So, we've spent a lot of time today I think on both concept and application and I hope that you are able to pick problems on your own other than the assignment. Go just use the web to try to do these evaluations and move on pick a new interesting problem to evaluate in your, you basically if you understood the example, you can do lot of stuff on your own. Okay. So, one lesson I want to take from what we have achieved which is very important. When we compare things Projects, new ideas and so on. The risk of what is very important? So we get caught up in risk of the firm versus risk of the project. And the bottom lesson here is that a lot of firms use their own cost of capital to evaluate new projects. So let me give you an example. I'll take an extreme example to make a point. I'll use the example of General Electric in this context, so think of General Electric, what's the difference fundamental between General Electric and say Microsoft, Apple, Oracle, Walmart. Mm, even Walmart. What is the fundamental difference? The fundamental difference is, Jack Welch was the jack of all trades, which is not a good idea, typically. It's not a good idea to do different businesses under the same company. Because violated, violates one of the few lessons of economics that you can probably do much better if you specialize. However, I believe specialization also has its issues. But we're not going to get into that right now. So what if, what if GE were to say this? We are going to use own cost of capital. Like the video game cost of capital. Evaluate all projects. And by the way, this is done by a lot of firms. And I think this is really scary, and dangerous. So let me explain to you. Let me just draw a graph. And show you GE. So, here's return zero, return zero risk and here are returns and here is risk data. Would you agree with me that the relationship between risk and return is positive. This relationship was called capital asset pricing model. But let's forget about that for a second. Let's ask the following question. High risk, high return. Almost everybody nods. Yes, has to be the case. Let's assume that on average, GE's beta is one. Why? Because it covers just about every product under the sun. You know, I tease in class they probably produce underwears too, but they don't want to have a label saying GE's underwear, you know? Anyway, so, anyway, for whatever it's worth. And what does the return here commiserate? The market return. So you can plot this one point, the return on the market in beta is one. What is this point? R F. Why? Because at beta zero your are talking about the risk free rate. Okay? And what I am going to do just for simplicity I am going to borrow from the previous example. Actually let me just use round numbers so that were are all okay. Suppose this is ten percent and suppose this is five%. Okay, just for simplicity. So ten percent is the return on average return on the market, but it's also the average return on GE. So let's for simple, as you know that, so that you're not confused about return on asset versus return on market. So this is the return on assets market return for GE. Again, why would it be approximately market return because let's say GE does everything in the same proportions right as the market. Now, the quick question, suppose GE were to use this ten percent to evaluate all new projects. Quick question. A project locks in with a beta of one. Right? A project walks in with a beta of one and let's call that project, beta B. Is this the right return to use? So the project has a beta of one project B. And your return is ten percent because your beta is one. Answer is yes. So ten percent is right to use for any project whose beta is equal to G's average beta, which is one. But, obviously, not all g projects are exactly one beta, because then G wouldn't be G, it wouldn't be a conglomerate. Do you agree that some projects are here, and some projects are here? Yeah, look at what, what will happen if GE starts using ten%. Let me ask you this, what should be the cost of capital for this? So lets assume, that this beta is equal to close to, 0.5 and this beta is two. Right? One is a low risk project, one is a high risk project. So for the low risk project what should you be using? A very low rate of return hurdle rate, but instead what are you using? Ten%, so all project with IRR between this range, All these projects are positive MPV, Why? Because their return is beating what the competition suggests low risk. But you're using what? High, hurt the rate, you'll kill all these projects. And instead, you call this value, destruction. Why? Because if you have a high murder rate, which is the average of your everything. Rarely, low risk projects that are value enhancing ones will get killed. Go to the other extreme. What will happen about this project? The discount rate here should be greater than ten%. Clearly, because the beta is two. Remember, ten percent is the return on the market beta one. If the beta is two, the return should be substantially higher benchmark. But what benchmark are you using? Ten%. So all these projects with IRR's in-between are actually value destruction again. So what, what do you end up doing? If you use one hurdle rate, i.e. Risk of what? If you use risk of your total term to evaluate every new project walking in. What do you do? You chase high risky businesses, high risk businesses, which make actually value to destroy. So you will lose track of the fundamental lesson we learnt today. Risk in return always go, hand in hand. When you break that connection, you end up making really bad