[MUSIC] In the files finance for everyone course on decisions, we learned that there are only two types of money, my money or equity, and your money or debt. Even though all money can be broken down into these two types, from the perspective of a firm, how much of each type to raise is a difficult question to answer. What managers of firms have learned however, is that debt can be enormously beneficial when it is used to increase the value of the firm. Yes, you actually heard that correctly. Debt can be used to increase the value of a firm. But again, only when used properly, which we're going to explore later on in this course. So in addition to the temptations that encourage individuals to take on debt that we discussed in the earlier video segment, firms have their own set of temptations or rationales to use debt. Debt is relatively cheaper than equity simply because bondholders expect less than shareholders since they take on less risk. And under certain conditions, debt can magnify earnings. However on the flip side, managers have also learn that the excessive use of debt leads to financial distress and bankruptcy. So because of this delicate balance of benefits and risk, the decision of how much to borrow is really critical. Let's think about these two types of money a slices representing a pie which symbolizes the value of the firm. The over arching goal is to actually increase the size of the pie because that would make the firm more valuable. And in order to do that, we must mix the right amounts of debts and equity proportions that cannot be found in a recipe book. But rather, they are a result of experience and strategy that the Chief Financial Officer must determine. We know that the right slice of debt will influence the size of this pie. Too small a slice or too big a slice can change the size of the pie, which makes this decision a very challenging one. As we're going to be learning here, the key question is how much a firm should borrow. If for example, the firm decides to borrow $1 for every $3 in equity, the debt to equity ratio would be 33%, that is $1 over $3. But the total debt ratio would be 25%, that would be a dollar over the total debt plus equity which is $4. This might be dimmed to be the appropriate target debt ratio if the firm decides to maintain it and that would signal, how much amount of financial leverage exists in the firm. So when you hear your business manager talk about using financial leverage, it's just another way of saying that they're considering to use debt. And they're trying to use it to try and increase the firm's value. Notice that in thinking about the question of whether to use debt, we're implicitly comparing the choice with the alternative which is to use equity. And a study points one to this question is to look at the choice based on selecting that alternative, debt or equity which will maximize the firms earnings. This is what we will consider together right now. But a little later on, we will use more sophisticated framework to make this choice based on maximizing the firm's value. So, let's begin our analysis by projecting future revenues of a hypothetical firm which help us to determine whether debt or equity would maximize the firm's earning. That's our goal. Recall from course one, decisions that earnings can be calculated by projecting net income. It's also useful to express earnings on a per share basis, commonly referred to as Earnings per share or EPS. And that's measured by the ratio of taking net income and dividing it by the number of shares. For example, if a firm projects net income to be $2,000 and it has 400 shares, it would be earning $5 per share, that's 2,000 divided by 400. In addition, two other profitability ratios that are often used in conjunction with earnings per share include the Return on assets or ROA, which is the ratio of net income over assets, and then the Return on equity or ROE, which is the ratio of net income divided by equity. There's one other definition worth noting in analyzing these sorts of questions and that is common to use EBIT which represents Earnings Before Interest and Taxes. EBIT is a measure of operating income which is an alternative to focusing on sales revenue. And to calculate EBIT, we simply start with sales revenue and then we subtract our operating expenses such as labor, material, overhead expenses, and we arrived at EBIT. So, as we're going to see, we'll begin our analysis of projecting future revenues of the fund with EBIT. So that we can keep the operating cost constant and instead, we can keep our focus on the cost associated with financial leverage which is using debt. And those cost include interest because remember, leverage means we are taking on more debt. So let me summarize this very quickly for you, some of the definitions that I have just verbalized. We talked about earnings per share. Earnings per share is simply net income and we divide that net income by the number of common shares. And that gives us earnings per share. We also looked at a ratio called return on assets. Again, return measured by net income and that we divide by our assets, the total assets that are going to be employed. We can also look at a ratio called return on equity. This is for owners, they take special interest in looking at this