Hi, welcome back. If you haven't taken a break, then let's keep going. But if you have, hopefully you've thought about this. So this, I would like you to stare at this idea or snap shot from, this is my favorite learning tool, by the way, in finance. Because it reminds us value's created on the asset side, something that we forget very often. And liabilities are just financing. Okay? For the time being. However, if you didn't have publicly traded firms, we wouldn't know what the value of the best opportunity, relative opportunity, for an investor is. Okay? So, what I'm going to do is just recap this in bullet point kind of reminder. So, cost of capital in an all equity world. That means a world in which almost no firm has any debt, which by the way is not true, therefore, we'll get more real in the remainder of this class. If the firm, if an idea, is financed only by shares or equity or stocks, by definition you want the return on assets to be able to value. But the return on equity is equal to the return on assets. The return on equity in turn has to be estimated, and what it requires is two things. The beta estimate of equity of Apple, because remember, Orange is the idea and best alternative is Apple. Equity of Apple, but you also need a model that takes the beta and converts it to the cost of equity capital, which in turn is the return on asset. I know this is a little bit mind boggling, but you need to just stay very focused. And in the second half of today's class, I'll do a problem very slowly with you. Because if you understand that problem, you understood the last three weeks, essentially, for class purposes. And then you have assignments, which I hope you've been keeping up with. But this week's assignments are richer than the past two weeks because they're putting things together. One finally point. All published betas, by published betas I mean which you find on websites, which you find in various places, are betas of equity. Not betas of the firm, not betas of debt. Betas of equity. And the reason is very simple. The one thing about equity which is very attractive, is there's a market equity trade. Okay? So that's why betas of equity are available. So this is very easy if you have all equity world. However, the world has both equity and debt. And turns out, if you look at firms all over the world, and I hope you're referring to the books, or chapters and so on. My goal is not to give you data for the heck of data, because that's to me, anything you can Google is, you should Google and not spend time thinking about, right? So the fact is that a lot of firms, if not most firms in the world, not just in the U.S., take on debt and also have equity. So we would not understand valuation fully unless we understood the implication of having debt. A firm, idea, or a project or you, your new idea, could be financed in two ways. The first one is equity, and we'd talked about it. But the second one is debt. And there are a lot of other instruments, like convertible debt and so on, or preferred stock, which are kind of a mix of the two, which are hybrid. So I'm not going to spend too much time on those, because if you understand equity and debt, you should be able to understand combinations of the two. Having said that, no amount of practice is enough. So there are classes on financing that are very interesting. I personally think valuation should come before financing, because if you don't have valuable things to provide, nobody's going to give you financing. Not even you yourself. Equity and debt capture, therefore, most important aspects of financing as far as valuation is concerned. I'm not going to get into more interesting or complicated instruments, because they really don't help as far as valuation are concerned. Leverage or leverage as I like to call it, is a word used in the finance world. And it can be substituted by something called capital structure. So capital structure is the way you're financing is structured. So, for example, if you have no debt, remember Apple? In fact, look at Microsoft. Go to Yahoo Finance as I'm talking and see how much debt they have, and you'll find it's basically non existent. So the capital structure is the way of financing a structure, and a lot of firms have both equity and debt. And having debt is called leverage. Capital structures how it's financing is done, and if you have debt it's called leverage, a leverage. Okay? A Path-Breaking Result, and I want to pause here and show you how awesome this is [LAUGH]. And I mean, most people look at it and say, can't be true. That's how awesome it is. But it is, in a fundamental way, it's very true. So let's talk about it for a second. And by the way, books are written on this. In a world where markets are more or less competitive, and I would like you to just focus on this financing. That means how you finance the idea, in our case the mix of equity and debt has no effect on the value of the firm. So in other words, in a world where you let the world operate instead of mess with it, create frictions or there's too many costs involved in transacting and creating value, it turns out, and in financing, of course, it turns out that value's created on which side of the balance sheet? The asset side. And financing has no impact. I view, this set of theorems were written by Modigliani-Miller in couple of joint papers, just broke the mindset of what people use to think finance