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0:03
Jason Heavilin: In this video, we are gonna go over some basic concepts of capital structure and the M. And M. Propositions.
0:15
Jason Heavilin: as you shouldn't know by now given your previous accounting clients and finance classes or things we have discussed in this course previously a capital structure. Jason Heavilin: It's the combination of debt and equity. Now, for this Jason Heavilin: definition here assume pre, first stock is be part of equity as well. But that's what it comes out to.
0:41
So we are going to focus on some specific specific vocabulary. The value of a firm Jason Heavilin: is going to be defined as the sum of the value of the first debt and the value of the firms. Equity
0:57
Jason Heavilin: no surprises there. If the goal of the firms management is to make the firm as valuable as possible. Jason Heavilin: then the firm should pick the debt equity ratio that makes the pi as big as possible. No. Jason Heavilin: I want to make sure there's an understanding of the difference between the value of equity versus the value of the firm.
1:24
Jason Heavilin: So here we're talking about the value of the firm as a whole to include the value of debt.
1:31
Jason Heavilin: and that is to create some kind of distinction between what we might consider the value of the stock Jason Heavilin: and the market capitalization. I'm not going to get into the whole theoretical part of the stock price on the market reflects all value and all information. but this keeps somewhat of a separation in our minds between the value of the firm and what we call the value of equ. What do you the value of the stock market about capitalization?
1:59
Just so, it makes a a little sense of what we're gonna talk about in this Jason Heavilin: chapter. Stockholder interests. There are 2 important questions. Why should the stock quarter care about maximizing firm value. Jason Heavilin: So you see, there's a difference between maximizing the equity value, which is where the stockholder Jason Heavilin: is is, you know, present in that equation versus the entire firm value.
2:28
Jason Heavilin: because perhaps they should be interested in strategies that Max, my shareholder value. We're going to eventually see with a couple of examples how Jason Heavilin: it, it comes together. It is a benefit, but we also gotta be careful of what we call trans as a wealth Jason Heavilin: where Jason Heavilin: the value of the firm may increase, but not in the
2:49
Jason Heavilin: best direction for the dead holder on the best direction for the equity holder. what is the ratio of that to equity that maximize it is the shareholder value. as it turns out. Jason Heavilin: changes in capital structure primarily benefit the stockholder. If the value the firm increases.
3:09
Jason Heavilin: That's another way to say.
3:12
Jason Heavilin: Remember the pi. let's go back. There is not necessarily 50 50.
3:19
Jason Heavilin: So what they're saying is that maybe increasing Jason Heavilin: that this red area.
3:28
Jason Heavilin: while it looks like the value of that is the one going up.
3:32
Jason Heavilin: We're gonna see how increasing that red area may actually increase the total value of the gray area. even though it plays a smaller part, an entire pie. Jason Heavilin: But if entire pie grows, then a smaller part of a bigger pie could mean more than a large part of a smaller pie. Jason Heavilin: That's what we're saying.
4:00
Jason Heavilin: This is a quick way to visualize some of how how some of this plays out when you increase that
4:10
Jason Heavilin: in the company.
4:14
Jason Heavilin: Now, there's more to it, of course. But here's one way to start visualizing how these numbers come out. So let's say we get to the same company here. and all equity companies here Jason Heavilin: on the left. and a company where has some equity and some deck here on the right. So these are just some key figures. So let's say the company has, all assets of $20,000,
4:41
Jason Heavilin: and those $20,000 and assets all came from equity. So this company did not borrow any money. All money came out the pockets of investors.
4:53
Jason Heavilin: So the day to equity R will be 0 because there is no debt. There are no interest rate payments. And in this case we're gonna say, 400 shares of standing. That number could be higher, lower. It doesn't really matter, because what matters is the total. The point is that when you take the $20,000
5:13
Jason Heavilin: and you divided by the 400 shares. Now, the equity is what we're doing here. Jason Heavilin: The share price will be $50. Now, this is an oversimplified example. Of course, it's more elements that come and play when you look at the market price. But
5:27
Jason Heavilin: let's just go with that, for now. So equity, divided by shares, share price.
