --> 00:50:19.730 maybe by looking at incremental cash flows, 00:50:19.730 --> 00:50:22.880 or looking at different ranking methods. 00:50:22.880 --> 00:50:26.420 But the bottom line is use NPV. 00:50:26.420 --> 00:50:29.150 Be aware of how to compute an IRR, 00:50:29.150 --> 00:50:31.670 but you should understand that IRR, 00:50:31.670 --> 00:50:36.740 in the cases where it matters, either it agrees with NPV or it 00:50:36.740 --> 00:50:37.262 doesn't. 00:50:37.262 --> 00:50:38.720 And if it doesn't, you can't use it 00:50:38.720 --> 00:50:41.690 because it's going to create all sorts of contradictions 00:50:41.690 --> 00:50:42.515 and weird results. 00:50:46.690 --> 00:50:49.810 I want to conclude this lecture on capital budgeting 00:50:49.810 --> 00:50:53.860 by talking about what people actually do in practice, 00:50:53.860 --> 00:50:56.410 and give you a little bit of a preview about what you're 00:50:56.410 --> 00:51:01.060 going to learn in 402 as well as in 434 and other courses 00:51:01.060 --> 00:51:04.300 on corporate financing and capital budgeting. 00:51:04.300 --> 00:51:07.840 Right now, as of maybe five years ago 00:51:07.840 --> 00:51:11.080 when this survey was done, for large US firms, 00:51:11.080 --> 00:51:13.870 believe it or not, payback period 00:51:13.870 --> 00:51:17.030 was probably the most popular. 00:51:17.030 --> 00:51:19.010 It's the one that people focused on the most. 00:51:19.010 --> 00:51:21.177 Again, not necessarily exclusively. 00:51:21.177 --> 00:51:23.260 So it could well be that people use payback period 00:51:23.260 --> 00:51:26.720 as one criterion, but they use many others as well. 00:51:26.720 --> 00:51:31.530 But over 80% of the companies surveyed use payback period. 00:51:31.530 --> 00:51:34.900 65% use IRR, which is quite a lot. 00:51:34.900 --> 00:51:37.600 But again, a significant fraction of that 00:51:37.600 --> 00:51:40.730 is private equity. 00:51:40.730 --> 00:51:43.100 And by the way, for non-financial corporations that 00:51:43.100 --> 00:51:46.910 have private equity operations within it, for example, 00:51:46.910 --> 00:51:50.420 General Motors has a part of their pension fund devoted 00:51:50.420 --> 00:51:51.950 to private equity investments. 00:51:51.950 --> 00:51:54.560 They will use IRR as well, because other venture 00:51:54.560 --> 00:51:56.960 capitalists use that. 00:51:56.960 --> 00:52:00.410 NPV is actually gaining ground. 00:52:00.410 --> 00:52:02.720 So it's now more popular than IRR. 00:52:02.720 --> 00:52:06.380 If you surveyed multinationals and US corporations 00:52:06.380 --> 00:52:09.110 20 years ago, it would have been flipped around. 00:52:09.110 --> 00:52:12.500 IRR would have been way more popular than NPV, 00:52:12.500 --> 00:52:16.200 but that's changed a lot just in the last 20 years. 00:52:16.200 --> 00:52:18.500 However, when you look at multinationals, 00:52:18.500 --> 00:52:22.460 you see that actually, IRR is still more popular. 00:52:22.460 --> 00:52:25.250 So that's something to keep in mind. 00:52:25.250 --> 00:52:27.140 When you're dealing with foreign companies, 00:52:27.140 --> 00:52:30.170 they may be looking at investments 00:52:30.170 --> 00:52:34.520 from a VC perspective, as opposed to from a pure net cash 00:52:34.520 --> 00:52:36.500 flow NPV perspective. 00:52:36.500 --> 00:52:39.530 So that's something that you'll want to be wary of. 00:52:39.530 --> 00:52:41.750 And by the way, that's probably one area 00:52:41.750 --> 00:52:46.305 where you can make real progress in terms of an impact 00:52:46.305 --> 00:52:47.180 through your careers. 00:52:50.090 --> 00:52:51.860 Historical comparison, this gives you 00:52:51.860 --> 00:52:54.950 a little bit of a time series of how 00:52:54.950 --> 00:52:56.730 things have changed over time. 00:52:56.730 --> 00:53:01.250 So back in 1959, payback period, IRR, 00:53:01.250 --> 00:53:03.020 was quite a bit more popular. 00:53:03.020 --> 00:53:06.860 Over time, that's declined, and over time, IRR 00:53:06.860 --> 00:53:08.540 has gained more ground. 00:53:08.540 --> 00:53:13.280 But NPV, as of 1981, was lagging far behind. 00:53:13.280 --> 00:53:17.060 And within the last 20 years, we see this chart where 00:53:17.060 --> 00:53:19.460 NPV has caught up a great deal. 00:53:19.460 --> 00:53:21.020 A large part of that, if you want 00:53:21.020 --> 00:53:23.103 to know where that came from, a large part of that 00:53:23.103 --> 00:53:25.910 was thanks to Brealey and Myers. 00:53:25.910 --> 00:53:27.680 The textbook that you're using now 00:53:27.680 --> 00:53:31.010 was probably the first major corporate finance textbook ever 00:53:31.010 --> 00:53:33.980 written, way back in the 1980s. 00:53:33.980 --> 00:53:38.330 And Stu Myers and Dick Brealey wrote the book really 00:53:38.330 --> 00:53:39.980 because there was nothing else that 00:53:39.980 --> 00:53:43.310 was out there that corresponded to these kind of modern finance 00:53:43.310 --> 00:53:44.390 principles. 00:53:44.390 --> 00:53:47.420 And so Stu and Dick have a lot to do 00:53:47.420 --> 00:53:49.940 with these numbers as of today. 00:53:54.830 --> 00:53:57.570 Other issues that we were not able to take on in this course, 00:53:57.570 --> 00:54:00.950 but which you will see in 402 and 434, 00:54:00.950 --> 00:54:06.050 is how to deal with other aspects of the capital 00:54:06.050 --> 00:54:07.100 budgeting process. 00:54:07.100 --> 00:54:09.740 For example, competitive response. 00:54:09.740 --> 00:54:11.960 When we think about making investments in projects, 00:54:11.960 --> 00:54:16.532 we are assuming everything else as given. 