If the return on assets is the same and Apple had no debt but already decides to take on debt, 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. Let's start this equation a little bit. Don't worry about this, we can derive this by the way. This equation turned around. 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 question you will get. Just a little bit of refocusing or redoing will lead to this equation. I'm not going to go to the algebra, just remember one thing, debt plus equity equal to the total value of the firm. We'll get into this in a second. Let me ask you this. You went and saw Apple. How much debt did they have? Zero. Which part of this equation will vanish? Let me just ask you a simple question. If D is 0, that is your compatible form has no debt, which equation will disappear? Which part? The second part of the equation has to do with debt being greater than 0. If debt is 0, the second part of the equation goes away. What are you left with, the return on assets and return on equity has to be the same. For which company? A 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. As you take on more debt, what happens to the return on equity? Think about it. This remains the same. This is the same. This can't change. This is always greater than this. This number is positive. The reason for that is simple. That expect a return on assets is something that the whole firm produces, and you promise part of it to the debt. That this thing is positive. D/E is always positive if you have debt because of limited liability. You have no zeros. What happens? As you take on debt expect a return on equity goes up. The fundamental reason as always, you're taking on more risk. 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. The idea here is you now have to pay somebody else called "debt" before you can take the return for yourself. That imposes risk. If you don't like it, this example for a company, you're not working for a company. Imagine if you bought a house 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. What I'm going to do now is just show you the nice thing about finance. Look at this equation. This is an question of Beta. Does it look very similar to the previous one? It's identical to the previous one. The risk equation is identical to the return equation and what relates the two? CAPM. If you want to know the risk return relationship, you go to CAPM. 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 0, 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. Now that you know finance, you've got to be able to deal with both formulas and graphs and examples. Right now, let me just focus on this formula a little bit. What is Beta asset? Look at the awesomeness of it. It's the risk of your business. Think about this, risk of your business is related to the 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 risk, like when you're getting your eyes checked, they say, this or this. Basically, these are the same things, except one is called return, one is called risk. That's another good lesson. Whenever you think return, what should you think? Risk. What is the measure of risk? Beta. Beta, risk. Beta, risk, return. Relationship is intimate. Never think of one without the other. Beta offer equity firm without any debt is beta asset. Everybody okay with that? Yeah. Now imagine you take on debt. Turns out the asset risk, this is positive and it's called financial risk. What does that mean? That the owners of quote unquote, "The equity holders of the firm have decided by essentially passing that responsibility to a manager." The managers working for the equity holders decided that maybe we should take on some debt. What kind of firms have debt? Well, airlines have debt because there fixed assets are so large and they are the reason. 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. 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. By the way, there's very few things in life that are true. 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. By the way, that could be what we have been doing for a long time in the last 5-10 years in the housing industry. We got so levered up on houses that as long as times were good and house values were going up, it was cool. But as soon as house value crashed, it's a very bad situation to be in. Basically, there were some houses that had almost no equity in them, very little, very risky. If you think about a bank, a bank is basically high on leverage. Anyway, just giving a little bit of a flavor of this. One last time, what will be the relationship between Beta equity and Beta asset if there's no debt? 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 rated average cost of capital for our purposes [inaudible]. 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 so cool. Just let me show you graphically and then what I promise we have to do is, we have to internalize this. This is a little bit as I said, today is a little bit tricky. Let's 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 senior. This is very important. This is a promise and it's 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. The debt is a promise and it's paid first. Makes equity riskier. That's debt. Payment to equity holders can be thought of this, 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 Andron. What do you do? You try to steal as 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. 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. Yes, stare at this, what's on this axis? Rate of return. You can have returns on equity debt or return on asset, what's on this axis? Debt to equity ratio. When you have no debt, where are you? Zero debt. 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 [inaudible] at it's best. The graph tells you this, that the return on assets, will not change with financing. Even now, people think this baloney. People think they're stuck. 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 the flat. You go to buy a TV, and there's a Samsung and there's a Sony. Let's assume they 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?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, come to the party because this party has nobody else. For most of the time, what are you focused on? The product, or how is it made of financing? You always say you're focused on the value of the product. The value of the product has nothing to do with how it was financed. Just because that was used doesn't mean Sony suddenly becomes a really bad product, so remember that. This simple result is so powerful that the return on assets cannot change. But let's 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. 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 assets are the same, the value of the firm is the same, and you have a lot of debt that is debt to equity ratios booming up as you're going this way is increasing drastically, what is likely to happen? Default likely to happen. People know this, people are not silly. What will they do? They'll ask for high return before they sign up for debt. 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 and that they call junk bond, in fact, they're almost like the stock of the firm, very risky. But the key here is not this. To me, the beauty of this graph is not this. This goes up, is 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. 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 asset. I want you to take a break. I want you to think about this. I do not want to do an example till 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 toward the end of the class that we can put everything together and 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 get confused between financing and value. See you in a little.
