[MUSIC] Believe it or not, it's possible to become a financial hero by boosting your company's earnings per share and it's rates of returned simply by making a phone cal. This call would be to the bank to borrow money and here's what's really incredible, the money would not be used to invest in operations, or to support a particular project, or for that matter, to do anything normally seen as productive. Instead, it would be used to increase the firm's financial leverage which means buying back shares of the firm which reduces equity but increases debt. In other words, the total capital from stocks,l which is equity and from bonds, which is debt, would not change but since you borrowed to buy back shares, the firm would be carrying more debt overall. Now as we saw in the previous video, the use of financial leverage in this way can produce the magical result of magnifying earnings and rates of return. But there is one caveat. Success is completely dependent on future earnings of operating income or as we call EBIT, earnings before interest and taxes, and it's really that simple. Let's briefly consider why this happens. Debt is cheaper than equity, and its cost is fixed. When the firm earns more operating income, the gains go directly into the pockets of the shareholders who own the firm's equity, which boosts their return. In other words, the lower cost interest on the bonds is fixed, so bond holders do not share the growing earnings of the firm, those gains go to shareholders. This makes shareholders very happy, of course, as the return on equity and the returns on investment are magnified and this helps us to understand why it's so tempting for managers to boost returns with that one phone call. But the bigger picture is a little bit different because when it comes to borrowing money, this result has another side to it. There is no magic bullet to achieve superior results. And simply stated, the other side of the coin is that additional financial leverage is always accompanied by additional financial risk. For example, if the operating income that is expected to increase actually decreases, shareholders experience the opposite, a demagnification of earnings per share, the rate of return becomes more volatile. If the firm is unable to meet its higher debt obligations, it also experiences financial distress. In these cases of decreasing sales and earnings, the financial hero who made made that phone call becomes the villain who drove the firm to bankruptcy. We've established how debt is connected to earnings. In this video, we are also going to connect debt to one of the most important concepts we've been exploring in this Finance for Everyone specialization and that concept is of value. The relation of debt to value becomes clear as the market works to factor the risk of financial leverage into the price of its bonds and into the price of its shares. We've seen in the market's cost that while the market tries to price a risk, it doesn't always do such a good job of this because markets can easily over value equity and create bubbles in all kinds of financial assets. But for our purposes, the important point is that a firm's debt level can affect how risk is priced into its market value. Given this, how much debt can a firm take on without seriously compromising that value? The first step in answering this question is to understand why the cost of debt must be cheaper than the cost of equity in a well functioning market. Consider this basic relationship that we've mentioned several times in this specialization. Bondholders who hold debt take less risk than shareholders who hold equity because the firm has to pay contractually the bondholders before they pay the shareholders. If they don't, it's all over for the firm. But less risk for bondholders means a lower return for them as well, compared to what the firm must earn for shareholders who take on more risk and therefore, expect more return. If bondholders expect less and if the firm earns less for them, then the firm incurs a lower cost for bonds and this explains why debt is cheaper than equity. Now add to this another very important factor, the government. The government effectively subsidizes the cost of debt since it allows interest on debt to be a tax deductible expense, which as you know,l reduces earnings. In other words, the interest expense reduces the earnings the firm makes, which reduces the firm's taxes and we've shown in the value cost that any expense times the tax rate gives the amount of taxes that are saved. This means that if a firm pays 40% tax rate for every dollar of interest paid to a bond holder, it would save $0.40 in taxes. This means the firms real after tax cost would be $0.60 for every dollar that it pays out in interest. In other words, you pay $1, you save $0.40 in taxes, so the real cost is $0.60. This makes debt significantly cheaper than equity. Remember, on equity you pay dividends and on those dividends, you get no tax breaks, no tax deductions. Debt is therefore a significantly cheaper source of funds than equity and can reduce the firm's overall cost of capital. Now, you might be wondering what is the firm's cost of capital? This idea can be explained with a very simple example. Assuming you start off a new firm with some equity capital, those are shares that the owners are going to use to control the firm. Let's also assume that these shares have a cost of 10%. Now, you decide to use cheaper debt that cost 6% and you start substituting some of the equity with the debt. Now let's assume you have 50% of equity and debt. What this means is your firm's overall cost of capital will go down from 10% where you started to 8%. How did we get 8%? That 8% represents half of the cost of equity, that's half of 10%, which is 5 and half of the cost of debt, which was 6%, which is 3. So 5 plus 3 gives us that 8%. So you started with 10% and you're now down to 8%. This is known as the weighted cost of capital. And of course, you want to keep this weighted cost of capital going down as long as you can substitute cheaper debt with the more expensive equity. Let's put this information in a simple equation that you can use for purposes of calculation later on. We want to calculate the company's cost of capital expressed as a rate. Let's say that rate is r, and that's going to equal to the cost of debt times the weight of debt, plus the cost of equity times the weight of equity. Now in this problem we just illustrated, we saw the company had only equity, it cost 10% It was 100% all equities of the cost of the firm's capital was 10%. Now we found some cheaper debt. So what we did is we made that phone call, took that money, and bought back some shares. So in total, the capital didn't change but our costs did. The