5:34
Jason Heavilin: Now, what they can do is again go ahead and borrow, let's say, about $8,000, Jason Heavilin: and buy back some of those shares with a thousand dollars
5:47
Jason Heavilin: right
5:49
and then.
5:54
Jason Heavilin: Now then, that will reduce the amount of equity that was needed. or that is still in the company.
6:01
So you still get the same $20,000. But it's that being 0 and 20,000, you have 8,000. 12,000. Jason Heavilin: Now you're there to could racist two-thirds.
6:14
Jason Heavilin: and the interest rate in this case is 8%, because now they have debt and they got to pay that. But what happens is we purchase back those shares at $50 a piece.
6:27
Jason Heavilin: You're down now to 400 shares of standing, so we take the Equity
6:34
Jason Heavilin: and, divided by the shares of standing, you still get the same $50 per share price. Now we will see a little bit how, even though the share price was the same.
6:46
Jason Heavilin: This 12,000 drop from 20,000. It's gonna make a huge difference on the return to those shareholders.
6:59
Jason Heavilin: Now here we have an example of how things will play out when there's no debt. Jason Heavilin: let's say the economy could be in a recession. It could be go as expected, as normal, or there was a boom. There was an expansion on the economy with things went better than expected. So we're gonna start Jason Heavilin: at the edit portion of the income statement or these before interest in taxes.
7:21
because there's no debt in this example, there is no interest to be paid, so your net income is the same as your edit.
7:30
Jason Heavilin: so earnings per share. What you do is, remember, we have 400 shares outstanding. as in this no debt scenario. 400.
7:41
Jason Heavilin: So when you divide the 1,000 by 400, you get $2 and 50 cents per share.
7:46
Jason Heavilin: Return on assets is 50. How do we do that? We take that net income. and we divided by the total assets, which is 20,000, and that's our return on assets. or return on equity. Jason Heavilin: because there's no Dick. Jason Heavilin: and everything is inequity turns out to be the same as current assets, because when you divided by the equity, it's the same 20,000 in the assets, because there's no debt.
8:14
Jason Heavilin: So you get a 5% or so our way is going to equal roe when there's no debt. and these how the numbers play on a recession. If the economy goes as normal, they expect a negative, $2,000, no interest. So then it goes 2,000. You do the same numbers. Jason Heavilin: $2,000, divided by the 400 shares, you get a $5 of earnings per share.
8:34
We turn on as us 10%, the 2,000 divided by the 20,000, and answers that we saw. Jason Heavilin: and as we know now, because there's no debt, you return equity place to say if things go better Jason Heavilin: earnings for sure, 7, 50, 15%, and 15 to 3,000, divided by the $20,000 and assets. and the $3,000 divided by the $20,000 in equity. Now let's see how these numbers Jason Heavilin: change. If you do borrow some money.
9:05
Jason Heavilin: So the edit is gonna be the same right? 1,000 2,000 3,000 depending on the outcome of the economy. Jason Heavilin: But now we have an interest that we have to pay. and that was the 8 here multiplied by the $8,000 that were borrowed. So that's how you get the Jason Heavilin: $640 an interest here. So when you take the of it minus interest. By the way, this assumption of no taxes here you get the net income of $360.
9:41
Jason Heavilin: But now remember that because you borrowed money and you purchased back some shares, you're down to 240 shares.
9:50
Jason Heavilin: so the earnings per share is your 360 divided by the 2 4, you get a dollar, 50 earnings per share. Your return on assets Jason Heavilin: is 1.8%, because you take the 360 divided by the $20,000,
10:07
Jason Heavilin: and either 1.8. However, in this case, because there's debt. Jason Heavilin: and your equity is now down to 12,000. The net income is going to get divided by the equity. So you return. Equity is going to be higher than return assets. Jason Heavilin: and it shows here 3%, because now we divided by the $12,000 in equity, not the 20,000 we had in the previous scenario.
