I would like you to stare at this idea or snapshot of, this is my favorite learning tool, by the way, in finance. Because it reminds us value is created on the asset side, something that we forget very often and liabilities are just financing for the time being. However, if we didn't have publicly traded firms we wouldn't know what the value of the best relative opportunity for an investor is. What I'm going to do is just recap this in bullet point reminder. Cost of capital in an all equity world. That means a world in which almost no firm has any debt, which, by the way, is not true. Therefore, will get more real in the remainder of this class. If an idea is financed only by shares or equity or stocks, by definition the return on equity is equal to the return on assets. The return on equity, in turn, has to be estimated because remember, orange is the idea and best alternative is apple, equity of apple. But you also need a model that takes the beta and converts it to cost of capital, or cost of equity capital, which in turn, is the return on asset. I know this is a little bit mind boggling but you need to just stay very focused and in the second half of today's class, I'll do a problem very slowly with you. One final point, all published betas, by published betas I mean which you find on websites, which you find on various places, are betas of equity, not betas of the firm, not betas of debt, betas of equity. The reason is very simple, the one thing about equity which is very attractive is if there's a market, equity trades. So that's why betas of equity are available. This is very easy if you are have all equity world. However, the world has both equity and debt and turns out, if you look at firms all over the world, and I hope you are referring to the books or chapters and so on. My goal is not to give you data for the heck of data. Because that's, to me, anything you can Google is, you should Google it and not spend time thinking about it. So, the fact is that a lot of firms, if not most firms in the world, not just in the U.S., take on debt and also have equity. We would not understand valuation fully unless we understood the implication of having debt. A firm idea or a project or you, your new idea could be financed in two ways. The first one is equity and we've talked about it but the second one is debt. There are a lot of other instruments like convertible debt and so on, or preferred stock, which are kind of a mix of the two, which are hybrids, so I'm not going to spend too much time on those. Because if you understand equity and debt, you should be able to understand combinations of the two. Having said that, no amount of practice is enough so there are classes on financing that are very interesting. I personally think that valuation should come before financing because if you don't have valuable things to provide, nobody is going to give you financing, not even yourself. Equity and debt capture, therefore most important aspects of financing, as far as valuation is concerned. I am not going to get into small interesting or complicated instruments because they really don't help as far as valuation are concerned. Leverage is a word used in the finance world and it can be substituted by something called capital structure. Capital structure is the way your financing is structured. For example, if you know that, remember Apple? In fact, look at Microsoft. Go to Yahoo Finance, as I'm talking, and see how much debt they have. You'll find, basically, nonexistent. The capital structure is the way you're financing a structure, and a lot of firms have both equity and debt and having debt is called leverage. Capital structure is how it's financing is done and if you have debt, it's called leverage. A path-breaking result and I want to pause here and show you how awesome this is. [LAUGH] Most people look at it and sa,y can't be true, that's how awesome it is but it is. In a fundamental way, it's very true, so let's talk about it for a second. By the way, books are written on this. In a world where markets are more or less competitive, and I would like you to just focus on this, financing, that means how you finance the idea, in our case the mix of equity and debt, has no effect on the value of the firm. In other words, in a world where you let the world operate instead of mess with it, create frictions, or there is too many costs involved in transacting and creating value. It turns out, and in financing, of course, that value's created on which side of the balance sheet? The asset side, and financing has no impact. These set of theorems were written by Modigliani-Miller, in a couple of joint papers, just broke the mindset of what people used to think finance is all about. This, combined with the risk return we talked about, laid the foundations of modern finance and when I say this to people, they still don't believe me. So let me just re-emphasize it and then explain a little bit more. If you remember the simple principle, value is created by an idea, and it's ability to generate cash flow. Now the word cash is a little bit, again, unnecessary. Any idea is worth it's ability to generate value in the future, and it's present value is called value today. Where does the value come from? It can not come from financing. Imagine if value came from financing, we'd just sit at home, buy and sell stocks and we'd make a lot of money. No, ideas generate values and in some sense, this hypothesis of this theorem is so cool because it's basically saying finance can't generate a value. Financing can't generate value. Unless you have a great idea, you cannot generate value, point number one. Point number two, just profitability is not good enough. Remember, you have to beat what, the next best alternative. So value's generated by assets, not by liabilities. The cost of capital, or the return on your asset, is determined by what, then? What provides you a return on your assets? It's determined by the marketplace and to the extent that your cash flows, or your values, moving up and down with the market, that risk is called beta. The risk and return are value generating propositions are coming entirely from the idea, not by how it's financed. This is so important I'd like to, again, go back to the fundamentals and show you what I'm talking about. No amount of talking is going to convince you, so let's spend some time and then I'll kind of make it more real for you. Stare at this equation, and I'll leave it up over there. First, some clarification, weighted average cost of capital is called a WACC, W-A-C-C. Let's just look at that equation before we jump, let's define that equation. It is equal to, in a world with no major frictions, the return on assets. What is the E doing in front? Let me just circle some stuff. What are these? These are simply from the fact that nothing is for sure. Many times I drop these. These are That I do not know the future, so I'm trying to estimate what on average the expected return on assets will be. Quick, what is this L? This L stands for leverage, so a firm with no debt, the equity will have no L. This is distinguishing two firms, one firm in which there is equity and there is debt, versus is one firm where there is no debt. Imagine, go back to orange, imagine apple being a comparible. Apple had no debt. So it's equity would have no subsequent value. It's as simple as that. Now in a world in which there is both debt and equity, the return on asset has to be some weighted average of the return on debt and the return on equity. This is basically the cost of capital equation which we can run with barring something that I will do right at the end but I want to postpone it to the end because you see it's man made, it's not natural. Meaning it's not out there in the world, that when we were born it was introduced right then by nature. This is natural, ie your return on asset has to be a weighted average of the return on debt and the return on equity. What has D over E plus D? This is the rate of debt in the mix of financing. What is E over E plus D? These are many times, these are weights. This can be viewed very mechanically but it's a very profound regression and we will just dig deep into it but just let's stay out there. It's a very simple outcome of the balance sheet has to balance. What changes if the value of the firm doesn't change, the return on assets doesn't change? What changes? What Modigliani–Miller said is the following. This is very important. That if you take the return on assets of two very similar businesses, they have to be the same, regardless of what? How they're financed.