00:54:16.532 --> 00:54:18.740 This is sort of like putting money in a stock market. 00:54:18.740 --> 00:54:20.573 When you put your money in the stock market, 00:54:20.573 --> 00:54:24.470 you're assuming that the means and the variances are given. 00:54:24.470 --> 00:54:26.780 That your investment has no impact 00:54:26.780 --> 00:54:28.940 on the market as a whole. 00:54:28.940 --> 00:54:32.900 For specific kinds of projects, that's not true at all. 00:54:32.900 --> 00:54:34.820 The perfect market's assumption that we 00:54:34.820 --> 00:54:38.660 make from the perspective of a small investor investing 00:54:38.660 --> 00:54:40.880 in the entire market, those set of assumptions 00:54:40.880 --> 00:54:44.060 don't work for you making a decision 00:54:44.060 --> 00:54:46.430 about whether to invest in a new technology 00:54:46.430 --> 00:54:47.960 in your particular industry. 00:54:47.960 --> 00:54:50.510 Because most likely, that new technology 00:54:50.510 --> 00:54:54.470 will have a very significant impact on that industry 00:54:54.470 --> 00:54:55.610 if it's any good. 00:54:55.610 --> 00:54:57.026 So therefore, you're going to have 00:54:57.026 --> 00:54:59.990 to deal with competitors and the competitive response. 00:54:59.990 --> 00:55:02.270 Things are going to change because of the way 00:55:02.270 --> 00:55:03.800 you make your investments. 00:55:03.800 --> 00:55:06.230 So that's something you'll have to take into account. 00:55:06.230 --> 00:55:08.600 Capital rationing, which means you 00:55:08.600 --> 00:55:10.249 don't have all the money in the world. 00:55:10.249 --> 00:55:12.290 There's a limit to how much money you can invest, 00:55:12.290 --> 00:55:15.500 so now, given that there are limits to how much money you 00:55:15.500 --> 00:55:19.670 have, you've got to pick your opportunities more carefully. 00:55:19.670 --> 00:55:24.290 And some of these capital rationing requirements 00:55:24.290 --> 00:55:26.610 are implemented over multi-year periods. 00:55:26.610 --> 00:55:28.730 So for example, you might have a three year 00:55:28.730 --> 00:55:32.750 budget of $100 million to make investments in new technology. 00:55:32.750 --> 00:55:35.679 Over three years, you can use up to $100 million. 00:55:35.679 --> 00:55:37.220 So now, not only do you have to think 00:55:37.220 --> 00:55:41.840 about how to spread your money over opportunities this year, 00:55:41.840 --> 00:55:43.670 you've got to think about a spread it out 00:55:43.670 --> 00:55:44.817 over a three year period. 00:55:44.817 --> 00:55:47.150 And you have to think about spreading it out to projects 00:55:47.150 --> 00:55:49.430 that you don't even know exist right now. 00:55:49.430 --> 00:55:52.500 So the problems, the challenges, become much, 00:55:52.500 --> 00:55:55.100 much more complex as you start making 00:55:55.100 --> 00:55:57.600 the assumptions more realistic. 00:55:57.600 --> 00:55:59.600 You've got now, the very basics to understand 00:55:59.600 --> 00:56:02.810 how to do this for the very, very simple cases. 00:56:02.810 --> 00:56:05.570 But the more advanced courses will, one by one, 00:56:05.570 --> 00:56:07.760 relax these assumptions and give you 00:56:07.760 --> 00:56:11.840 more tools to be able to handle more complex situations. 00:56:11.840 --> 00:56:13.610 The examples that I give in this slide 00:56:13.610 --> 00:56:18.170 are looking at short run versus the long run, 00:56:18.170 --> 00:56:20.990 as well as dealing with general noise. 00:56:20.990 --> 00:56:23.699 In other words, you may be taking in lots of data, 00:56:23.699 --> 00:56:25.490 not all of that data is equally meaningful. 00:56:25.490 --> 00:56:29.397 So you need to know what to ignore, and what to focus on. 00:56:29.397 --> 00:56:30.980 That will be part of those challenges. 00:56:30.980 --> 00:56:37.210 You'll get that in 402, and more in 434. 00:56:37.210 --> 00:56:43.720 So to summarize, we are now done with pretty much all 00:56:43.720 --> 00:56:46.510 of the finance theory that we need 00:56:46.510 --> 00:56:51.310 to value and to make decisions on virtually any kind 00:56:51.310 --> 00:56:54.680 of investment that's out there. 00:56:54.680 --> 00:56:56.530 The key points for capital budgeting 00:56:56.530 --> 00:57:00.220 is use NPV, or in the case of more advanced kinds 00:57:00.220 --> 00:57:03.580 of concepts, APV. 00:57:03.580 --> 00:57:06.790 Take all projects that are positive NPV, and if they're 00:57:06.790 --> 00:57:10.090 mutually exclusive, take the one with the biggest NPV. 00:57:10.090 --> 00:57:12.250 Consider project interactions separately. 00:57:12.250 --> 00:57:14.530 So consider the project on a standalone basis, 00:57:14.530 --> 00:57:17.260 then consider any interaction effects 00:57:17.260 --> 00:57:18.850 that may or may not exist. 00:57:18.850 --> 00:57:21.130 You can evaluate them separately, and add them 00:57:21.130 --> 00:57:23.230 together at the end. 00:57:23.230 --> 00:57:26.020 Use after tax cash flows for the NPV calculations, 00:57:26.020 --> 00:57:27.670 not accounting earnings. 00:57:27.670 --> 00:57:31.881 And when you need discount rate, use the capital asset pricing 00:57:31.881 --> 00:57:32.380 model. 00:57:32.380 --> 00:57:35.440 The capital asset pricing model provides you 00:57:35.440 --> 00:57:41.320 with a risk adjustment for the required rate of return. 