10:31
Jason Heavilin: and then so on. You do the same calculations here
10:39
Jason Heavilin: and the same here.
10:44
Jason Heavilin: Now, what I want to point out now is not just only the ro A and roe are going to be different because of the debt element. But Jason Heavilin: we compared to the note, this scenario. let's look at the recession. our way and our we 1.8 3, and recession, you ended up with less return assets in a in a lower return, on equity.
11:09
Jason Heavilin: however, on the expected or normal, or the expansion better than normal. You will notice that. Yes, your return assets. It became less than Jason Heavilin: the note that scenario. because you, divided by all assets, anyways. But your return on equity no actually became
11:33
Jason Heavilin: a higher number
11:36
Jason Heavilin: than the 10%. Same thing happened here
11:43
Jason Heavilin: 19.7 versus 15%.
11:47
Jason Heavilin: So the moral of the story is.
11:51
Jason Heavilin: when you borrow money. you are doing financial leverage. You're you're practicing financial leverage when things go. I guess. I say not as well as you expected. Jason Heavilin: then you would expect the lower return on equity. that if you didn't have any debt. but when things go normal or better. Jason Heavilin: you get a better return. So there is an example how shareholders benefit
12:20
Jason Heavilin: from there being some debt. a value of debt in the company.
12:26
Jason Heavilin: The idea is that Jason Heavilin: in one scenario $20,000 came out of the pockets of the investors and the other scenario that only $12,000. So while your net income Jason Heavilin: was lower
12:43
Jason Heavilin: than the no scenario. Jason Heavilin: When you do a dollar per dollar that came in versus the dollar, that where it was invested you end up with a higher Jason Heavilin: return per dollar invested, and that's what the ari is looking at.
13:01
Jason Heavilin: And if you look at the earnings per share. Jason Heavilin: same situation happens when things don't go too well, and you have financial leverage. The earnings per share came lower. Jason Heavilin: but once things are normalized or better than expected, your earnings per share, then jump up.
13:19
Jason Heavilin: and that's what those numbers mean are doing. A lot of people get worked on. But if you're making less money, what would you do that way. You've our money. Jason Heavilin: you might be making a list total amount.
13:34
Jason Heavilin: But when you look at the amount you made per dollar invested, you came out with a higher number in a more broad concept, more a broader way to view it is Jason Heavilin: when you do it this way, with a debt of a thousand, and you only put $12,000. That's $8,000 more that you can invest somewhere else and make a return elsewhere as well. Jason Heavilin: So you can still invest your entire 20,000. But make more money that way. If you want to duplicate the situation.
14:03
Jason Heavilin: you end up making more money by having multiple investments that have debt versus just having all your money in one place and not to. That's not even considering that you diversify your portfolio. Jason Heavilin: But anyways, there's a quick example of the simple way to look at return equity Jason Heavilin: where financial leverage, borrowing money Jason Heavilin: can increase the value to shareholders as explained earlier.
14:29
Jason Heavilin: So we know long eminem. Jason Heavilin: It's Jason Heavilin: nickname for a couple of researchers that developed a so mathematical proof Jason Heavilin: about the value of the company in scenarios with and without taxes. and if you add that or not, and how the value changes, and that the main driver.
14:50
Jason Heavilin: one of the main drivers of the with the added value can come from the tax benefit to all investors, not just shareholders. That's important to understand the difference here. Okay, so there's some assumptions. Now in in economics and finance. Jason Heavilin: we, typically. we will be something new or unique or trying to show us the value of something. We will start with the most oversimplify simplified scenario to get to the
15:23
Jason Heavilin: fundamental of it. What happens then? Later? You can add the nuances of dividends or income taxes versus capital gains taxes, and then so on, so forth.