result, which is again net income for our return, and then we look at total equity. And finally, I mention to you the term EBIT which is Earnings Before Interest and Tax and you arrived that by taking the revenue and subtracting all of our operating cost. So we can work with these particular acronyms, let's look at the following example. And that's going to demonstrate how financial leverage can maximize a company's earnings. Now, we're going to imagine, hypothetically, that we have an existing capital structure. Remember, there're two types of capital. Your money, my money, debt, or equity. In this case, we're going to assumed [COUGH] we have assets of $20,000, that you can see in this very simplified balance sheet, and there is no debt in the company while there is equity so it's completely finance two shares or equity of $20,000. The debt to equity ratio obviously is zero. There's no interest rate applicable, and we have issued 400 shares, so that means, if the equity is worth 20,000 divided by 400 shares, that gives us a share price of $50 per share. So, this is the existing situation. This is the current capital structure. We're now thinking of using financial leverage. And so what we're proposing here are the same assets. We're not going to change the assets. We're only going to change the mixture. Of how those assets are financed. And this time we are thinking of issuing, let's say $8,000 worth of debt. So this means that since assets are equal to debt plus equity, our equity will have to be reduced from 20,000 to 12,000, so the total is 20. And our debt to equity ratio is now 8,000 of debt over 12,000 of equity. That is 67%. The interest rate on the debt, we have been told is 8%. And so because we have less equity, we have less shares at $50 each. So they go from 400 to 240 shares. And there you can see the two capital structures. Now to evaluate whether this is a good idea or not, what we're going to do is project some revenue. So here you see a forecast of three different scenarios that we've outlined. And we're calling them, worst case, best case and a expected scenario. So worst case, let's say we have a recession. What would happen to our earnings before interest and taxes? What would happen under the expected, and what would happen under the expansion scenarios? We've got three numbers for you, for the recession $1,000, expected 2,000, and expansion $3,000. Because this is the existing capital structure, you see there is no debt, no interest to pay. So we have the same operating income. I've assumed just for simplicity, there are no taxes, so we don't have to complicate the numbers. And we'll work with the same numbers as we have for EBIT, as we do for net income. Now if we look at the number of shares outstanding, recall there were 400 shares outstanding. We divide the net income using our ratio here. And you'll see the earnings per share range from $2.50 in a recessionary period to $5 expected, and then to $7.50 if we're experiencing an expansion. Now the return on assets, remember the assets are 20,000. We take our net income divided by 20,000. And that's how you get the 5% for recession, 10% expected, and 15% for the expansionary period. Same calculation, but with different denominator. In this case, actually, the denominator does not change because total assets are equal to total equity. So exactly the same numbers for return on equity. And there you see the assumptions of no taxes. 400 shares are out standing, total assets were $20,000, and so was total equity. Let's do this same exercise again for the proposed capital structure, to see what happens to our profitability ratios if we employ debt. So we're going to start off with the three exact same scenarios, for the three expected, expansion, and recessionary periods. Same numbers as you before, except this time we have to pay interest on our debt, because we have issued $8,000 of debt at 8%. So that gives us interest payments of $640 across the board for whatever the scenario might be. Subtract the interest, and you get your net income. Again, remember, we're just ignoring taxes just to keep the numbers simple. And you see the differences in each of those scenarios. We are now ready to calculate our earnings per share. Again, we look at the net income figure. But this time, remember, we're going to divide each of these numbers by a lower number of shares because there is less equity in the firm. And you see the calculations of $1.50, $5.60 and $9.83. Again, compute our return on assets, I'll do one example. For instance, in the expected scenario, our return on assets are going to be the net income of 1,360 divided by our total assets, which are still $20,000, and that gives us 6.8%. We do finally the calculations on return on equity. Remember, we now have a lower equity base. And so we again do the calculations. And in this case, net income divided by return on equity goes up to 11% under the expected scenario and jumps to 20% in an expansionary situation. Again, the assumptions are listed there. And what we really want to do now is to compare the situation when we had no debt and the situation where we had debt. So I'll let you think about for a moment, what exactly has happened here? What are some of the takeaways that we can generalize when we see a