00:57:41.320 --> 00:57:44.710 And be wary about risks that change over time. 00:57:44.710 --> 00:57:48.460 So every single year you use your cost of capital, 00:57:48.460 --> 00:57:52.060 make sure you can justify the particular risk associated 00:57:52.060 --> 00:57:52.840 with that year. 00:57:52.840 --> 00:57:55.630 Remember the example of drilling for oil 00:57:55.630 --> 00:57:57.940 and how the risks change dramatically 00:57:57.940 --> 00:58:01.900 as you go from oil exploration to oil production. 00:58:01.900 --> 00:58:04.660 Those are two different activities. 00:58:04.660 --> 00:58:09.160 Finally, think about all the other alternatives to NPV. 00:58:09.160 --> 00:58:11.740 And you don't have to be a snob about it. 00:58:11.740 --> 00:58:14.170 Don't tell people, NPV's the only way to go. 00:58:14.170 --> 00:58:16.150 It's either my way or the highway. 00:58:16.150 --> 00:58:19.900 You recognize that there are other elements of risk 00:58:19.900 --> 00:58:22.990 and reward that may be captured by payback, 00:58:22.990 --> 00:58:26.590 by internal rate of return, by the profitability index. 00:58:26.590 --> 00:58:28.240 But in the end, what you're going 00:58:28.240 --> 00:58:31.360 to want to base your decision on is primarily 00:58:31.360 --> 00:58:34.570 NPV considerations, with these other factors 00:58:34.570 --> 00:58:37.580 thrown in as well. 00:58:37.580 --> 00:58:40.910 I'll conclude with one last comment about capital 00:58:40.910 --> 00:58:44.462 budgeting, which is something that is completely 00:58:44.462 --> 00:58:45.920 outside the purview of this course, 00:58:45.920 --> 00:58:48.947 but it's not outside the purview of your MBA. 00:58:48.947 --> 00:58:50.530 And that is that why I've been talking 00:58:50.530 --> 00:58:53.800 about for the exclusion of everything else in this course 00:58:53.800 --> 00:58:58.300 is the economic and financial considerations. 00:58:58.300 --> 00:59:00.910 Obviously, when you're engaged in trying 00:59:00.910 --> 00:59:06.262 to get a project approved, or making a decision on a project, 00:59:06.262 --> 00:59:07.720 there are many other considerations 00:59:07.720 --> 00:59:09.280 that you should not forget about. 00:59:09.280 --> 00:59:13.210 Considerations like political, social, cultural, 00:59:13.210 --> 00:59:17.440 implementation, all sorts of practical aspects 00:59:17.440 --> 00:59:19.640 that you need to put together. 00:59:19.640 --> 00:59:21.970 And so all of the other courses that you've been taking 00:59:21.970 --> 00:59:24.580 are designed to try to get you to think about that. 00:59:24.580 --> 00:59:28.180 But unfortunately, or maybe inevitably, 00:59:28.180 --> 00:59:32.470 in a curriculum like the MBA, we pick apart 00:59:32.470 --> 00:59:34.780 all of the various aspects of a decision 00:59:34.780 --> 00:59:36.850 and then study it to death, and try 00:59:36.850 --> 00:59:40.000 to come up with the very best possible approaches for each 00:59:40.000 --> 00:59:42.820 of those particular silos. 00:59:42.820 --> 00:59:46.276 It's your job, ultimately, to put all of that together. 00:59:46.276 --> 00:59:47.650 And you will do that, you will be 00:59:47.650 --> 00:59:49.540 asked to do that, whether you know it or not, 00:59:49.540 --> 00:59:50.920 when you start working. 00:59:50.920 --> 00:59:53.830 So what I've been focused on exclusively 00:59:53.830 --> 00:59:56.080 is the financial and economic considerations. 00:59:56.080 --> 00:59:58.240 And I believe you now have the tools 00:59:58.240 --> 01:00:00.100 to be able to analyze any project, 01:00:00.100 --> 01:00:03.640 at least to get a starting point for an intellectually 01:00:03.640 --> 01:00:05.352 consistent way of looking at it. 01:00:05.352 --> 01:00:07.810 But don't for a moment think that those are the only things 01:00:07.810 --> 01:00:09.270 that are important. 01:00:09.270 --> 01:00:13.090 The political, social, cultural ramifications 01:00:13.090 --> 01:00:15.460 are going to be extraordinarily critical, 01:00:15.460 --> 01:00:17.380 and only you will be able to figure out 01:00:17.380 --> 01:00:19.120 how to put that all together. 01:00:19.120 --> 01:00:21.670 So hopefully in this particular course, 01:00:21.670 --> 01:00:24.130 you've learned something valuable from that one aspect. 01:00:24.130 --> 01:00:26.140 But just keep in mind, it is only one aspect, 01:00:26.140 --> 01:00:27.281 one perspective. 01:00:27.281 --> 01:00:29.530 And there are others that you will have to incorporate 01:00:29.530 --> 01:00:30.910 into your way of thinking. 01:00:33.850 --> 01:00:36.650 That's it for capital budgeting. 01:00:36.650 --> 01:00:38.560 Any final questions before we move 01:00:38.560 --> 01:00:42.021 on to the final lecture of this course? 01:00:42.021 --> 01:00:42.520 Yes? 01:00:42.520 --> 01:00:46.454 AUDIENCE: I just have one small question on IRR again. 01:00:46.454 --> 01:00:50.927 In the examples you showed, the cash flows in the out years 01:00:50.927 --> 01:00:56.269 and years [INAUDIBLE] were more, they 01:00:56.269 --> 01:01:00.060 were the opposite direction from the initial year cash flow, 01:01:00.060 --> 01:01:02.290 but greater than the [INAUDIBLE] cash flow. 01:01:02.290 --> 01:01:04.900 Does it matter that that's not the case that can happen? 01:01:04.900 --> 01:01:08.110 ANDREW LO: Well, I guess the answer is, it depends. 