0:00

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

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

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

0:15

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

Don't worry about this we can drive this.

Either way.

This equation, turned around.

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

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

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

0:36

Alright?

Just a little bit of refocusing, rethinking,

redoing will lead to Desecration.

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

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

Right?

We'll get into this in a second.

So let me ask you this.

If D = 0, which equation will disappear?

Which part?

The second part of the equation.

1:58

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've promised part of it to the debt right?

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

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

So what happened?

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

2:34

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, 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 it, this example, for a company.

A hardworking company.

Imagine if you bought a house or an apartment.

3:09

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?

Kappa.

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

Look what's going on here.

4:06

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 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, except this is for

returns and the next equation is for risks.

Just, do this.

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

They'll say this or this?

This or this?

You know, so basically these are the same things.

Except one is called return and 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 the equity firm without any debt beta has it.

Everybody okay with that?

Yeah?

Now as, imagine, you take on debt.

Turns out the debt risk that,

the asset risk is positive and its called financial risk.

5:49

And essentially passing that responsibility to a manager.

The manager is working for the equity holder.

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

What kind of firms have debt?

Well, airlines have debt.

6:06

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

6:26

So what happens to beta equity?

Beta equity starts going up about 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 potential risk.

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

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 value crashed it's a very bad situation to be in all 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.

7:46

Same.

What would 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 rate of leverage cost of capital for our business now.

8:04

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

Return on equity goes up.

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

This is so cool.

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

We have to internalize this.

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

So, let's just recap.

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

8:57

And senior.

What do I mean by that.

Imagine you're running a farm.

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.

It makes equity riskier.

Right?

That's a bet.

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

(project cash flows)- (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 much money from the firm.

Okay.

10:54

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

Let's assume they both have the best model 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 that, or does Samsung have that?

Do you ever think about how this product was financed?

If you do.

11:30

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

Right?

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

The product or how is it made, financing?

You always say, you first in 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 really 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?

12:18

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

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

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 assets are the same, the value of the firm is the same and

you have a lot of debt.

That is, debt to equity ratio is booming right?

As you're going this way.

12:51

people know this.

People are not silly.

So what will they do?

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

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 bonds.

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

Very risky, but the key here is not risk.

To me the beauty of this graph is no risk.

This goes up, it's very intuitive.

13:18

Risk 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 assets.

Do 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 assets.

I want you to take a break.

I want you to think about this.

I do not want to do an example

til you're 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.