company that introduces debt in its capital structure? This example, in fact, illustrates those very important principles that help us to better understand the effect of financial leverage. In other words, what is the effect of using debt on earnings? And note that the following generalizations can be applied to all firms that are considering the use of debt in this way. Note also, nothing productive has been done. The company just issued pieces of paper called debt. And they used that money to buy back shares so that the total assets didn't change. It was just the mixture of those assets that are now different. Right, first and foremost, the most important figure that drives the entire analysis that we've seen so far is EBIT. As we saw in the definition itself, EBIT comes from sales. Worth noting this down. Without sales revenue there would be no cash flow. In fact, there would be no firm at all. So keeping in mind that our forecast of sales is going to be very much going to influence whether or not we are going to use debt. So while this is obvious, managers still need to ask hard questions about what is the forecast for sales. That of course going to ultimately result in our forecasted EBIT. And that will drive the choice of whether debt or equity will be use to maximize the bottom line. This leads us to the second point. Increases in EBIT always favor debt significantly, whereas decreases in EBIT favor equity. That's because equity provides a bigger cushion when you have hard times, when revenues are declining. However when revenues are increasing, EBIT is going up. This is going to favor debt. This is because it's going to magnify the profitability by increasing earnings per share, return on assets, and return on equity. In fact, compare for example, let's look at those numbers again. Our forecast, let's compare recession versus expected. When EBIT went from 1,000 in a recession to 2,000, which were considered normal times, this is an increase of 100%. If you did not have any debt in your capital structure, this 100% increase was mirrored in all of the profitability calculations. So EBIT went up a 100%, all of these numbers went up by a 100%. However, when we use debt, what did we see here? An 100% increase in EBIT resulted in a 278% increase in earnings per share. And you can do the calculation there. The $5.67, which is the expected EPS in the normal situation, less the $1.50 in the recession, divided by $1.50, gives us the 278%. Similarly, you could do the calculations for ROA and ROE, and again find a magnification. Let's not forget though, the same thing would happen if we were going from Normal to recession. There would be a demagnification of EBI to 278%, right? So this drama of magnifying or demagnifying happens with debt. And the reason is because when EBIT is going up the cost of debt remains fixed, and so the increase feeds right into the pockets of the owners. And so your return on assets, return on equity, get magnified, okay? This is the case, of course, when revenues are going up. Let's then look at the third principle. The third principle also can be derived from this example, which shows you very clearly that in the case of debt you have a higher variability of earnings. And that's always going to be expected with debt. All of the numbers for EPS, RoA, RoE, are more volatile, and since finance uses volatility as one measure of risk, it's clear that debt is going to be a riskier choice for the firm. So we have been sort of examining this fundamental risk return relationship in the previous course on value, if you recall. So to help us to understand its importance to this particular course, it's probably useful to consider the different experiences of a firm's stockholders versus those of bondholders. And I want to be clear that when a firm issues shares, these are purchased by stockholders. But when it issues deck, these are purchase by bondholders who are investing in the firm's bonds. And during the value cost, when we look at risk from the investor's point of view, that is from the bondholder or shareholders point of view. We concluded that shareholders take on more risk because they are the last ones to be paid, in fact that may not be paid at all. Were as bondholders are guaranteed to be paid with interest. The result of this is that shareholders expect to earn more return to compensate for this additional risk. And if I translate that from the investor to the firms perspective, we can see that from the firms point of view, if shareholders are supposed to make more money, if they have higher returns, the cost is also going to be higher. So this is why debt is cheaper than equity. And as we will see later on in this course, this means that why debt is cheaper than equity, bondholders will expect less. And even though the cost of debt is less from the firms point of view it's riskier for the firm to hold debt. It's riskier because bondholders if you don't pay them. This can result in severe financial distress and ultimately bankruptcy. So with this knowledge we can establish the key points. The key learnings that inform us about whether or not you should use debt, how much to borrow, if our focus is on earnings, okay? Here are some of the key points. Number one, everything will depend on EBIT, right? Keep an