01:01:08.110 --> 01:01:10.420 In other words, what you detected 01:01:10.420 --> 01:01:14.110 was not a universal pattern that can be systematized 01:01:14.110 --> 01:01:16.390 and then incorporated into IRR. 01:01:16.390 --> 01:01:19.300 In other words, if I had a longer period of time 01:01:19.300 --> 01:01:21.520 to be able to play with changes of sine 01:01:21.520 --> 01:01:24.807 and changes of magnitude, I can get any kind of pattern 01:01:24.807 --> 01:01:25.390 that you want. 01:01:25.390 --> 01:01:28.870 For example, in the dotted line curve, 01:01:28.870 --> 01:01:31.870 I can have this curve flip around the other way 01:01:31.870 --> 01:01:33.790 so that it starts negative, goes positive, 01:01:33.790 --> 01:01:34.870 and it goes up like that. 01:01:34.870 --> 01:01:38.020 Just by changing the sign patterns to something else. 01:01:38.020 --> 01:01:39.970 If I had a quartic term in there, 01:01:39.970 --> 01:01:41.960 I can make it even more complicated. 01:01:41.960 --> 01:01:44.770 So the longer the number of periods, the more number 01:01:44.770 --> 01:01:46.870 of periods that I have to play with, the more 01:01:46.870 --> 01:01:49.300 patterns that you can create so that it would be really 01:01:49.300 --> 01:01:53.380 impossible to reduce it to a systematic 01:01:53.380 --> 01:01:58.440 set other than this proscription here. 01:01:58.440 --> 01:02:01.010 If these four conditions are satisfied, 01:02:01.010 --> 01:02:04.810 then you're OK with using this as opposed to NPV. 01:02:04.810 --> 01:02:07.570 But that's the only simple case where you 01:02:07.570 --> 01:02:10.090 can say something meaningful. 01:02:10.090 --> 01:02:14.350 By the way, the number of 0's and the nature of the 0's 01:02:14.350 --> 01:02:19.790 of polynomials, that turns out to be related to a very, very, 01:02:19.790 --> 01:02:23.920 very famous and hard unsolved problem in mathematics known 01:02:23.920 --> 01:02:25.479 as the Riemann zeta hypothesis. 01:02:25.479 --> 01:02:27.520 We're not going to talk about that in this class, 01:02:27.520 --> 01:02:28.103 unfortunately. 01:02:28.103 --> 01:02:30.430 It is beyond the scope of the school. 01:02:33.790 --> 01:02:36.430 But I just want to let you know that there is something 01:02:36.430 --> 01:02:40.180 inherently extraordinarily deep about 01:02:40.180 --> 01:02:43.644 the underlying contradictions that get generated by IRR. 01:02:43.644 --> 01:02:45.310 You don't have to solve the Riemann zeta 01:02:45.310 --> 01:02:49.510 hypothesis to understand it, but you can get very, very complex, 01:02:49.510 --> 01:02:55.000 very quickly by looking at these kinds of patterns. 01:02:55.000 --> 01:02:57.940 In fact, it would be bad news for us 01:02:57.940 --> 01:03:01.000 if these patterns actually mattered for investing. 01:03:01.000 --> 01:03:02.170 The fact is they don't. 01:03:02.170 --> 01:03:04.330 The bottom line is NPV. 01:03:04.330 --> 01:03:06.280 How much money are you generating 01:03:06.280 --> 01:03:08.270 from this investment, period. 01:03:08.270 --> 01:03:10.180 And if you focus on that, you're not 01:03:10.180 --> 01:03:12.130 likely to make a lot of mistakes. 01:03:12.130 --> 01:03:15.650 But you should at least be aware about these other techniques. 01:03:15.650 --> 01:03:17.200 So that's why I went over them. 01:03:17.200 --> 01:03:18.054 Yeah, David? 01:03:18.054 --> 01:03:19.720 AUDIENCE: Can you talk a little bit more 01:03:19.720 --> 01:03:24.780 about social, political, and cultural risks. 01:03:24.780 --> 01:03:29.346 From the perspective of the CFO of a company for example, 01:03:29.346 --> 01:03:32.490 who has to make a decision on whether and where to invest. 01:03:32.490 --> 01:03:37.170 It makes sense that there will be some political implications 01:03:37.170 --> 01:03:39.900 that cannot be captured by every model. 01:03:39.900 --> 01:03:42.570 But if I'm a private investor and I 01:03:42.570 --> 01:03:45.660 invest in a company that is listed in a stock exchange, 01:03:45.660 --> 01:03:49.320 I would expect all these considerations to be captured 01:03:49.320 --> 01:03:52.800 already in the stock price. 01:03:52.800 --> 01:03:55.410 ANDREW LO: Well, yes and no. 01:03:55.410 --> 01:03:57.802 Let me give you an example that is 01:03:57.802 --> 01:03:59.010 a somewhat controversial one. 01:03:59.010 --> 01:04:00.660 I don't really know the answer to it, 01:04:00.660 --> 01:04:02.034 but at least we can talk about it 01:04:02.034 --> 01:04:03.660 in the context of current events. 01:04:06.022 --> 01:04:07.480 If you take a look at what happened 01:04:07.480 --> 01:04:12.340 with Bear Stearns versus what happened with Lehman Brothers. 01:04:12.340 --> 01:04:17.560 It's kind of hard to understand why what happened, happened. 01:04:17.560 --> 01:04:20.350 Bear Stearns was deemed too big to fail. 01:04:20.350 --> 01:04:25.600 And so it was navigated to a soft landing with JP Morgan. 01:04:25.600 --> 01:04:28.450 Lehman on the other hand, which in certain respects 01:04:28.450 --> 01:04:30.940 was even bigger and even more broadly 01:04:30.940 --> 01:04:37.100 intertwined in our financial system, was allowed to fail. 01:04:37.100 --> 01:04:40.140 I don't understand that from an economic perspective. 01:04:40.140 --> 01:04:43.790 In fact, I'm not sure there is an economic perspective to why 01:04:43.790 --> 01:04:46.100 it failed. 01:04:46.100 --> 01:04:48.530 But there may be a political dimension. 01:04:48.530 --> 01:04:51.950 For example, and again this is pure speculation, 01:04:51.950 --> 01:04:55.910 so asking me for my views on political elements, 01:04:55.910 --> 01:04:56.990 I'm happy to provide. 01:04:56.990 --> 01:05:00.560 But it's like asking Roger Federer what 01:05:00.560 --> 01:05:02.460 he thinks about the S&P 500. 