If the return on assets is the same, and Apple had no debt, but Orange decides to take on debt, what changes? Something has to change, right? Because you're changing the financing. Turns out, yes. The one thing that will change will be the return on equity. Okay so let's stare at this equation a little bit. Don't worry about this. We can derive this by the way. This equation turned around if you just let me just show you how to do this. If you take this to the left hand side. And solve for it, this is what the equation will get. Correct? So, just a little bit of refocusing or rethinking, redoing will lead to this equation, and I'm not going to go through the algebra. Just remember one thing. Debt plus equity equals the total value of the firm, right? We'll get into this in a second. So let me ask you this. You went and saw Apple. How much debt did they have? Zero. Which part of this equation will vanish? So let me just ask you a simple question. If you got, if D is zero. That is your comparable firm has no date, which equation will disappear? Which part? The second part of the equation has to do with debt being greater than zero. If debt is zero the second part of the equation goes away, yes? So what are you left with? The return on asset and return on equity have to be same. To which company? The company which has no debt. But as soon as you take on debt, the key thing is, the one thing that you cannot change, is this. This is determined by what? The business. But what happens when you take on debt? You start changing this. So as you take on more debt what happens to the return on equity? Think about it. This remain the same. This is the same. This can't change. This is always greater than this. This number is positive. And the reason for that is simple. That expected return on the assets is something that the whole firm produces. And you promise part of it to, to the debt. Right? So that this thing is positive. D over E is always positive if you have debt, because it's, because it, of limited liability, right? You have no zeroes. So what happens? As you take on debt expected return on equity goes up. And the fundamental reason is, as always, you're taking on more risk. So you're the shareholder, you have a business, but to run the business you take on some debt. As a result what do you take on? Some risk, because you are the owner. So, so, so the idea here is you now have to pay somebody else, called debt, before you can take the return for yourself. And that imposes risk. If you don't like the, this example for a company, and aren't looking for a company. Imagine, if you bought a house or a, or, or an apartment. You could buy it without any debt, then you own the whole thing. Or you could buy it typically with debt, it's called leveraging. And therefore your investment, your equity becomes riskier. Okay? So, what I'm going to do now is just show you the nice thing about finance. Look at this equation. This is an equation of betas. Does it look very similar to the previous one? Right, it's identical to the previous one so the risk equation is identical to the return equation, and what relates the two? Cap end. So if you want to know the risk return relationship you go to cap end, so look what's going on here. I will do this multiple times. Beta is the risk of your business. If you have no debt what is the risk of equity? If debt is zero, beta equity is equal to beta assets. Remember I told you right at the beginning? Right now it's a little bit intense on formulas and so on but I'll shift gears in a second. But it got to, now that you know finance, you've got to be able to deal with both formulas and graphs and examples. So right now let me just focus on this formula a little bit. So what is beta asset? Look at the awesomeness of it. It's the risk of your business. Right, so think about this. Risk of your business is related to return of your business. Again, I'm going back to the previous equation. The previous equation is identical. Expect this is for returns. And the next equation is for, risks. Just, do this you know, like op. When you're getting your eyes checked, they say, this or this. This, or this. You know so, so basically these are the same things, except one is called return, one Is called risk. And that's another good lesson. Whenever you think return, what should you think? Risk. And what is the measure of risk? Beta. Beta risk, beta. Risk, return. Relationship is intimate. Never think of one without the other. Okay. So beta of an equity firm, without any debt, is beta asset. Everybody okay with that? Yeah? Now as, imagine, you take on debt. Turns out the debt risk, the, the asset risk, this is positive, and it's called financial risk. What does that mean? That the owner's of, quote-unquote, the equity holders of the firm, have decided on, by, essentially, passing that responsibility to a manager. The manager is working for the equity holders has decided that maybe we should take on some debt. What kind of firms have debt? Well, [laugh], airlines have debt, right? Because their fish stick assets are so large. And there are other reasons, right? We are not getting into it, but just to give you an example. Airlines has a lot of debt, software companies don't. Growth companies don't. But suppose you have debt, this thing is positive. It's called financial risk, if this is positive. So what happens to beta equity? Beta equity starts going up, above what, beta asset, as soon as you start taking on leverage. That's the idea of taking leverage. So this equation, by the way, there's very few things in life that are true. And one thing that has to be true is, as you take on more debt, you make your equity riskier. As you make your equity riskier, what should happen to return on equity? It should go up because you're taking on financial risk. And by the way that could be what we've been doing for a long, long time in the last five to ten years in the housing industry, right? We got so levered up on houses, that as long as times were good and house values