cost of debt as I mentioned to you in this example is actually 6%. So we have 6% of cheap debt, 10% of expensive equity. Half of my capital is now with debt and the other half is with equity. So of course, we do the math here 5% + 3%, that gave us a new cost of capital of 8%, so we're down from 10% to 8%. Of course, the temptation is, let's just start putting in more and more debt, higher and higher weight for debt, less equity and lower weight. And that will reduce our cost of capital, that's the idea. We know, of course, you can't keep doing this indefinitely. Otherwise, all farms would have nothing but debt in their capital structure, and no equity. So the question is, what are the limits? And how much can any firm really borrow, which is commonly referred to as the Debt Capacity. So if anyone, whether it's a firm, an individual, or a government, they all have a certain debt capacity, and if they go beyond that debt capacity, that's when they experience something called, financial distress. And if they persist on borrowing too much, eventually we know what happens, that's called bankruptcy. So for farms, the idea of debt capacity can be understood by returning to the relative costs of debt and equity. Since debt and equity are the only two sources of capital, with the debt always being cheaper than equity. We can establish the links to value with something that was remarkable and done back in the 1950s by two professors in the name of Miller and Modigliani. With the famous two propositions, the MM Theorems who was subsequently awarded the Nobel Prize in Economics. Now the result of the MM Theorem produces two fundamental insights which is what I want to talk to you about. The first one assumes perfect well-functioning markets and the second one traces the effect of a single market imperfection, and we used those two scenarios perfect markets, market imperfection to come as better, so that we can better understand the connection between the forums ratio of debt and it's debt capacity. And of course, the ultimate question of how this affects its market value? So let's look at the first scenario. In MM's first scenario of perfect market efficiency, the theory shows that when the firm starts substituting, just like I've done here. More expensive equity with cheaper debt, then the cost of capital does in fact decrease as you saw here. But in their scenario, because the markets are perfect, the shareholders aren't stupid, when they see that there's going to be more debt in the firm then they are going to need to be compensated for the more financial risk in the firm. And so they're going to demand a higher return on equity. So if we return to this example, in the world of Miller and Modigliani, what would happen in this case if you introduce this cheaper debt at 6%, and you want half of your capital structure to be this way. What they were proposing is that the shareholders now seeing the farm is riskier would want 10% anymore in fact they will want 14%, and if you work with 14%, you're to end up with guess what? 7 + 3 and that gives us 10%, so we're back to we're we were before. No change in the overall cost of capital without debt, we were 10%, with the debt, we're still 10%. So what they're saying and this is a very important insight is really, it doesn't matter whether you have debt or if you don't have debt, because at the end of the day your cost of capital, which is reflected in this r here, is simply going to remain unchanged. So if r is not going to change, what is going to effect value? And that becomes the key question in this particular work. That answer to the question of, what happens to the value of the firm if debt doesn't matter? We can get that insight from one of the first courses that we took in decisions where we used a very elegant and simple valuation formula, you might recall it the valuation formula looked like this v for value equal to some sort of cash flow in the numerator we're simply going to call it cash flow divided by an interest rate called r. So you can see the relationship of value, cash flow, and a rate of return. If I plug in the numbers, I'll just pick some, let's say the farm is going to produce cash flows of 100, and it's cost to capital is 10, then you can see the result is going to be 1000, okay? What we can see here is that, if r doesn't change, and you want to affect V, then the only way V is going to be affected is if you focus on the cash flows, right? And that will be the key to value generation. So to summarize in the first scenario, the inside regard for Miller and Modigliani was, don't worry about whether you have debt or equity, worry about your cash flows. It's the cash flows that are going to determine the value of the firm and in this case, debt would be irrelevant. So the second insight from the Miller-Modigliani Theorem looks like the impact of one market imperfection and that imperfection is the effect of corporate taxes. Now we've already seen that since interest on the debt is tax deductible and because that generates tax savings, this is obviously going to be valuable for the firm. It means that every single time the firm is going to issue debt or add debt. The value of the firm will increase because it will simply be saving taxes arising from the debt, but we also established that there's a limit to the amount of debt that can be added. Since, at some point, the firm will have to exhaust its debt capacity. Yet is we explore these points a little bit further, the second insight from Miller and Modigliani is really powerful because what it does is it gives us these outer limits to answer the question of the optimal amount of debt the company should hold. I guess the best way to understand this without going through a whole bunch of equations is to allow you to visualize this and I'd like you to visualize this by looking at a particular graph I'm going to draw. That graph has, of course like every graph two axis. So we have the vertical axis which is going to be value and we have the horizontal axis which is what we're looking for the optimal amount of debt the company will issue. If we look at the first proposition in perfect markets, what Miller-Modigliani said here was that the value of the firm actually is going to remain unchanged if markets are perfect. So it doesn't matter whether you have this much debt or that much debt, the value remains unchanged. This is the value of a firm That has no debt and to be equal exactly with the value of from that has debt leverage on leverage, no difference at all. However, if we start looking at proposition two which says if you just add more debt, the value comes going up. We have another line that starts looking like this. Now, this is amazing. This is suggesting that just keep