01:05:02.460 --> 01:05:06.410 Not that I'm Roger Federer, but it's 01:05:06.410 --> 01:05:08.690 asking somebody who's a professional in one area what 01:05:08.690 --> 01:05:10.023 they think about something else. 01:05:10.023 --> 01:05:12.290 I'm not sure it's a good idea. 01:05:12.290 --> 01:05:14.690 But the point is that my conjecture 01:05:14.690 --> 01:05:18.230 is that the reason Lehman Brothers was left to fail 01:05:18.230 --> 01:05:21.620 was because there was so much criticism and backlash 01:05:21.620 --> 01:05:26.720 from the Bear Stearns event that both Treasury and the Federal 01:05:26.720 --> 01:05:31.100 Reserve thought that it was politically untenable for them 01:05:31.100 --> 01:05:32.420 to do it again. 01:05:32.420 --> 01:05:34.670 Because if they did it again, then they 01:05:34.670 --> 01:05:36.290 would be expected to do it again, 01:05:36.290 --> 01:05:37.650 and again, and again, and again. 01:05:37.650 --> 01:05:40.520 In which case, all the firms would be in line 01:05:40.520 --> 01:05:42.520 to try to get a bailout. 01:05:42.520 --> 01:05:45.380 And they are. 01:05:45.380 --> 01:05:48.600 However, to highlight the complexity, 01:05:48.600 --> 01:05:51.860 to highlight the complexity of the political dimension, 01:05:51.860 --> 01:05:55.940 now that Lehman did fail and it caused 01:05:55.940 --> 01:06:00.980 such disastrous consequences, now maybe it's truly impossible 01:06:00.980 --> 01:06:02.637 to let any company fail. 01:06:02.637 --> 01:06:04.970 Because people will say, oh you remember Lehman Brothers 01:06:04.970 --> 01:06:05.970 and what happened there? 01:06:05.970 --> 01:06:07.670 You better not do that again. 01:06:07.670 --> 01:06:11.060 So I don't know the answer to the question about what 01:06:11.060 --> 01:06:14.750 the political landscape is going to look like a year from now, 01:06:14.750 --> 01:06:17.010 or even six months from now. 01:06:17.010 --> 01:06:19.010 So I don't know whether or not it's 01:06:19.010 --> 01:06:21.620 significant in terms of what will happen, 01:06:21.620 --> 01:06:25.220 but surely in the past, politics has played a very big role, 01:06:25.220 --> 01:06:26.714 even for private investors. 01:06:26.714 --> 01:06:29.130 But that actually wasn't the politics I was talking about. 01:06:29.130 --> 01:06:31.217 That certainly matters a great deal now, 01:06:31.217 --> 01:06:33.050 but the kind of politics I was talking about 01:06:33.050 --> 01:06:35.070 was more within a company. 01:06:35.070 --> 01:06:37.340 So I'll give you an example. 01:06:37.340 --> 01:06:38.930 You're a new division manager that 01:06:38.930 --> 01:06:43.970 was specifically hired by the CEO to turn around a division. 01:06:43.970 --> 01:06:47.270 And in your first quarter on the job, 01:06:47.270 --> 01:06:50.720 you propose a very specific restructuring 01:06:50.720 --> 01:06:53.210 for that division. 01:06:53.210 --> 01:06:56.950 Chances are the CEO is going to agree with you. 01:06:56.950 --> 01:06:58.700 Knowing nothing about whether the proposal 01:06:58.700 --> 01:07:01.992 is smart, or stupid, or good, or bad, 01:07:01.992 --> 01:07:03.950 most likely, the CEO's going to agree with you. 01:07:03.950 --> 01:07:04.730 Why is that? 01:07:04.730 --> 01:07:05.630 You know why, right? 01:07:05.630 --> 01:07:07.340 You guys agree with me. 01:07:07.340 --> 01:07:10.004 If you agree with me, that means that you understand something 01:07:10.004 --> 01:07:11.420 about the political situation that 01:07:11.420 --> 01:07:14.720 has nothing to do with P&L, nothing to do with NPV, nothing 01:07:14.720 --> 01:07:17.060 to do with cost of capital or risk adjustment. 01:07:17.060 --> 01:07:19.160 Somebody just hired you to do a job 01:07:19.160 --> 01:07:21.419 and they're going to have to give you 01:07:21.419 --> 01:07:23.210 the benefit of the doubt for a little while 01:07:23.210 --> 01:07:25.550 before they can pull in the reins. 01:07:25.550 --> 01:07:27.830 That's what I mean by political considerations. 01:07:27.830 --> 01:07:30.080 So when you're thinking about capital budgeting, 01:07:30.080 --> 01:07:33.157 you've got to factor in all of these considerations. 01:07:33.157 --> 01:07:33.740 Which is hard. 01:07:33.740 --> 01:07:37.280 It's what makes business both an art and a science. 01:07:37.280 --> 01:07:40.220 You need to have both of those elements represented. 01:07:40.220 --> 01:07:41.810 And I just wanted to bring that up 01:07:41.810 --> 01:07:45.770 to remind you not to forget about those elements. 01:07:45.770 --> 01:07:48.740 Economists have a very bad habit, myself included. 01:07:48.740 --> 01:07:51.950 We think that everything is economic. 01:07:51.950 --> 01:07:54.840 Someone said that to a person that owns a hammer, 01:07:54.840 --> 01:07:57.140 everything looks like a nail. 01:07:57.140 --> 01:07:57.942 And I agree. 01:07:57.942 --> 01:07:59.400 As an economist, I have these tools 01:07:59.400 --> 01:08:01.230 that I think apply to everything. 01:08:01.230 --> 01:08:03.860 And there's a danger that as an economist, 01:08:03.860 --> 01:08:06.640 I see everything from the economic perspective. 01:08:06.640 --> 01:08:08.660 And it's only after you've been hit 01:08:08.660 --> 01:08:11.591 over the head with a bunch of failures of your theories 01:08:11.591 --> 01:08:13.340 that you'll begin to realize maybe there's 01:08:13.340 --> 01:08:15.950 something else out there that's explaining behavior. 01:08:15.950 --> 01:08:18.149 Which I'm going to talk about next. 01:08:18.149 --> 01:08:21.229 But the traditional approach of economists 01:08:21.229 --> 01:08:23.490 is to assume that everybody is rational, 01:08:23.490 --> 01:08:26.510 everybody's maximizing NPV, the markets work efficiently. 