mistakes. Why doesn't the world know about this? Because, in spite of all the availability of information firms are now managed by managers. They're closed boxes. They're held by investors all over the world. And you really don't realize what's happening till the world figures out that's been going on. And stock price starts going down. They're numerous examples of value destructing activities of firms. And one of the reflections of this is this. If you use one hurdle rate to evaluate all projects, you probably are going to make a lot of bad mistakes. So I just wanted you to understand this that risk goes with return, risk goes with return. You cannot compare going to our own, our own example. You cannot compare video gaming with software. If you do that, it's apples versus oranges. Makes no sense whatsoever. So if you use your company's hurdle rate for every new project, you are violating that every time. It's not going to help you. So I hope this makes sense. Think about it. I'm going to wrap up things with a little bit. More additional information. Because, to be honest with you, this class ends here technically. But I want to leave you with one thought about the real world of financing issues. Two reasons why capital structure may actually affect firm value in the real world. Remember what have we done until now? We have realized that financing is irrelevant to value creation. But there is something about the real world, which by the textbooks are written about. So if I, If I took out this real world angle, finance text books would fall in less than half. So, there's a whole business created by tax laws of the government and textbooks become thicker and thicker because of it. So, let me tell you why, first is, but there is a tax benefit given to debt that is not given to equity at the corporate level. So I'll show you what that means. What that means is if you take debt you get a tax break on the interest you pay. So the government gives you some return back if you borrow. That encourages borrowing. However, that, as you borrow more, there are some costs of borrowing. And we as a society are saying what has happened in the last five years, that cost of borrowing can show up as financial dris, distress, perverse incentives, and so on, when borrowing is very high. One thing you'll see, and which I wanted to emphasize is, remember, if you stare at this equation, and I'll let it stay there, what has happened? Weighted average cost of capital has a new term in there because of the tax law I just said. This. This is what? If the tax rate is Tc, say if corporate tax rate is 35%, and suppose the debt rate is ten%, you're paying your debt holders. You're actually not paying ten%. How much are you paying? 6.5 percent if tax rate is 35%. Why? Because the government has chosen to let you deduct the interest as an expense from your account. Because of this, what happens? Debt becomes attractive. This is artificial value, this is not what nature said. Nature never distinguishes between debt and equity. It didn't say let debt have a subsidy. No. So, what does this do? This will encourages you to take debt on some debt. Same is true of house financing, right? So, when you buy a house and you take on debt what happens? The interest you pay on the debt is tax deductible. Right? Encourages you to take debt. However, what I want to go on and talk about is, if this is the case, if debt is very attractive, why don't everybody have only debt in financial things? So the tax deductibility of interest should push debt towards 100%. However, firms do not borrow even close to 100%. As I said earlier, maybe some industries have 50%, 60 percent leverage as a total value of the company, many firms don't borrow at all. So why is it that firms don't have a lot of debt given that debt gets this favorite child treatment. Postal taxes may actually may favor equity. So postal taxes, may favor equity. So taxes when you think about it, you shouldn't just think about just the firm, but at the personal level. Second reason is, taking on debt can be extremely costly if there is default and more the debt, the more the chances of default. Again, society is facing cost of this now. What I don't like, the way finance treats debt is that it focuses too much on the tax-deductibility part, and not on possible costs of debt. And therefore, I'm at the point where, it's almost I believe that debt and equity are irrelevant again. Because, though we emphasize the tax-deductiblity costs of debt, bankruptcy costs and other costs are extremely important which may happen rarely, but recent times have set, shown us, that when they happen, they can be pretty severe, okay? So, having said that, what I want to do is I just want to wrap up today and say, it was nice to cover the whole class. It was nice to be able to talk about an example right at the end, which put everything together, and I sincerely hope that you take the time in this week to revisit this video, to do the example in detail, and to do the assignments. I promise you that next week, will not be content driven. I will talk about the main key learnings of this class that you need to equip yourself with and keep going back to, why finance is so awesome. I'll also give you some hints about how to think about other resources, classes that you need to do to make your financial manage even better. And I will also give you time to do prepare for the final so next week you will not have a ten question, a heartbreaking, sweating, working exam work to do but to prepare for the final. See you next week and may the force be with you.