adding debt because keep on increasing value. So in this case with the second proposition you can see that the value of a levered firm is always going to be greater than the value of an unlevered firm, because as you add on more debt, the value keeps going up. Of course, we realize there is a limit. You can't just keep issuing debt because you're going to hit the debt wall, and your debt capacity. So what do real capital structures look like? Real capital structures do increase in value as you add on debt. Meaning the value of the firm does go up, goes up, up, and then it starts to come down. In what we're interested in, is to find that point around here which maximize this. This is the maximum value of the firm, [COUGH] and of course this correspond to what we will looking for that magical proportion or the optimal amount of debt. So this is what we're really after and what is actually squeezing the firm’s value here this distance that you see over here, all of this distance that squeezes the value, has to do with the distress that's caused by adding too much debt. So these are financial distress costs that squeeze the value of the firm. Of course, the MM theory is an economic model. And so, we cannot draw these curves for any real life firm, nor determine exactly what the optimal debt ratio might be. But the MM framework critically connects the idea of borrowing with value. Which is what we were after in the first place. And it pushes managers to think carefully about their mixture of capital. More importantly, what the firm's target debt ratio might be. So in addition to the tax savings that we've been discussing, there are of course other factors that influence how much debt a firm should take on. Some of the most obvious factors are benchmark such as industry norms that the company compares itself to. But if you think about norms, those norms came from somewhere. What are they influenced by? And so, norms themselves have to take into account other considerations. For example, if you look at some of the debt ratios of Canadian firms in 2015 you can definitely observe some differences. Canada is of course famous for oil mining and other resource extraction industries. Here, it's very common to experience a lot of volatility in the cash flows because sometimes you get the minerals you're looking for and other times you don't. The result is that many Canadian farms have lower debt or issues, this is debt divided by their total assets, which are about 39-40%, compared to firms with more predictable cash flows, say in the utility business which have debt ratios of up to 56%. Or the hospitality and food services where it's much more predictable in terms of what kind of demand you will have. Where the debt ratios are even higher, right up to 68 or 70%. So that's another factor. The predictability of cash flows. What about other factors? How about assets? The nature of assets that will dictate different levels of debt. After all, if a farm has a lot of the invested money in tangible assets such as land, building, equipment, machinery and other physical assets, they're likely to borrow more money against these assets than say, they invested a lot of money in intangible assets like research and development that may or may not be realized. Or may or may not produce any value, so there's a long list of other further considerations as well. Now, [COUGH] another one of these really important concepts is called financial slack. Financial slack occurs when profitable funds don't really need debt. In fact, they may not even need equity. What they're doing is they are just generating cash. They're so profitable that they stockpile this cash, so they are not dependent on the financial markets to issue more debt or more capital for that matter. Related to this idea of financial slack is really a conservative policy of holding less than optimal debt. So you want to be somewhere left of this point which allows firms to raise money during hard times when their competitors can't. So this is a very strategic way of thinking about debt. In this situation, under leverage firms wait to use debt during cyclical or market downturns, when their competitors are experiencing financial distress. And it is during these difficult times when cash is scarce, when firms with excess debt capacity, use the debt to aggressively go after the market share or they buy out the competition, permanently damaging them, and expand aggressively at the expense of more indebted competitors. Overall, perhaps the most important takeaway about debt is to remember that all debt markets, now I'm thinking about not just the market for companies where bonds are issued, but also the debt that individuals take out which we have a couple of videos on. And of course, the sovereign debt, the debt that governments take on, they are all interconnected there is one big debt market and it's not that we can just look at our situation by kind of segmented view of particular market or industry, we have to look at the big picture. In this specialization that has repeatedly been emphasized, look at that big picture for the entire debt market. And like all financial markets they're highly interconnected globally. And so, market turmoil or failure in any one given country can have repercussions around the world, think, of course, no further than the debt crisis that was engendered around the world with a tiny country like Greece, had huge consequences for the economies and financial systems of the European Union, and of course, for the rest of the world. So we're going to take a much closer look at sovereign debt in another video, but in the wake of the Greek disaster and as the governments of developed countries show signs of borrowing too much money, we need to understand how that is going to affect other financial markets which in turn is going to affect. The answer to the central question we've raised in this video of how much debt in any given context. Now, individuals and managers of firms must really be vigilant about whether debt markets are showing signs of reaching their debt capacity, because if these deck markets go down, they're going to drag everything else down. So it won't matter whether you're focusing on the equity markets because when deck markets go, that's the ultimate catastrophe, everything else goes down with them. So it might be really prudent at this point in time to monitor the levels of deck that you are engaged with, and try to go on the conservative side. Not just because you want to survive in a turbulent market or if that, the net markets do implode. But really to position yourself to become market leaders, simply because you prepared yourself to take advantage of what seems to be inevitable. A debt market correction.