01:08:26.510 --> 01:08:28.350 And by the way, if that's the case, 01:08:28.350 --> 01:08:30.540 then your job is really easy. 01:08:30.540 --> 01:08:34.100 What makes it hard, and I would argue fun and challenging, 01:08:34.100 --> 01:08:35.810 is all the other stuff that makes 01:08:35.810 --> 01:08:38.930 this stuff not work the way it's supposed to all the time. 01:08:38.930 --> 01:08:42.319 You have to know when to use these methods 01:08:42.319 --> 01:08:44.149 and when to use other methods in order 01:08:44.149 --> 01:08:47.420 to be able to advance your particular objectives. 01:08:47.420 --> 01:08:49.640 And ultimately, you have to understand exactly 01:08:49.640 --> 01:08:52.200 what kind of objectives you want to achieve. 01:08:52.200 --> 01:08:54.200 So that's going to actually be the topic 01:08:54.200 --> 01:08:57.680 of the latter part of the next lecture, is objectives. 01:08:57.680 --> 01:09:00.350 I've told you up until now that the objective for most 01:09:00.350 --> 01:09:05.000 shareholders and most corporate managers is to maximize NPV. 01:09:05.000 --> 01:09:08.970 That is an approximation to a much more complex reality. 01:09:08.970 --> 01:09:12.500 So I'm about to change your view of that reality 01:09:12.500 --> 01:09:16.590 over the next lecture and a half. 01:09:16.590 --> 01:09:18.380 Any other questions? 01:09:22.069 --> 01:09:25.490 This concludes our lecture on capital budgeting, 01:09:25.490 --> 01:09:28.760 and what I want to turn to now is the last lecture 01:09:28.760 --> 01:09:34.080 of the course, which is efficient markets, lecture 21. 01:09:34.080 --> 01:09:37.529 I'm going to get started on this just very briefly 01:09:37.529 --> 01:09:40.569 today, because we're almost out of time. 01:09:40.569 --> 01:09:43.710 We've got about another 10 minutes or so. 01:09:43.710 --> 01:09:46.890 I want to give you an overview of where we're going 01:09:46.890 --> 01:09:49.680 and why we're going to do this lecture. 01:09:49.680 --> 01:09:52.680 Typically, efficient markets is a lecture 01:09:52.680 --> 01:09:56.370 that is given in most corporate finance and Introductory 01:09:56.370 --> 01:09:59.732 finance courses at the beginning of the course. 01:09:59.732 --> 01:10:01.440 And the reason it's done at the beginning 01:10:01.440 --> 01:10:05.550 is because actually, we need this efficient markets 01:10:05.550 --> 01:10:09.450 hypothesis to justify most of what I taught you 01:10:09.450 --> 01:10:12.960 over the last 13 weeks. 01:10:12.960 --> 01:10:16.130 Let me explain why that is. 01:10:16.130 --> 01:10:18.460 For the longest time now in this course, 01:10:18.460 --> 01:10:21.860 I've kept repeating that when we need a discount rate, when 01:10:21.860 --> 01:10:25.790 we need a price, when we need a value, where do we go? 01:10:25.790 --> 01:10:26.510 To the market. 01:10:26.510 --> 01:10:27.500 All of you, right? 01:10:27.500 --> 01:10:28.190 And we did that. 01:10:28.190 --> 01:10:31.310 The first day of class, I auctioned off certain items 01:10:31.310 --> 01:10:34.770 and we engaged in price discovery. 01:10:34.770 --> 01:10:38.190 That's an enormous benefit, this wisdom of crowds 01:10:38.190 --> 01:10:39.750 that we relied on. 01:10:39.750 --> 01:10:41.670 And that's why at the very beginning of most 01:10:41.670 --> 01:10:44.970 of these finance courses, we typically teach our students 01:10:44.970 --> 01:10:46.860 to trust in the market. 01:10:46.860 --> 01:10:48.480 Now I didn't do that in this course 01:10:48.480 --> 01:10:50.760 because I don't want you to trust the market. 01:10:50.760 --> 01:10:53.550 I want you to learn from experience when to trust 01:10:53.550 --> 01:10:55.710 the market, and when not to. 01:10:55.710 --> 01:10:59.610 But the fact of the matter is the theories that we rely on, 01:10:59.610 --> 01:11:03.370 this notion of risk adjustment, this cost of capital, 01:11:03.370 --> 01:11:04.770 this CAPM. 01:11:04.770 --> 01:11:07.920 All of that relies on people being rational. 01:11:07.920 --> 01:11:10.800 It relies on all of you in this room wanting 01:11:10.800 --> 01:11:13.320 to hold the tangency portfolio. 01:11:13.320 --> 01:11:16.620 It relies on supply equaling demand. 01:11:16.620 --> 01:11:22.320 And unless we have that kind of behavior, a lot of our results 01:11:22.320 --> 01:11:24.340 go out the window. 01:11:24.340 --> 01:11:27.700 So I want to talk about the justification 01:11:27.700 --> 01:11:30.760 for that assumption in this particular lecture. 01:11:30.760 --> 01:11:32.920 I told you that I'm going to tie together 01:11:32.920 --> 01:11:34.570 all the various different loose strands 01:11:34.570 --> 01:11:36.970 of the course in this one lecture, 01:11:36.970 --> 01:11:38.800 and I do mean to do that. 01:11:38.800 --> 01:11:40.874 What I'm going to do is first of all, 01:11:40.874 --> 01:11:42.540 make an argument for why it is you ought 01:11:42.540 --> 01:11:43.780 to trust in market prices. 01:11:43.780 --> 01:11:49.320 Why the wisdom of crowds is very wise, most of the time. 01:11:49.320 --> 01:11:52.290 But then I want to spend the bulk of this lecture telling 01:11:52.290 --> 01:11:54.079 you why it can break down. 01:11:54.079 --> 01:11:55.620 Now, I don't think I need to tell you 01:11:55.620 --> 01:11:57.090 that after the last 13 weeks. 01:11:57.090 --> 01:11:59.910 You've sort of seen that in real time. 01:11:59.910 --> 01:12:04.140 But I want to give you an understanding of what happened. 