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 have not setup 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 asset and return on equity. And in life, very few things are true. What's true is the return on equity will be always greater than or equal to return on asset, 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 return on equity because it's less risk. But the weighted average of the two, 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., the straight line that's cutting right through the heart will not be affected by financing. because 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. We'll go into why the real world looks a little bit different from this, but we'll get to that in a second. But in spite of manmade 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 have done. And then I encourage you to do the assignments as and when you find the time, then increasing in complexity. And this is last assignment of the whole program because next week, we will 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 liabilities? Simple, value is created by your assets. You can also think of this as you ideas. And by the way, you can think of any asset, small garage based entrepreneur, to the biggest company in the world, to a 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, what determines the return on assets on your real ideas? The marketplace. And what is the risk associated with it, given that people who invest in your real assets don't invest in just you, you being orange? They also invest in what? Many other things. The kind of risk that is called beta asset. Unfortunately, both are not observable because the real assets, the products and services produced by your 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. So now we have to go to the right-hand side. This is where finance starts adding quote, unquote, 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, lowercase, uppercase, I go back and forth, I apologize. And 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 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 going 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 you do. The two are related through CAPM. Beta equity, return on equity through CAPM, in our exercise we'll do it. CAPM is so simple that I worry people plug and chug with it. It's just a model. Everything, it's just so simple, that's what its beauty is. Beta debt to return on debt, it's a little bit more complicated because debt doesn't trade that much. And as 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 happened? The key thing to remember is this. The total risk of your 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, it doesn't make sense. iPad depends on its technical architecture, blah, blah, blah. Nothing to do with financing, right? So beta asset is 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? A weighted of average of beta equity and beta debt. Similarly, what is return on assets equal to? Weighted average of return on equity, return on debt. That's why it's called weighted average cost of capital. In fact I think the word cost of capital is unfortunate, because you start 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 got to measure it through your liabilities. 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 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 any idea or project you want the beta and 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 risk of business. But as you take on more debt, one of them goes up, which one? Beta equity, because you can't change beta assets, it's based on the marketplace. Now if you want beta asset of a firm that has both equity and debt, you got a problem. You gotta 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.
