0:24

Even though all money can be broken down into these two types, from the perspective

Â of a firm, how much of each type to raise is a difficult question to answer.

Â What managers of firms have learned however, is that debt can be

Â enormously beneficial when it is used to increase the value of the firm.

Â Yes, you actually heard that correctly.

Â Debt can be used to increase the value of a firm.

Â But again, only when used properly,

Â which we're going to explore later on in this course.

Â So in addition to the temptations that encourage individuals to take on debt

Â that we discussed in the earlier video segment,

Â firms have their own set of temptations or rationales to use debt.

Â 1:33

So because of this delicate balance of benefits and

Â risk, the decision of how much to borrow is really critical.

Â Let's think about these two types of money a slices representing a pie

Â which symbolizes the value of the firm.

Â The over arching goal is to actually increase the size of the pie

Â because that would make the firm more valuable.

Â And in order to do that, we must mix the right amounts of debts and

Â equity proportions that cannot be found in a recipe book.

Â But rather, they are a result of experience and

Â strategy that the Chief Financial Officer must determine.

Â We know that the right slice of debt will influence the size of this pie.

Â 2:26

As we're going to be learning here,

Â the key question is how much a firm should borrow.

Â If for example, the firm decides to borrow $1 for every $3 in equity,

Â the debt to equity ratio would be 33%, that is $1 over $3.

Â But the total debt ratio would be 25%,

Â that would be a dollar over the total debt plus equity which is $4.

Â This might be dimmed to be the appropriate target debt ratio

Â if the firm decides to maintain it and that would signal,

Â how much amount of financial leverage exists in the firm.

Â So when you hear your business manager talk about using financial leverage,

Â it's just another way of saying that they're considering to use debt.

Â And they're trying to use it to try and increase the firm's value.

Â Notice that in thinking about the question of whether to use debt,

Â we're implicitly comparing the choice with the alternative which is to use equity.

Â And a study points one to this question is to look at the choice based on selecting

Â that alternative, debt or equity which will maximize the firms earnings.

Â This is what we will consider together right now.

Â But a little later on, we will use more sophisticated framework

Â to make this choice based on maximizing the firm's value.

Â So, let's begin our analysis by projecting future revenues of a hypothetical firm

Â which help us to determine whether debt or equity would maximize the firm's earning.

Â That's our goal.

Â Recall from course one,

Â decisions that earnings can be calculated by projecting net income.

Â 4:09

It's also useful to express earnings on a per share basis,

Â commonly referred to as Earnings per share or EPS.

Â And that's measured by the ratio of taking net income and

Â dividing it by the number of shares.

Â For example, if a firm projects net income to be $2,000 and it has 400 shares,

Â it would be earning $5 per share, that's 2,000 divided by 400.

Â In addition, two other profitability ratios that are often used

Â in conjunction with earnings per share include the Return on assets or

Â ROA, which is the ratio of net income over assets, and

Â then the Return on equity or ROE, which is the ratio of net income divided by equity.

Â 4:55

There's one other definition worth noting in analyzing these sorts of questions and

Â that is common to use EBIT

Â which represents Earnings Before Interest and Taxes.

Â EBIT is a measure of operating income

Â which is an alternative to focusing on sales revenue.

Â And to calculate EBIT, we simply start with sales revenue and

Â then we subtract our operating expenses such as labor,

Â material, overhead expenses, and we arrived at EBIT.

Â 5:25

So, as we're going to see,

Â we'll begin our analysis of projecting future revenues of the fund with EBIT.

Â So that we can keep the operating cost constant and instead, we can keep our

Â focus on the cost associated with financial leverage which is using debt.

Â And those cost include interest because remember,

Â leverage means we are taking on more debt.

Â So let me summarize this very quickly for

Â you, some of the definitions that I have just verbalized.

Â We talked about earnings per share.

Â Earnings per share is simply net income and

Â we divide that net income by the number of common shares.

Â And that gives us earnings per share.

Â 7:06

Now, we're going to imagine,

Â hypothetically, that we have an existing capital structure.

Â Remember, there're two types of capital.

Â Your money, my money, debt, or equity.

Â In this case, we're going to assumed [COUGH] we have assets of $20,000,

Â that you can see in this very simplified balance sheet, and

Â there is no debt in the company while there is equity so

Â it's completely finance two shares or equity of $20,000.

Â The debt to equity ratio obviously is zero.

Â There's no interest rate applicable, and we have issued 400 shares, so

Â that means, if the equity is worth 20,000 divided by 400 shares,

Â that gives us a share price of $50 per share.

Â So, this is the existing situation.

Â This is the current capital structure.

Â We're now thinking of using financial leverage.

Â And so what we're proposing here are the same assets.

Â We're not going to change the assets.

Â We're only going to change the mixture.

Â Of how those assets are financed.

Â And this time we are thinking of issuing, let's say $8,000 worth of debt.

Â So this means that since assets are equal to debt plus equity,

Â our equity will have to be reduced from 20,000 to 12,000, so the total is 20.

