0:00

If the return on assets is the same, what changes,

Â something has to change because you're changing the financing.

Â Turns out yes, the one thing that will change will be the return on equity.

Â 0:15

Okay so let's stare at this equation a little bit.

Â Don't worry about this we can drive this.

Â Either way.

Â This equation, turned around.

Â If you just let me show you how to do this.

Â If you take this to the left hand side and solve for

Â it, this is what the equation you'll get.

Â 0:36

Alright?

Â Just a little bit of refocusing, rethinking,

Â redoing will lead to Desecration.

Â And I'm now going to go through the algebra.

Â Just remember one thing, debt plus equity equal to the total value of the firm.

Â Right?

Â We'll get into this in a second.

Â So let me ask you this.

Â If D = 0, which equation will disappear?

Â Which part?

Â The second part of the equation.

Â 1:58

This is the same.

Â This can't change.

Â This is always greater than this.

Â This number is positive.

Â And the reason for that is simple.

Â That expected return on the assets is something that the whole firm produces.

Â And you've promised part of it to the debt right?

Â So that this thing is positive, d over e is always positive if you have debt.

Â Because of limited liability, right, you have no zeros.

Â So what happened?

Â As you take on debt, expected return on equity goes up.

Â 2:34

And the fundamental reason is, as always, you're taking on more risk.

Â So you're the shareholder.

Â You have a business, but to run the business you take on some debt.

Â As a result, what do you take on?

Â Some risk, because you are the owner.

Â So, the idea here is you now have to pay somebody else, called debt.

Â Before you can take the return for yourself, and that imposes risk.

Â If you don't like it, this example, for a company.

Â A hardworking company.

Â Imagine if you bought a house or an apartment.

Â 3:09

You could buy it without any debt.

Â Then you own the whole thing.

Â Or you could buy it, typically with debt.

Â It's called leveraging.

Â And therefore your investment, your equity becomes riskier.

Â Okay. So what I'm going to do now is just show

Â you the nice thing about finance, look at this equation.

Â This is an equation of betas.

Â Does it look very similar to the previous one, right?

Â It's identical to the previous one.

Â So the risk equation is identical to the return equation.

Â And what relates the two?

Â Kappa.

Â So if you want to know the risk return relationship, you go to kappa.

Â Look what's going on here.

Â 4:06

If debt is zero, beta equity is equal to beta assets.

Â Remember I told you, right at the beginning?

Â Right now it's a little bit intense on formulas and so on.

Â But I'll shift gears in a second.

Â But now that you know finance,

Â you've got to be able to deal with both formulas, and graphs, and examples.

Â So right now, let me just focus on this formula a little bit.

Â So what is beta asset?

Â Look at the awesomeness of it, it's the risk of your business, right?

Â So think about this.

Â Risk of your business is related to return of your business.

Â Again, I'm going back to the previous equation.

Â The previous equation Is identical, except this is for

Â returns and the next equation is for risks.

Â Just, do this.

Â You know like when you're getting your eyes checked.

Â They'll say this or this?

Â This or this?

Â You know, so basically these are the same things.

Â Except one is called return and one is called risk.

Â And that's another good lesson.

Â Whenever you think return, what should you think?

Â Risk.

Â And what is the measure of risk?

Â Beta.

Â Beta risk.

Â Beta.

Â Risk.

Â Return.

Â Relationship is intimate.

Â Never think of one without the other.

Â Okay.

Â So beta of the equity firm without any debt beta has it.

Â Everybody okay with that?

Â Yeah?

Â Now as, imagine, you take on debt.

Â Turns out the debt risk that,

Â the asset risk is positive and its called financial risk.

Â 5:49

And essentially passing that responsibility to a manager.

Â The manager is working for the equity holder.

Â It is decided that maybe we should take on some debt.

Â What kind of firms have debt?

Â Well, airlines have debt.

Â 6:06

Right, because their fixed assets are so large, and they are the reason, right.

Â We are not getting into it, but just to give you an example.

Â Airlines has a lot of debt.

Â Software companies don't.

Â Growth companies don't.

Â But, suppose you have debt.

Â This thing is positive.

Â It's called financial risk, if this is positive.

Â 6:26

So what happens to beta equity?

Â Beta equity starts going up about what?

Â Beta asset as soon as you start taking on leverage.

Â That's the idea of taking leverage.

Â So this equation, by the way, there's very few things in life that are true.

Â And one thing that has to be true is, as you take on more debt,

Â you make your equity riskier.

