0:14

Now we have to talk a little bit more about risk, okay?

Â We've just done our sensitivity analysis, right?

Â And it might seem to some of you that the example we just solved

Â suggests that risk is actually not changing the NPV, right?

Â We laid down the risk in the sales of the company, but

Â in the end we decided that the NVP is still the same, right?

Â So it might seem a bit strange, you know?

Â Where did risk go?

Â Right?

Â Of course this is wrong, okay?

Â Risk is going to affect the value of a project.

Â We like safety, right?

Â We want projects to be safe, so

Â the higher the risk of the project, the lower the value should be, right?

Â This idea has to be true, right?

Â So what we're gonna learn now is how do we incorporate risk into the evaluation.

Â 1:03

The reason why risks is hidden is because

Â we have been taking the discount rate as given, okay?

Â That's really the main reason why we

Â haven't found out risk yet in this course, okay?

Â I've always been telling you the discount rate is 10%, is 8%, is 7%, right?

Â So the idea, and this is the key idea in finance,

Â is that the discount rate should reflect the risk of the project.

Â That is the number that is going to capture risk for us, okay?

Â So what we're gonna talk about now is how do we use,

Â I mean how do we implement this concept, okay?

Â To understand this better, let's go back to model three, and

Â think about the internal rate of return again, right?

Â What we learned in model three is that if the IRR is bigger than the discount rate,

Â then the NPV is positive, okay?

Â So you have to compare the IRR of a project with the discount rate.

Â If you're thinking about risk, right?

Â What we're learning now is that the discount rate captures risk.

Â So another way you can think about this statement is that

Â the higher the risk of a project.

Â If a project is more risky, right?

Â Then it's going to take a higher rate of return

Â to turn this project into a good project, okay?

Â So to make a project positive NPV, if risk is high,

Â you're going to need a high rate of return, okay?

Â So that's an intuitive way for you to think about this relationship, right?

Â It turns out that measuring the risk of a project, measuring the risk of a company,

Â measuring the risk of an investment is one of the key topics in finance.

Â In fact, you spend a lot of your time in an investments

Â course when you're studying investments rather than corporate finance.

Â A lot of the course is typically devoted to this topic, okay?

Â What we will do in the next few slides is to do a review so

Â our course is self-contained and

Â you know how to incorporate risk into corporate finance valuation, okay?

Â But if you would like a more in-depth discussion, what I

Â recommend is that you have a look at Scott Weisbenner's investments course, okay?

Â Which is also available, and it does have a much more in-depth discussion of how we

Â measure risk in finance, which really is the same idea as we're gonna use here

Â to incorporate risk into corporate finance valuation, okay?

Â Let me give you the bottom line first,

Â which you might remember if you took Scott's class already, okay?

Â The way that we're going to measure risk, for a company project,

Â for a company, is by using the weighted average cost of capital formula, okay?

Â If you haven't seen this, it's going to look foreign.

Â If you have, it's going to look familiar.

Â That's why I want to do a review of this anyway.

Â Even if you took Scott's class, I think it might be useful to do a review and

Â think about the weighted average cost of capital from

Â a corporate finance point of view, okay?

Â The name says it all.

Â The weighted average cost of capital is a weighted average, right?

Â You have the required return on that.

Â And then you're multiplying this by the fraction of

Â the value of the company that comes from that, okay?

Â It's debt over value where value is defined as debt plus equity, okay?

Â And then you have the required return on the equity multiplied by

Â the fraction of the value of the company that comes from equity, okay?

Â So the E here is going to be the market value of equity.

Â So it's just a weighted average.

Â What I want to do in the next few slides is to do an example with you, okay?

Â And I'm gonna use this example to review the key concepts and

Â as we've been doing in this course so far,

Â I want to use data from a real world company to do this, okay?

Â Specifically, what we are going to do is we're going to computer the WACC for

Â Pepsico as of June 2015.

Â We need to do this for a certain period of time because, as you just saw the formula,

Â the WACC depends on the value of the company, so we have to measure

Â the value of the company and some of the market data for a specific period of time.

Â But the ideas are the same.

Â You can use the same principle, the same calculation

Â to compute weighted average of capital for any company in any period of time, okay?

Â 5:28

Let's start with the required return on debt.

Â The data that we're going to use here is expressed here in this graph, okay?

Â It's the data on yield-to-maturity of Pepsico bonds, okay?

Â So debt holders, in this case, they own bonds, right?

Â Pepsico has issued bonds, so debt holders now own these bonds.

Â And what bond holders get is the yield-to-maturity, okay?

Â So this graph shows the yield-to-maturity on Pepsico bonds of different maturity.