01:12:04.140 --> 01:12:07.170 And actually, I'm going to be able to provide you 01:12:07.170 --> 01:12:10.530 with a complete and satisfactory theory that 01:12:10.530 --> 01:12:13.560 makes sense of everything that has happened over the last 13 01:12:13.560 --> 01:12:14.340 weeks. 01:12:14.340 --> 01:12:17.940 You may be skeptical about that, but I promise you, 01:12:17.940 --> 01:12:20.040 it will be true. 01:12:20.040 --> 01:12:23.310 I have a theory, which is not generally accepted. 01:12:23.310 --> 01:12:25.329 So I've got to start with that disclaimer. 01:12:25.329 --> 01:12:27.120 This is a theory that I'm going to tell you 01:12:27.120 --> 01:12:31.020 that is my own pet theory, it's not in any textbook 01:12:31.020 --> 01:12:33.514 because it's relatively new. 01:12:33.514 --> 01:12:35.430 And if you do a search for it on the internet, 01:12:35.430 --> 01:12:38.070 my name was the only name that's going to come up. 01:12:38.070 --> 01:12:39.830 So that's both good and bad. 01:12:39.830 --> 01:12:41.661 You're hearing it from the horse's mouth, 01:12:41.661 --> 01:12:43.410 but it is a horse that's telling you this. 01:12:46.577 --> 01:12:48.660 I'm going to start by first explaining to you what 01:12:48.660 --> 01:12:50.430 efficient markets is. 01:12:50.430 --> 01:12:51.930 I think you already know, right? 01:12:51.930 --> 01:12:53.460 You can trust the market prices. 01:12:53.460 --> 01:12:57.030 The market price tells you what you need to know. 01:12:57.030 --> 01:12:59.730 And after I make that argument, I'm 01:12:59.730 --> 01:13:01.260 going to then turn around and take 01:13:01.260 --> 01:13:03.090 the other side of the debate, and give you 01:13:03.090 --> 01:13:07.380 all the reasons why people are irrational, silly, mistaken, 01:13:07.380 --> 01:13:11.160 stupid, all of the reasons that psychologists tell us markets 01:13:11.160 --> 01:13:14.379 are crazy, and you should never trust in market prices. 01:13:14.379 --> 01:13:16.170 And then I'm going to try to bring together 01:13:16.170 --> 01:13:18.240 the two sides of the debate using 01:13:18.240 --> 01:13:21.510 some recent research from the cognitive neurosciences. 01:13:21.510 --> 01:13:24.240 So I'm going to actually talk a bit about the neurophysiology 01:13:24.240 --> 01:13:26.312 of the brain, and it turns out that that research 01:13:26.312 --> 01:13:28.770 is going to be directly relevant to how we interpret what's 01:13:28.770 --> 01:13:33.570 been going on over the last 13 weeks, over the last 130 years. 01:13:33.570 --> 01:13:38.010 Let me start with that argument about efficient markets. 01:13:38.010 --> 01:13:42.300 Market efficiency says that there's no free lunch, 01:13:42.300 --> 01:13:44.730 there's no arbitrage, you don't get something for nothing, 01:13:44.730 --> 01:13:47.370 prices fully reflect all available information, 01:13:47.370 --> 01:13:50.940 and there's no way to make money in the marketplace. 01:13:50.940 --> 01:13:55.080 Active management does not add any value. 01:13:55.080 --> 01:13:59.130 Now, if you really believe this, why are you here? 01:13:59.130 --> 01:14:00.800 Why are you taking finance? 01:14:00.800 --> 01:14:03.410 Well, it turns out that there is a reason for taking finance 01:14:03.410 --> 01:14:05.700 even if this is true, which is that finance 01:14:05.700 --> 01:14:09.620 is the language by which you conduct discussion and analysis 01:14:09.620 --> 01:14:11.570 in business negotiations. 01:14:11.570 --> 01:14:15.860 But even apart from this, I would argue that most of you 01:14:15.860 --> 01:14:18.230 are probably thinking you can beat 01:14:18.230 --> 01:14:20.060 the market if you work hard enough 01:14:20.060 --> 01:14:21.620 and if you're smart enough. 01:14:21.620 --> 01:14:24.170 That's not the perspective of modern finance theory. 01:14:24.170 --> 01:14:26.420 So remember I was telling you the difference to Warren 01:14:26.420 --> 01:14:28.130 Buffett and modern finance. 01:14:28.130 --> 01:14:29.480 They do part company. 01:14:29.480 --> 01:14:31.340 Warren Buffett literally believes 01:14:31.340 --> 01:14:34.780 that he can pick stocks better than you and I can. 01:14:34.780 --> 01:14:37.150 And what academics would have you believe 01:14:37.150 --> 01:14:40.060 is that nobody can pick stocks, that it's all luck, 01:14:40.060 --> 01:14:41.710 and what you ought to do is simply buy 01:14:41.710 --> 01:14:43.300 the tangency portfolio. 01:14:43.300 --> 01:14:45.550 It's going to turn out that both of these perspectives 01:14:45.550 --> 01:14:48.610 are wrong, and they're right in very specific ways, 01:14:48.610 --> 01:14:51.730 and I'm going to show you how to put it together. 01:14:51.730 --> 01:14:53.230 But let me first start by motivating 01:14:53.230 --> 01:14:54.970 this idea of efficient markets. 01:14:54.970 --> 01:14:59.320 Why you cannot make money, why all information is incorporated 01:14:59.320 --> 01:15:00.310 into market prices. 01:15:00.310 --> 01:15:02.920 And to do that, I'm going to tell you about a research 01:15:02.920 --> 01:15:06.550 paper that was published in 2003 by two economists, Michael 01:15:06.550 --> 01:15:10.294 Maloney and Herold Mulhearn, titled the complexity 01:15:10.294 --> 01:15:12.460 of price discovery in an efficient market, the stock 01:15:12.460 --> 01:15:16.891 market reaction to the Challenger crash. 01:15:16.891 --> 01:15:19.190 Now this is a rather somber subject. 01:15:19.190 --> 01:15:23.570 It has to do with an event that occurred on January 28, 1986, 01:15:23.570 --> 01:15:26.270 at 11:39 AM. 01:15:26.270 --> 01:15:29.540 At that time, the Challenger space shuttle 01:15:29.540 --> 01:15:32.810 exploded before our very eyes. 01:15:32.810 --> 01:15:35.570 Apparently, one of the booster rockets 01:15:35.570 --> 01:15:39.590 ignited and destroyed the space shuttle. 