15:34
Jason Heavilin: But when you see this list of assumptions yes, it's some realistic that we all does not operate that way, but it eliminates what we call noise. So we can actually look at the essence of the of the item, because once you have that one proven. Then you can just adjust your formulas and calculations according to real world scenario scenarios where variables change all the time.
15:54
Jason Heavilin: So here we gonna saw start with homogeneous expectations. just what it means. Same expectations across the board. Jason Heavilin: homogeneous business risk classes. just what it means. Same business risk across the board on the study. Perpetual cash flows. That's a way to say that we expect the company to live forever. we don't. We don't expect
16:19
Jason Heavilin: a a bankruptcy case, and in this case also steady cash flows, of course, like I said. as you move forward, and more and deeper analysis. Then you would adjust those items Jason Heavilin: perfect capital markets, meaning, as in, you know, frictions. No arbitrage, no. All those good things I hear about. So everything is pretty much perfect in the sense that there's no leakage, no information barriers, etc., etc., perfect competition.
16:49
Jason Heavilin: Just what it sounds like, and just like you learned in the economics class. perfect competition. In other words, nobody really has a market advantage over others.
17:02
Jason Heavilin: Firms and investors can borrow Lin at the same rate. Yes, in the real world. firms do have different business risks. so they'll be all for different rates, or they might be in different states, different geographical locations, different industries, all kinds of different things. But for this example, we just Jason Heavilin: like, I said. keeping it as simple as possible. So everybody's exposed to same interest rates.
17:28
Jason Heavilin: equal access to all relevant information that is, I guess, related to the perfect capital markets that we spoke about. These are the items under preferred capital markets. so we we're talking about strong form Jason Heavilin: market efficiency like I said, it can be adjusted afterwards before now, we don't want all that noise. no transactional calls and no taxes. So that's the base form. Let's start with that
17:56
Jason Heavilin: when none of those things happen. Jason Heavilin: we argue that the value of the leverage firm, in other words, vo. Meaning the value of a firm with debt will equal, will be the same as a value of the unlevered firm, the company with no debt. Jason Heavilin: some of the value.
18:17
Jason Heavilin: This is a different from what we talked about of return equity that was just showing how shareholders can benefit from the over value going up, even if some of that value goes to the debt holders. Okay? So in that situation that we spoke about Jason Heavilin: with no taxes and all those perfect scenarios Jason Heavilin: there will be no difference whether you borrow money or not. The total out of the firm will be the same.
18:43
Jason Heavilin: and that kind of reflects here. If you look at the assets, it's a which look at it with debt or no debt. The assets was still $20,000. If you want to kind of somewhat Jason Heavilin: look at it from that angle
18:57
Jason Heavilin: also, remember, and I'm going to review here. We there was no taxes involved in this example.
19:04
Jason Heavilin: So, moving forward.
19:07
Jason Heavilin: we also going to talk about we call the Jason Heavilin: well. Let's recap the eminent proposition. One, we know, taxes. The value of the livid firm equals the value of the univered firm Jason Heavilin: as a financial leverage. The second proposition Jason Heavilin: is that leverage increases the risk and return to stockholders. So.
19:32
Jason Heavilin: as you know, from all the previous financial talk. risk and return always tied together. Jason Heavilin: higher risk should equal higher return. Now do not confuse value with return here, we saying the values are same. Here, we're saying is that the return goes up so that would be like saying.
19:53
Jason Heavilin: the values stay the same on both scenarios without debt. But the Aroe was not the same as debt went up Jason Heavilin: the or we can go up. Of course, recession being the the the risk side that if things go bad. things go worse as well. So that's a representation of high risk, higher return. Higher risk can also mean Jason Heavilin: lower returns with the losses. And that's what they're expressing here with this formula. just so, you know, this is just
20:29
Jason Heavilin: the same way to average cost of capital formula just turned around on your briakery to put the the letters in this order. So we can talk about Rs, which is a return on the lever Jason Heavilin: equity.
