Welcome back. I'm going to leave this graph up for you to look at. And as I have emphasized many times, I will give you a sheet with formulas and everything but I will not, I mean, I have not set up this video online program to give you a lot of notes, so you have books to go back to and so on. I want this video to be the essential piece. So I'm coming back to this graph. What does this graph tell us? For those inclined to be visual, it tells us the following. The return on assets and the weighted average cost of capital is the only thing that will not change with financing. What will, however, change, is as you take on debt, there will be a break between the return on assets and return on equity. And in life very things few things are true. What's true is a return on equity will be always greater than or equal to return on assets because the beta of equity is always greater than the beta of assets or equal to. And therefore, what will change is, the return on equity will start going up. The return on debt is always below the return on equity because its less risk but the weighted average of return. Why weighted average? Because you have to weight returns by the amount of equity. And debt in the capital structure will remain the same. This result i.e. A straight line that's right, cutting right through the heart will not be effected by financing. As I think, such a profound result, again, because it's simple and again because it's mostly true. In fact, there's a lot of research written when you go to, into why the real world looks a little bit different from this but we'll, we'll get to that in a second. But in spite of man made intrusions this result is profoundly true for the most part. Makes a lot of sense. So, let me give one more shot before doing an example. And that example by the way will be really, really slow. Really, really capturing all elements of what we've done, and then I encourage you to do the assignments as and when you find the time. Then quizzing and complexity, and the last assignment of the whole program, because next week we'll focus largely on the big issues and give you time to recap and study for the final. Okay? So let's get started here. So, what's going on? Where is value being created? Big question. Assets or liability? Simple. Values created by your assets. You can also think of this as your ideas and by the way you can think of any asset. Small garage based entrepreneur to the biggest company in the world, two person buying a house and so on and so forth. Okay. So, real assets have two things. Cash flow and return on asset. Right? So let's start with this. Which, but, what determines the return on assets on your real ideas, the market place. And what is the risk associated with it given that people who invest in your real assets don't invest, just you, you being orange. They also invest in what? Many other things. The kind of risk that is determined is called beta asset. Unfortunately, both are not observable, because the real assets, the products and services produced by our buildings and ideas and so on are clearly observable, right? But the return requires trading and value to determine the value of your assets, not done. Now we have to go to the right hand side. This is where finance starts adding "value". Financing no, finance yes. Okay, so this we call return on equity, corresponding risk we call beta equity. This return is called return on debt. Lower case, upper case I go back and forth, I apologize. And its risk is also beta debt. Which is easier to measure? Which is more complicated, equity or debt? Obviously equity. Debt is promised payment. Equity is love and fresh air. Tough. But because equity trades it's easier to figure out the beta of equity. That's why most, almost all published betas are equity betas. So, now here's what the problem is. You know that RA and Beta A is the thing you want to know. How do you figure out beta A and RA? You're left to go in to the other side of the balance sheet. Let us assume like apple there's no debt. What's true? Life is very simple. You just take the beta equity of apple plug into which, I shouldn't say plug but that's what to do. The two are related through Cap-M. Beta equity return on equity through Cap-M. In our exercise we'll do it. Cap-m is so simple that I'm worried people plug-in chug with it. It's just a monitor. You know, everything, it's just so simple that's what its beauty is. Beta debt to return on debt, a little bit more complicated. Because debt doesn't trade that much. And in many countries it's a relationship between a bank and a company. So we'll get to that in a second. The good news is that there's no debt, beta equity and beta asset are the same. Return on equity, return on assets are the same. And we are off and running. However if there's debt what happens? The key thing to remember is this. The total risk of the idea is beta asset. You cannot change that by financing. It's like saying, I can change the nature of an iPad simply by using debt or equity. Uh-uh, uh-uh, doesn't make sense. Ipad depends on its technical architecture blah, blah, blah. It has nothing to do with financing, right? So, Beta has kind of given by the marketplace. How you divide it up between your financing components is up to your decision, you being the manager or owner. So if you have no debt, beta asset and beta equity are the same. If you have debt, what is beta asset equal to? Weighted average of beta equity and beta debt. Similarly, what is return of assets equal to? Weighted average of return on equity, return on debt. That's what it is called weighted average cost of capital. In fact, I think that the word cost of capital is unfortunate, because you stop thinking that somehow capital is the source of returns and value. No, your idea is. But because you cannot measure the return on your idea directly, you go to measure it through your own liability. So, so, this is one more view of the same. And I'll just wrap this up a little bit and then go on to the example. And, I'll do the example exceptionally slowly. And I will almost force you, long distance, by two arch you know, mind molding to make you stop and think at each question, promise you that. Okay. So, let's do it one more time. To evaluate and idea or a project, you want the beta and the return on the assets. That's the only thing you want. Since the beta of assets is not observable, you have, can run with beta equity only if you have no debt otherwise, please focus on what this says. You have to purge the effects of debt from equity to make it equal to beta of assets. Remember, one more time. If there's no debt, no problem. Risk of equity is the risk of business. But as you take on more debt, one of them goes out. Which one? Beta equity because you can't change beta asset based on the marketplace. Now, if you want beta asset of a firm that has both equity and debt, you got a problem. You got to take beta equity, which you can observe or estimate, and remove the effects of financing, because you know financing is not going to add value or destroy value.