01:15:39.590 --> 01:15:43.340 11: 47, the space shuttle was reported to have exploded. 01:15:43.340 --> 01:15:49.400 It came across the news wire 12:17, Lockheed, 01:15:49.400 --> 01:15:51.920 which is one of the contractors that built the shuttle, 01:15:51.920 --> 01:15:53.390 had no comment. 01:15:53.390 --> 01:15:57.080 12:52, Rockwell International, another one of the vendors 01:15:57.080 --> 01:16:00.050 that built parts for the space shuttle, they had no comment. 01:16:00.050 --> 01:16:02.820 This is all through the news wire. 01:16:02.820 --> 01:16:06.750 And over the course of the next several months, 01:16:06.750 --> 01:16:10.620 a presidential commission was impaneled 01:16:10.620 --> 01:16:15.270 to study what happened with the space shuttle explosion. 01:16:15.270 --> 01:16:17.220 And many of you know, the physicist 01:16:17.220 --> 01:16:19.410 Richard Feynman was on that panel 01:16:19.410 --> 01:16:22.980 and wrote a dissenting opinion about what happened. 01:16:22.980 --> 01:16:25.560 But the bottom line, after all the dust settled, 01:16:25.560 --> 01:16:30.120 was that in June of that year, so about six months later, 01:16:30.120 --> 01:16:32.280 there was a report that was produced 01:16:32.280 --> 01:16:36.570 that showed that it was an O-ring, a piece of rubber, 01:16:36.570 --> 01:16:40.920 around a booster rocket that ended up becoming brittle. 01:16:40.920 --> 01:16:43.520 And because it became brittle in the cold weather, 01:16:43.520 --> 01:16:46.230 there were gases that leaked from that booster rocket, 01:16:46.230 --> 01:16:49.150 and those gases ignited after take off. 01:16:49.150 --> 01:16:51.450 And so in the end, after all of this analysis, 01:16:51.450 --> 01:16:55.320 it was determined that the O-ring was at fault. 01:16:55.320 --> 01:16:58.020 And who produced this O-ring and the rocket? 01:16:58.020 --> 01:16:59.020 It was Morton Thiokol. 01:17:01.620 --> 01:17:04.920 They were the culprit, or the weak link in all of this, 01:17:04.920 --> 01:17:06.210 according to this study. 01:17:08.790 --> 01:17:14.560 Now, this was on June 9, 1986. 01:17:14.560 --> 01:17:19.510 Let me show you what happened to the stock prices of all 01:17:19.510 --> 01:17:23.930 of the different vendors for space shuttle parts, 01:17:23.930 --> 01:17:27.380 right after the explosion on January the 28th, 01:17:27.380 --> 01:17:30.580 six months earlier. 01:17:30.580 --> 01:17:32.350 Let me show you a graph. 01:17:32.350 --> 01:17:34.960 There are four vendors. 01:17:34.960 --> 01:17:40.220 Lockheed, Martin Marietta, Rockwell, and Martin Thiokol. 01:17:40.220 --> 01:17:46.010 And these are the tick-by-tick price changes, all normalized 01:17:46.010 --> 01:17:51.530 to start at $1 at the very beginning of the sample, which 01:17:51.530 --> 01:17:57.380 was at 11 o'clock, or 11:39, when the shuttle exploded. 01:17:57.380 --> 01:17:58.880 So this is where we start, we all 01:17:58.880 --> 01:18:02.420 start with them at a dollar. 01:18:02.420 --> 01:18:06.890 Within minutes of the explosion, I'm talking minutes now, 01:18:06.890 --> 01:18:08.450 not nine months or six months. 01:18:08.450 --> 01:18:13.670 Within minutes, we see that the stock price that gets 01:18:13.670 --> 01:18:18.770 hit the hardest is Morton Thiokol. 01:18:18.770 --> 01:18:20.390 All of them get hit. 01:18:20.390 --> 01:18:23.630 But by 1 o'clock, Morton Thiokol's price 01:18:23.630 --> 01:18:25.012 is down below all the others. 01:18:25.012 --> 01:18:27.470 And this is all normalized so that they all start off at 1. 01:18:27.470 --> 01:18:30.560 So it's not difference of scale, I've rescaled them. 01:18:30.560 --> 01:18:33.440 And moreover, at the close of trading 01:18:33.440 --> 01:18:39.140 on that day, the only stock that was down significantly, 01:18:39.140 --> 01:18:42.370 the only one, was Morton Thiokol. 01:18:42.370 --> 01:18:44.020 They had to stop trading in that stock 01:18:44.020 --> 01:18:45.145 because it was down so far. 01:18:47.560 --> 01:18:52.250 This happened in less than six hours. 01:18:52.250 --> 01:18:55.190 It took the commission six months 01:18:55.190 --> 01:18:57.750 to come up with the O-ring and Morton Thiokol. 01:18:57.750 --> 01:19:01.910 Now, if you look at this, you don't see an O-ring. 01:19:01.910 --> 01:19:03.920 But you see Morton Thiokol. 01:19:03.920 --> 01:19:06.909 Plain and simple, like a sore thumb. 01:19:06.909 --> 01:19:08.200 This is what I'm talking about. 01:19:08.200 --> 01:19:11.037 This is the wisdom of crowds. 01:19:11.037 --> 01:19:12.870 This is why, when you look at market prices, 01:19:12.870 --> 01:19:15.036 you should look at them with a certain degree of awe 01:19:15.036 --> 01:19:16.230 and respect. 01:19:16.230 --> 01:19:18.750 It's because it aggregates information 01:19:18.750 --> 01:19:20.340 like you wouldn't believe. 01:19:20.340 --> 01:19:21.840 It's phenomenal. 01:19:21.840 --> 01:19:24.240 So this is what economists like to trot out 01:19:24.240 --> 01:19:26.370 and say, see I told you so. 01:19:26.370 --> 01:19:28.211 This is what we're good at. 01:19:28.211 --> 01:19:30.210 What I'm going to talk to you about on Wednesday 01:19:30.210 --> 01:19:33.750 is all of the other examples of where this fails. 01:19:33.750 --> 01:19:35.012 So this is the good news. 01:19:35.012 --> 01:19:37.220 On Wednesday, we're going to talk about the bad news. 01:19:37.220 --> 01:19:39.360 OK, see you then.