is all about. This, combined with the risk return we talked about, laid the foundations of modern finance. And when I say this to people, they still don't believe me. So let me just re-emphasize it and then explain a little bit more. If you remember, the simple principle value is created by an idea, right? And its ability to generate cash flows. Now, the word cash is a little bit, again, unnecessary. Any idea is worth it's ability to generate value in the future, and it's present value is called value today, right? So, where does the value come from? It cannot come from financing. Imagine if value came from financing, we'd just sit home, buy and sell stocks, and we'd make a lot of money. No. Ideas generate value. And in some sense, this hypothesis, or this theorem, is so cool because it's basically saying finance can't generate value. Financing can't generate value. Unless you have a great idea, you cannot generate value. Point number one. Point number two, just profitability is not good enough, remember. You have to beat what? The next best alternative. So value's generated by assets, not by liabilities. The cost of capital, or the return on your asset, is determined by what, then? What provides you a return on your assets? It's determined by the marketplace. And to the extend that your cash flows, or your value's moving up and down the market, that risk is called beta. The risk and return are value generating propositions, are coming entirely from your idea, not by how it's financed. This is so important, I'd like to, again, go back to the fundamentals and show you what I'm talking about. And no amount of talking's going to to convince you. So let's spend some time, and then I'll kind of make it more real for you. Okay. So, instead of this equation, and I'll leave it up over there. First, some clarification. Weighted average cost of capital is called a WACC, W, A, C, C. Let's just look at that equation before we jump, I mean, let's define that equation. It is equal to, in a world with no frictions, major frictions, the return on assets. So, what is the E doing in front? So, let me just circle some stuff. What are these? These are simply from the fact that nothing is for sure. Many times, I drop these. These are, that I do not know the future, so I'm trying to estimate what on average the expected return on assets would be. Right? Quick, what is this L? This L stands for leverage, right? So, a firm with no debt, the equity will have no L. So this is distinguishing two firms, one firm in which there is equity and there is debt. Whereas one firm where there is no debt. So imagine, go back to Orange. All right? So imagine Apple being a comparable, right? So Apple had no debt, so they would, it's equity would have no subscript L. It's as simple as that. So now in the world there is both debt and equity, the return on asset has to be some weighted average of the return on debt and return on equity. So this is basically the cost of capital equation which we can run with, barring something that I'll do right at the end. But I want to postpone it to the end because you see that it's manmade. It's not natural. Meaning, it's not out there in the world that when we are born it was introduced right then by nature. This is natural, i.e., your return on asset has to be a weighted average of the return on debt and return on equity. What is D over E plus D? This is the rate of debt in the mix of financing. What is E over E plus D? These are, many times these are weights. Let me ask you the following question, think about it. What was the rate on debt for Apple? Zero. If rate on debt for Apple was zero, what was rate on it's equity? One. So what was the relationship between it's weighted average cost of capital return on asset and return on equity? They were all the same. So this can be viewed very mechanically, but it's a very profound equation. And we will just dig deep into it. But just let's stay out there. It's a very simple outcome of the balance sheet has to balance. Okay? So, what I'm going to do now is I'm going to move on and just show you this equation, and just move on to what changes if the value of the firm doesn't change, the return on assets doesn't change, what changes? So what did Modigliani-Miller said as the following? This is very important. That if you take the return on assets of two very similar businesses, they have to be the same. Regardless of what? How they are financed. So let me repeat this again. Suppose you were to go in a world of Orange, which looks very similar to Apple, right? Apple had no debt, but Orange decides to take debt. All right, bear with me. Apple has no debt. But Orange decides to take debt. What's the relationship between their return on assets? If you think, you'll just start getting confused. But it you, I mean, if you get caught up in financing, you'll get confused. Stay clean. What does the return on assets, where does it come from? It comes from your idea. If your ideas are very similar, what should the return be on them? They should be very similar. So your asset is your idea. So regardless of whether Orange takes debt or not, it's return on its idea, if it's similar to Apple, will be the same. So, this is very profound, right? So the return on assets of Apple and Orange will be the same. Even though Orange decides to take on debt, its return on assets cannot change. And this is just unbelievably remarkable result.