Â As you make your equity riskier, what should happen to return on equity?

Â It should go up, because you're taking on potential risk.

Â And by the way that could be what we have been doing for a long time.

Â The last five to ten years in the housing industry right?

Â We got so levered up on houses.

Â That as long as times were good and house values were going up, it was good.

Â But as soon as house value crashed it's a very bad situation to be in all right.

Â So, basically there were some houses that had almost no equity in them.

Â Okay. Very little.

Â Very risky.

Â And if you think about a bank, a bank is basically high on leverage.

Â 7:46

Same.

Â What would be the relationship between return on equity and

Â return on assets no debt.

Â Same.

Â As soon as you take on debt what's the one thing you cannot change?

Â Beta asset, return on asset,

Â also called rate of leverage cost of capital for our business now.

Â 8:04

So, if return on assets is not changed, something has to give.

Â Return on equity goes up.

Â But the average of return on equity and return on that remain the same.

Â This is so cool.

Â Just let me show you graphically and then I would have promised we have to do it.

Â We have to internalize this.

Â So, this is a little bit, as I said today is a little bit tricky.

Â So, let's just recap.

Â Business risk is the risk of the firm's assets.

Â 8:57

And senior.

Â What do I mean by that.

Â Imagine you're running a farm.

Â Who do you pay first.

Â Yourself, the equity holder, or the debt?

Â You pay the debt first.

Â So debt is a promise and it's paid first.

Â It makes equity riskier.

Â Right?

Â That's a bet.

Â Payment to equity holders can be thought of in this way, very simple,

Â (project cash flows)- (amount owed on fixed borrowing).

Â Of course, many times, what do firms do?

Â They know they owe somebody a lot, and

Â the value of the firm is dropping, classic end run, what do you do?

Â You try to steal that much money from the firm.

Â Okay.

Â 10:54

So you go to buy TV, and there's a Samsung, and there's a Sony.

Â Let's assume they both have the best model in the entire spectrum.

Â You do not know which one to choose.

Â Do I choose the 42 inch Sony or do I choose the 42 inch Samsung, right?

Â You don't know what to do.

Â Do you ever think about asking the salesman.

Â Does Sony have that, or does Samsung have that?

Â Do you ever think about how this product was financed?

Â If you do.

Â 11:30

Come to the party, because this party has nobody else.

Â Right?

Â So for most of the time, what are you focused on?

Â The product or how is it made, financing?

Â You always say, you first in the value of the product.

Â So the value of the product has nothing to do with how it was financed.

Â Just because debt was used,

Â doesn't mean Sony suddenly becomes a really bad product.

Â Right?

Â So remember that.

Â This simple result is so

Â powerful that the return on assets cannot change, but see what happens.

Â What happens to the return on equity of the firm as you take more and more debt?

Â 12:18

Made the decision to take on debt and pay them first.

Â So look at the return on debt, initially its very close to the risk free range.

Â Why? Because debt,

Â chances of default are very little.

Â But gradually what happens to the return on debt?

Â It starts going up.

Â Why?

Â Because if the assets are the same, the value of the firm is the same and

Â you have a lot of debt.

Â That is, debt to equity ratio is booming right?

Â As you're going this way.

Â 12:51

people know this.

Â People are not silly.

Â So what will they do?

Â They'll ask for a higher return before they sign up for it.

Â And how will they ask for a higher return?

Â By paying you less for the same amount of promised payment.

Â And when things get really risky in debt, they're called junk bonds.

Â In fact that all looks like the stock of the firm, right?

Â Very risky, but the key here is not risk.

Â To me the beauty of this graph is no risk.

Â This goes up, it's very intuitive.

Â 13:18

Risk stays low and goes up gradually, is also very intuitive.

Â What's amazing is the weighted average of this plus this is this.

Â The weighted average of this plus this is what?

Â This?

Â So the addition of the two is always the return on assets.

Â Do you see the awesomeness of this?

Â So return on equity is going up, return on debt is changing.

Â But the average of the two will always be equal to the return on assets.

Â I want you to take a break.

Â I want you to think about this.

Â I do not want to do an example

Â til you're just uplifted by the beauty of this result.

Â We'll come back.

Â Spend a lot of time thinking about this one more time.

Â And then I will do a long example

Â towards the end of the class that will kind of put everything together.

Â And I promise you.

Â I promise you the following.

Â If you understand this aspect of finance.

Â That leverage, how it affects the value of the firm.

Â