Â And our debt to equity ratio is now 8,000 of debt over 12,000 of equity.

Â That is 67%.

Â The interest rate on the debt, we have been told is 8%.

Â And so because we have less equity, we have less shares at $50 each.

Â So they go from 400 to 240 shares.

Â And there you can see the two capital structures.

Â Now to evaluate whether this is a good idea or

Â not, what we're going to do is project some revenue.

Â So here you see a forecast of three different scenarios that we've outlined.

Â And we're calling them, worst case, best case and a expected scenario.

Â So worst case, let's say we have a recession.

Â What would happen to our earnings before interest and taxes?

Â What would happen under the expected, and

Â what would happen under the expansion scenarios?

Â We've got three numbers for you, for the recession $1,000,

Â expected 2,000, and expansion $3,000.

Â Because this is the existing capital structure,

Â you see there is no debt, no interest to pay.

Â So we have the same operating income.

Â I've assumed just for simplicity, there are no taxes, so

Â we don't have to complicate the numbers.

Â And we'll work with the same numbers as we have for EBIT, as we do for net income.

Â 9:38

Now if we look at the number of shares outstanding,

Â recall there were 400 shares outstanding.

Â We divide the net income using our ratio here.

Â And you'll see the earnings per share range from $2.50 in a recessionary period

Â to $5 expected, and then to $7.50 if we're experiencing an expansion.

Â Now the return on assets, remember the assets are 20,000.

Â We take our net income divided by 20,000.

Â And that's how you get the 5% for recession, 10% expected, and

Â 15% for the expansionary period.

Â Same calculation, but with different denominator.

Â In this case, actually,

Â the denominator does not change because total assets are equal to total equity.

Â So exactly the same numbers for return on equity.

Â And there you see the assumptions of no taxes.

Â 400 shares are out standing, total assets were $20,000, and so was total equity.

Â Let's do this same exercise again for the proposed capital structure,

Â to see what happens to our profitability ratios if we employ debt.

Â So we're going to start off with the three exact same scenarios, for

Â the three expected, expansion, and recessionary periods.

Â Same numbers as you before, except this time we have to pay interest on our debt,

Â because we have issued $8,000 of debt at 8%.

Â So that gives us interest payments of $640 across the board for

Â whatever the scenario might be.

Â Subtract the interest, and you get your net income.

Â Again, remember, we're just ignoring taxes just to keep the numbers simple.

Â And you see the differences in each of those scenarios.

Â We are now ready to calculate our earnings per share.

Â Again, we look at the net income figure.

Â But this time, remember, we're going to divide each of these numbers by

Â a lower number of shares because there is less equity in the firm.

Â And you see the calculations of $1.50, $5.60 and $9.83.

Â Again, compute our return on assets, I'll do one example.

Â For instance, in the expected scenario, our return on assets

Â are going to be the net income of 1,360 divided by our total assets,

Â which are still $20,000, and that gives us 6.8%.

Â We do finally the calculations on return on equity.

Â Remember, we now have a lower equity base.

Â And so we again do the calculations.

Â And in this case, net income divided by return on equity goes up to 11% under

Â the expected scenario and jumps to 20% in an expansionary situation.

Â 12:22

Again, the assumptions are listed there.

Â And what we really want to do now is to compare the situation when we

Â had no debt and the situation where we had debt.

Â So I'll let you think about for a moment, what exactly has happened here?

Â What are some of the takeaways that we can generalize when we see

Â a company that introduces debt in its capital structure?

Â This example, in fact, illustrates those very important principles

Â that help us to better understand the effect of financial leverage.

Â In other words, what is the effect of using debt on earnings?

Â And note that the following generalizations can be applied to

Â all firms that are considering the use of debt in this way.

Â 13:08

Note also, nothing productive has been done.

Â The company just issued pieces of paper called debt.

Â And they used that money to buy back shares so

Â that the total assets didn't change.

Â It was just the mixture of those assets that are now different.

Â Right, first and foremost, the most important figure that

Â drives the entire analysis that we've seen so far is EBIT.

Â As we saw in the definition itself, EBIT comes from sales.

Â Worth noting this down.

Â Without sales revenue there would be no cash flow.

Â In fact, there would be no firm at all.

Â So keeping in mind that our forecast of sales is

Â going to be very much going to influence whether or not we are going to use debt.

Â So while this is obvious,

Â managers still need to ask hard questions about what is the forecast for sales.

Â That of course going to ultimately result in our forecasted EBIT.

Â And that will drive the choice of whether debt or

Â equity will be use to maximize the bottom line.

Â 14:54

When EBIT went from 1,000 in a recession to 2,000,

Â which were considered normal times, this is an increase of 100%.

Â If you did not have any debt in your capital structure,

Â this 100% increase was mirrored in all of the profitability calculations.

Â So EBIT went up a 100%, all of these numbers went up by a 100%.

Â However, when we use debt, what did we see here?

Â An 100% increase in EBIT resulted in a 278% increase in earnings per share.

Â And you can do the calculation there.