were going up, it was good. But as soon as house values crashed, it was a very bad situation to be in, right? So basically there were some houses that had almost no equity in them, okay? Very little, very risky. And if you think about a bank, a bank is basically high on leverage. Anyway, just giving you a little bit of a flavor of this. One last time. What will be the relationship between beta equity and beta asset if there is no debt? Same. What will be the relationship between return on equity and return on assets, no debt? Same. As soon as you take on debt what's the one thing you cannot change? Beta asset, return on asset. Also called weighted average cost of capital, for our purposes now. So if return on assets has not changed something has to give. Return on equity goes up. But the average of return on equity and return on debt remain the same. This is, oh cool, just let me show you graphically and then what I promise. We have to do this, we have to internalize this. This is little bit as I said, today is a little bit tricky. So lets just recap. Business risk is the risk of the firm's assets. And it also is the risk of equity, as long as there is no debt. Financial risk, is the additional risk, placed on equity, because, it chooses to use some fixed income securities, that are also seen here. , This is very important. This is a promise, and senior. What do I mean by that? Imagine you're running a firm. Who do you pay first? Yourself, the equity holder or the debt? You pay the debt first. So debt is a promise and it's paid first, makes a equity riskier. Right, that's billed. Payment to equity holders can be thought of, of this way. Very simple. Project cash flows minus amount owed on fixed borrowing. Of course, many times what do firms do? They know they owe somebody a lot. And the value of the firm is dropping. Classic end run. What do you do? You try to steal that [laugh] much money from the, firm. And say, sorry. I'm bankrupt. I'm not saying that's what you should do. Unfortunately, that kind of incentive can really screw things up. Okay. So this graph, and then we'll take a break. I told you I'll show you a lot of stuff, but then we'll take a break, and do a long example. So here's, stare at this. What's on this axis? Rate of return, and you can have returns on equity, debt, or return on asset. What's on this axis? Debt to equity ratio. So, when you have no debt, where are you? Zero debt, right? What will be the return on asset? This. The cool thing is what will be the return on asset if you have a lot of debt? What does this graph tell you? This is the Moorehead Landing Miller at it's best. The graph tells you this, that the return on asset will not change with financing. Even now people think that's bologna. People think how does that? But let me ask you this. It is extremely intuitive. Why? Because suppose you go to buy a Sony versus a Samsung phone or let's call it a tv. I think that Sony doesn't produce a phone. So you go to buy a tv and there is a Samsung and there's a Sony. Let's assume that both have the best models in the entire spectrum. You do not know which one to choose. Do I choose the 42 inch Sony, or do I choose the 42 inch Samsung? Right? You don't know. What to do, do you ever think about asking the salesman, does Sony have debt, or does Samsung have debt. Do you ever think about how this product was financed? If you do, come to the party because this party has nobody else. Right, so for most off the time what are you focused on? The product or how is it made or financing? You always say you focus on the value of the product so the value of the product has nothing to do with how it was financed. Just because debt was used doesn't mean Sony suddenly becomes a very bad product, right? So remember that, this simple result is so powerful that the return on assets cannot change, but see what happens. What happens to the return on equity of the firm, as you take more and more debt? Starts going up. Why? Simply because equity is like the owner of the firm which owes to pay whom. Made the decision to take on debt and pay them first. So look at the return on debt. Initially it's very close to the risk free rate. Why? Because debt chances of default are very little. But gradually what happens to the return on debt? It starts going up. Why? Because if the asset are the same, the value of firm is the same. And you have a lot of debt. That is debt to equity ratio is booming up. Right? As you're going this way. It's increasing drastically. What is likely to happen? Default is likely to happen. People know this. People are not silly. So what will they do? They'll ask for a higher return before they sign up for debt. And how will they ask for a higher return? By paying you less for the same amount of promised payment. And when things get really risky in debt, they're called junk bond. In fact, they're almost the stock of the firm, right? Very risky. But the key here is not this. To me the beauty of this graph is not this. This goes up, it's very intuitive. This stays low and goes up gradually is also very intuitive. What's amazing is the weighted average of this plus this. Is this? The weighted average of this plus this is what? This? So the addition of the two is always the return on asset. You see the awesomeness of this? So return on equity is going up. Return on debt is changing. But the average of the two will always be equal to the return on the asset. I want you to take a break. I want you to think about this. I do not want to do an example 'til you are just uplifted by the beauty of this result. We'll come back, Spend a lot of time thinking about this one more time, and then I will do a long example towards the end of the class that will kind of put everything together. And I promise you, I promise you the following. If you understand this aspect of finance. That leverage, how it affects the value of the firm. You would have arrived because a lot of people out there have been confused between financing and value. Okay? See you in a little.