20:44
Jason Heavilin: So the idea is that as debt goes up, those are the bees that'd be here.
20:51
Jason Heavilin: Everything else. They sequel. That number is gonna go up. that's all the same.
21:03
Jason Heavilin: So both together here. So you can see him. So the same propositions that we spoke about value here with no taxes the same. The return in a no-tech situation goes up as that goes up Jason Heavilin: which it was in practice here with these numbers. Now, here's the same 2. But now we have taxes involved. Jason Heavilin: So we're saying that the value of the firm with debt
21:32
Jason Heavilin: increases as you add that to it.
21:37
Jason Heavilin: or let's say, add leverage, so shift from equity to debt. And the reason it is now we have that tax element there.
21:50
Jason Heavilin: The idea is that
21:56
Jason Heavilin: there's a portion of cash Jason Heavilin: that is always going to go out of the company. The question is, are you gonna pay that to the government. Jason Heavilin: or are you gonna pay that cash to your investors?
22:14
Jason Heavilin: And we call that cash flow to investors?
22:18
Jason Heavilin: Now, I'm not saying that all taxes could go to investors. and some Jason Heavilin: very unique and special circumstances that could happen, but at least for sure. Jason Heavilin: there's a portion of cash
22:31
Jason Heavilin: that is always gonna go out to the company, and you choose depending on your leverage. You're pretty much choosing when you decide on a capital structure. How much of that cash that could go to investors. Are you going to sign up? Just give it to the government or no? Let me give it to investors. Now, this cash the investors we're talking about is not stockholders. It's the actual debt holders, the ones that buy the bonds. But they also investors.
22:55
Jason Heavilin: So if you can move more of that cash flow to investors. In this case the bondholders, instead of to the government. Well, the value of firm is higher, because the firm is generating more cash to investors, and, as we know, is that then, if the the debt is a. Jason Heavilin: it's a healthy level of debt. The shareholders also benefit, because there are really goes up.
23:21
Jason Heavilin: And that's what this is capturing there.
23:25
Jason Heavilin: Okay. same formula as you saw here. We discussed the the return on equity.
23:34
Jason Heavilin: But now we have that one minus T in there. very similar to the way that it's cost of capital, the for me just turned around.
23:42
Jason Heavilin: and that is the general idea of we're trying to say here, when there's taxes you've got a different goes up with debt Jason Heavilin: up to a point. Too much debt can be bad for the company, because the risk goes too high.
23:56
Jason Heavilin: And what this proposition is saying is that because you're moving cash Jason Heavilin: that would otherwise go to the government, but you gonna to investors, your firm is more valuable to investors. Now.
24:11
Jason Heavilin: this is a, this graphical representation of what happens
24:16
Jason Heavilin: in this case. A firm without debt. So much cash is going to go to stockholders. and a chunk is going to go to government in taxes. But if you borrow money. Jason Heavilin: Now there's cash going to stockholders a little less. We'll talk about that again in a second. Jason Heavilin: But there was a big chunk of cash going to these debt holders. Those are also investors and less catch to the government. So the idea is that
24:42
Jason Heavilin: from this amount of cash going to investors versus this amount of cash going to investors. This one Jason Heavilin: has a higher value to investors, because, as you can see, the green and the blue add up to more than the blue here.
24:58
Jason Heavilin: so the firm becomes more valuable, and as we saw from these numbers. Jason Heavilin: while the total cash investors might be last year, the cash per dollar investors higher.
25:12
Jason Heavilin: So they benefit as well.
25:15
Jason Heavilin: They got more money per dollar invested.
25:19
Jason Heavilin: And that is the logic of these propositions of capital structure. remember. I'm gonna go back here. Jason Heavilin: Those are the basic concepts. There's a lot more to capital structure. And it's a very complex scenario, a lot of research on this about optimal capital structure, and a lot of different competing theories. But we will stop the video here. Jason Heavilin: See you on the next one.
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