eye on EBIT, that was the first one. The second thing we said was profitability dramatically changes with debt, especially if you're expecting EBIT to go up then debt will magnify returns for shareholders especially. The third point was that with debt you get more volatility in earnings, you get more volatility in returns for the shareholders. And so, while you can expect high return, you also take on higher risk. The fourth point where the debt is typically cheaper than equity, at least up to a certain point, so there's a temptation to use debt. And that particular point takes us to the last conclusion that in fact, to understand how much debt, we must understand valuation of the firm itself. Not just rely on profitability but we have to think about value. And that will give us a much better understanding of our ultimate question of how much debt. To conclude, let's do one final calculation that will help us to demonstrate where we're at in terms of understanding decisions of whether or not and how much a firm should borrow. Here we could use the earnings approach to calculate the breaking even or so called indifference point where earnings per share for both debt and equity are exactly equal. So we solve for EBIT by equating the earnings per share of each approach. Let me do that for you right now. So what I'm going to do is I will take the earnings per share ratio for my current capital structure, which was all equity, and simply look for EBIT, this is the unknown. There's of course no interest. In this case there are no taxes, I'm going to ignore that. Otherwise you could have included taxes here. And then these are of course the number of shares as you see in the ratio, and I'm going to equate this with the same ratio of the same exact ratio, but of course for the earnings per share that are based on using deck. So again I'm going to have EBIT. Minus interest, there's no taxes, I'm not going to worry about that, divided by the number of shares. Now you're going to say, while this looks the same, it looks the same but the numbers of course are going to be different because this right hand side represents debt. So let's plug the numbers in. We're looking for EBIT, interest is 0, taxes are 0, we have 400 shares in the current capital structure. We're going to equate this with again we're looking for EBIT, but this time we have interest of $640 no way for taxes and this time we end up with 240 shares. So if you solve for EBIT, you're going to get the break-even number and that break-even number is $1,600, right? This corresponds to an earnings per share of $4, what this means if you are forecasting 1,600 it doesn't matter whether you issue equity or whether you issue debt, because the earnings per share are exactly the same. However, what you can't see that any number greater than 1,600, a forecast greater than 1,600, you should take on more debt, right? Sell more bonds because earnings per share would be higher, you can see that on the graph. On the other hand a forecast of lower than 1,600 would favor equity. So you can see the advantage of using equity below the break even point advantage of using that above the break even point. Now once we have arrived at this break even indifference point, what we can do is visualize this information on a graph that will helps to decide when to use debt when to use equity. Now we can do by labeling earnings per share on the vertical and EBIT on the horizontal axis. So these are our two axis. You can already plot this information here. So we have a point where, our break even EBIT of $1,600 corresponds to earning per share of $4, right? What we have to do now is to show the two different financing profiles, one that represents the current capital structure which had no debt. And that simply is going to be representing equity. For the firm and then the other one which intersects at $640. That was the interest the company must pay, so that's the minimum level of EBIT where earnings per share will be zero. And that will be the profile for debt so here we go, so this represent debt. And what this is showing us now is that if you project anything beyond 1,600 as mentioned earlier on. Let's say at this point here, then your earnings per share under debt are going to be higher, than if they were under equity. So this whole area is the advantage for using debt financing. And this particular area that you see here is giving us the advantage for using equity. So the key of course is to forecast EBIT, and this way, with this analysis, we can see which of the two is going to maximize earnings per share. So while we get some answers using this analysis note it's rather simplistic because it's not entirely clear how the value of the fund is going to be affected by the decision to issue more debt or issue more equity. Because we haven't factored in a number of other considerations that are often use to determine this very illusive question when it comes down to debt. So we're going to in the future focus on firm value. And we have a Nobel price winning framework that will help us or guide us in deciding of that illusive question how much debt? And we're going to look into this additional considerations with more detail for the rest of this course. So for now I hope you'll stay with us and see you soon again.