Â The $5.67, which is the expected EPS in the normal situation,

Â less the $1.50 in the recession, divided by $1.50, gives us the 278%.

Â Similarly, you could do the calculations for ROA and ROE, and

Â again find a magnification.

Â Let's not forget though,

Â the same thing would happen if we were going from Normal to recession.

Â There would be a demagnification of EBI to 278%, right?

Â So this drama of magnifying or demagnifying happens with debt.

Â And the reason is because when EBIT is going up the cost of debt remains fixed,

Â and so the increase feeds right into the pockets of the owners.

Â And so your return on assets, return on equity, get magnified, okay?

Â This is the case, of course, when revenues are going up.

Â Let's then look at the third principle.

Â The third principle also can be derived from this example, which shows you very

Â clearly that in the case of debt you have a higher variability of earnings.

Â And that's always going to be expected with debt.

Â 17:03

So we have been sort of examining this fundamental

Â risk return relationship in the previous course on value, if you recall.

Â So to help us to understand its importance to this particular course,

Â it's probably useful to consider the different experiences of a firm's

Â stockholders versus those of bondholders.

Â And I want to be clear that when a firm issues shares,

Â these are purchased by stockholders.

Â But when it issues deck,

Â these are purchase by bondholders who are investing in the firm's bonds.

Â And during the value cost, when we look at risk from the investor's point of view,

Â that is from the bondholder or shareholders point of view.

Â We concluded that shareholders take on more risk

Â because they are the last ones to be paid, in fact that may not be paid at all.

Â Were as bondholders are guaranteed to be paid with interest.

Â The result of this is that shareholders expect to earn more return

Â to compensate for this additional risk.

Â And if I translate that from the investor to the firms perspective,

Â we can see that from the firms point of view, if shareholders are supposed to make

Â more money, if they have higher returns, the cost is also going to be higher.

Â So this is why debt is cheaper than equity.

Â 18:49

So with this knowledge we can establish the key points.

Â The key learnings that inform us about whether or not you should use debt,

Â how much to borrow, if our focus is on earnings, okay?

Â Here are some of the key points.

Â Number one, everything will depend on EBIT, right?

Â Keep an eye on EBIT, that was the first one.

Â The second thing we said was profitability dramatically

Â changes with debt, especially if you're expecting EBIT to go up

Â then debt will magnify returns for shareholders especially.

Â 19:44

The fourth point where the debt is typically cheaper than equity,

Â at least up to a certain point, so there's a temptation to use debt.

Â And that particular point takes us to the last conclusion that in fact,

Â to understand how much debt, we must understand valuation of the firm itself.

Â Not just rely on profitability but we have to think about value.

Â And that will give us a much better understanding of

Â our ultimate question of how much debt.

Â To conclude, let's do one final calculation that will help us to

Â demonstrate where we're at in terms of understanding decisions of whether or

Â not and how much a firm should borrow.

Â Here we could use the earnings approach to calculate the breaking even or

Â so called indifference point where earnings per share for both debt and

Â equity are exactly equal.

Â So we solve for EBIT by equating the earnings per share of each approach.

Â Let me do that for you right now.

Â 21:53

We're looking for EBIT, interest is 0, taxes are 0,

Â we have 400 shares in the current capital structure.

Â We're going to equate this with again we're looking for

Â EBIT, but this time we have interest of $640 no way for

Â taxes and this time we end up with 240 shares.

Â So if you solve for EBIT,

Â you're going to get the break-even number and

Â that break-even number is $1,600, right?

Â This corresponds to an earnings per share of $4, what this means

Â if you are forecasting 1,600 it doesn't matter whether you issue equity or

Â whether you issue debt, because the earnings per share are exactly the same.

Â However, what you can't see that any number greater than 1,600,

Â a forecast greater than 1,600, you should take on more debt, right?

Â Sell more bonds because earnings per share would be higher,

Â you can see that on the graph.

Â On the other hand a forecast of lower than 1,600 would favor equity.

Â So you can see the advantage of using equity below the break even point

Â advantage of using that above the break even point.

Â Now once we have arrived at this break even indifference point,

Â what we can do is visualize this information on a graph

Â that will helps to decide when to use debt when to use equity.

Â Now we can do by labeling earnings per share on the vertical and

Â EBIT on the horizontal axis.

Â So these are our two axis.

Â You can already plot this information here.

Â So we have a point where, our break even EBIT

Â of $1,600 corresponds to earning per share of $4, right?

Â What we have to do now is to show the two different financing profiles,

Â one that represents the current capital structure which had no debt.

Â And that simply is going to be representing equity.

Â 24:33

And that will be the profile for debt so

Â here we go, so this represent debt.

Â And what this is showing us now is that if you project anything

Â beyond 1,600 as mentioned earlier on.

Â Let's say at this point here, then your earnings per share under debt

Â are going to be higher, than if they were under equity.

Â So this whole area is the advantage for

Â using debt financing.

Â And this particular area that you see here is

Â giving us the advantage for using equity.

Â