Hi, welcome back to Finance for Non-Finance Professionals. At the end of week four, I'd like to have a conversation with our practitioner in the field, Christine Boyd, about risk and return and discount rates, which is what we've done this week. So, Christine, we talked this week about estimating the cost of equity, cost of debt, estimating market betas, putting them together in the weighted average cost of capital. Is that what you see in the field? Well, cost of capital is certainly very important in the finance decision making process. It can be tricky to calculate. It's cumbersome. There can be assumptions, guesswork. So, I have seen firms feel the tendency to just grab a ballpark estimate. Why not just use 10 percent? Let's just use 10 percent. Yeah. So, that's something I've certainly seen a lot, which is you go through this calculation of a beta, estimate what the equity premium is, you put it together with where you think treasury rates are going, you put that together, it's very complicated. So, I get this a lot. People say, "Well, we just threw in 10 percent as our cost of capital because it was close enough." I've seen it, yes. But the answer is that it really can make a lot of difference if you think about two different kinds of firms that have a very different kind of risk, if you think of what maybe was some of the safest businesses that you worked with. Did you work with anything that was in a regulated industry? Definitely, yes. In oil business, refining company, there's large fixed assets, very easily regulated by the government. Not going to grow at 20 percent a year, right? Definitely no growth, definitely mature industry in the US. Okay. So, there, for that kind of company, it might make a lot more sense to pick a conservative ballpark estimate and just throw that in, right? Right. But can you think of some other riskier companies that you might have worked with? Absolutely. Small oil field businesses, home-grown, original. In the field, the guys who grew it from the top up and no telling where it's going to go tomorrow. Right. So, now if I think about it from an equity investor's perspective, I'm thinking about buying stock or giving money, lending money to either this large regulated public utility or this mom-and-pop drilling operation. Am I as an investor really going to want 10 percent for either company? Great point. Yeah, no way, right? Absolutely not. So, we even know that even heuristically, the investors are going to require different rates. Yes. So, I'm sure out in the field even when you see people say, "All right, let's just use 10 percent." But even after that, they're going to say, "But let's scooch it up a little bit because this is particularly risky or let's pull that back down." They do, yes. So, when we talk about these different capital budgeting tools and using the capital asset pricing model or market betas or quality spreads, all we're trying to do is just put a little bit of conceptual framework around whether to take that 10 percent and scooch it up a little or scooch it down. Right, and it makes a meaningful difference to the bottom line as we saw in one of your examples. As we change the discount rate between the risky and less risky project, how large it affects the results. When we were looking at the valuation of that pizza parlor, right? Right. We changed the discount rate from five percent to something like 10 percent or 15 percent and the valuation almost doubled, right? Right. So, talking about risk of a firm, you know debt, I always hear debt is cheaper than equity, right? Right. But what are your thoughts on that? Certainly taking on more debt makes a firm riskier, why wouldn't a company lever up more? I will say, sometimes I think we get a lot of pressure from the street to possibly do that if we have a lot of cash on hand, and why wouldn't a company use their cash, lever up? That's a great comment because I see the same thing. I see pressure from external investors for the company to lever up and I see reluctance on the part of the firm sometimes to take on that debt. So, let's talk about those trade-offs. Okay. So, as the firm takes on more debt, it doesn't really make the firm any riskier, it just pushes that risk in different places. So, think about it. Let's say we opened a Whataburger franchise, yeah. What makes the Whataburger risky? It's labor costs, the cost of beef, whether how many people are going to come through, what we're spending on advertising. With our Whataburger, if somebody was driving down the street and saying "Hey, let's pull into James and Christine's Whataburger franchise." Would somebody stop them and say, "No, we better not go to that location, they have a lot of debt in their capital structure." Nobody would say that, right? Yeah. So, our capital structure doesn't make the cost of running our Whataburger any riskier or less riskier, what it does is push that risk around. So, if we take on a lot more debt, it makes the equity riskier, it doesn't make the overall firm riskier. Okay, good point. So, now as we think about making that trade-off, what's the benefit that we get from debt? The benefit that we get from debt is that it's tax deductible, so we get a nice big tax shield from that. Like we talked about in week two, that's a real cash flow. It is, definitely. But what's the worst thing that can happen if we take on debt? Yes, right, you're getting to what I was thinking exactly. I mean you're committed, those debt payments, you're committed every quarter. So, if we have to in the worst case scenario, if we can't make good on our debts, we're bankrupt. In the field, do you see this trade-off? Do you see CFOs talking about financial distress, their inability to raise cash? What happens in the bankruptcy process? Absolutely, absolutely. I mean we have to evaluate that every quarter for our banks too, right? Yeah. So, when we think about, is debt really a cheaper source of capital? Shouldn't we just lever up? It's really reflects that trade-off. That trade-off between, the debt generates some cash for us through the tax shield, but it also increases the probability of distress. So, the capital structure that we choose has to reflect the trade-off between those forces. Exactly. Thanks very much for talking to us again, Christine. Thank you. Always good to get your perspective. Thank you. Thanks for having me, James. All right.