Â So you can see here the x axis tells you the years, so here at the end

Â we will see that Pepsico has issued long term bonds that mature only in 2040,

Â those bonds have a yield of approximately 4%, okay?

Â So before we use this data we have to understand a little bit more about

Â what the yield to maturity actually measure, right?

Â And it turns out that the yield-to-maturity is just

Â the expected return on the bond, okay?

Â So you can think of the yield-to-maturity on a bond as the return,

Â the percentage return, right?

Â As we discussed in module three, the IRR is the percentage return.

Â You can think of the YTM, the yield-to-maturity, as the percentage

Â return that an investor would hold by holding a Pepsico bond to maturity, okay?

Â So if you buy the bonds today and

Â the bond does not default, you expect to make 4.2% a year.

Â And default is an important word here.

Â Okay?

Â This calculation only works exactly if the company is far away from bankruptcy, okay?

Â We're not gonna have much time to discuss this in this course,

Â but remember that you can only approximate the required return on that

Â with the yield-to-maturity for a company that's far away from bankruptcy.

Â So for Pepsico, this would be a reasonable assumption,

Â it might not be that reasonable for a company that has a really,

Â really high leverage ratio that is approaching bankruptcy.

Â As we discussed in module one, the leverage ratio gets too high,

Â the company is gonna go bankrupt, okay?

Â So really what happens is that if the bond defaults, you're not going to get 4.2%,

Â so the true expected return for

Â a company like that is lower than the yield to maturity, okay?

Â So here's a question for you.

Â We just figured out that the IRR of the long-term bond is 4.2%, okay?

Â So if you buy the 2040 Pepsico bond and

Â hold until maturity your expected return is 4.2%.

Â Let's think about NPV, right?

Â That's the question.

Â What should be the NPV of these investments?

Â 8:43

I just showed you how to do calculations, spreadsheets, formula.

Â How do I know the NPV is zero, right?

Â It seems like I'm a, that I have a crystal ball here, okay?

Â Really, what I'm using is a market equilibrium argument, okay?

Â Think about the formula.

Â Suppose the NPV was positive, okay?

Â The NPV of, you know, picking up and think about what would it take for

Â you to buy a Pepsico bond, okay?

Â If you had the money, all you need to do is to pick up a phone,

Â call a trader, or go to your computer and buy a Pepsico bond, okay?

Â You should not be making money by that, right?

Â It's very easy to do that, so

Â if the NPV is positive, many investors would be picking up the phone.

Â All the traders would be buying Pepsico bonds, right?

Â They would be calling their brokers, they would be just buying and

Â buying and buying, right?

Â And we learn, we know from economics, basic economics,

Â that if there is a lot of demand for a product, if there is a lot of demand for

Â a financial asset, the price should go up, okay?

Â And if a price of an asset goes up, future return should be lower, right?

Â If pay more for a Pepsico bond today, your return is gonna be lower, right?

Â 10:02

So if the NPV is positive, everybody would be buying the bond.

Â Same thing, if NPV is negative, everybody would be selling the bond, okay?

Â So the only possible equilibrium in the market for

Â Pepsico bond is one where the net present value is zero, okay?

Â For a financial asset like a bond that is very simple to understand,

Â that everybody can buy and sell, NPV = 0 is a very reasonable assumption, okay?

Â Why are we going over this?

Â Why is this an important idea?

Â Because we are going to use this to estimate returns, okay?

Â This really is a beautiful idea in finance.

Â We just learned that zero NPV is a reasonable condition for many markets.

Â What this means is that, remember model three,

Â if the NPV is zero, the actual return, the expected

Â return should be the same as the discount rate, the required return, okay?

Â So if the Pepsico bond NPV is zero, what this means it that we can use

Â the yeild-to-maturity to approximate the required return on that.

Â 11:13

The return that we measure in the market

Â is just the return that investors demand to invest in a Pepsico bond.

Â It's the required return, okay?

Â Right?

Â So that's a very useful idea because we can use that data to input

Â in our evaluation and figure out what the required return on that is, okay?

Â One more point here I prefer to use a long term yield to maturity for

Â corporate finance, and we know already why.

Â Since we started this course, I've been pushing this idea that corporate

Â finance application have a long horizon, okay?

Â We're always thinking about the long term, right?

Â So my suggestion is that we always take, try to estimate,

Â the long term cost of that, the long term required return on that.

Â What this means for Pepsico is that we are going to use the 4.2% number,

Â which is the yield to maturity on the long term bonds.

Â So rather than use 2, 3, 4, 5 year maturities, we're

Â gonna take the longest possible maturity that we have available in our data, okay?

Â But really, the key idea is the zero NPV idea, and

Â how we can use that to estimate required returns using

Â expected returns, using actual expected returns.

Â