{"version":"1.0.0","segments":[{"startTime":5.505,"endTime":10.383,"body":"So today, as you know, I'm, this year's series of lectures is about the big"},{"startTime":10.383,"endTime":11.685,"body":"ideas of finance, right?"},{"startTime":12.185,"endTime":15.845,"body":"The nice part about finance is probably the simplest of all business school topics."},{"startTime":16.105,"endTime":19.885,"body":"And the reason is we only have six ideas, right?"},{"startTime":20.225,"endTime":24.293,"body":"So if you understand these six ideas, you understand everything there is to understand in"},{"startTime":24.293,"endTime":24.565,"body":"finance."},{"startTime":25.425,"endTime":30.005,"body":"And as Darran pointed out, five of these ideas have won Nobel prizes."},{"startTime":30.385,"endTime":34.602,"body":"So the only idea which didn't win a Nobel Prize is the first concept, net"},{"startTime":34.602,"endTime":35.165,"body":"present value."},{"startTime":35.345,"endTime":40.045,"body":"But that is such a basic concept that nobody had the audacity to claim they"},{"startTime":40.045,"endTime":41.925,"body":"came up with the idea, right?"},{"startTime":42.465,"endTime":45.485,"body":"So today we're gonna talk about the third idea in finance."},{"startTime":46.905,"endTime":51.172,"body":"The Gresham College lecture that you're listening to right now is giving you knowledge and"},{"startTime":51.172,"endTime":51.457,"body":"insight from one of the world's leading academic experts making it takes a lot of"},{"startTime":51.457,"endTime":55.725,"body":"time."},{"startTime":56.385,"endTime":59.628,"body":"But because we want to encourage a love of learning, we think it's well worth"},{"startTime":59.628,"endTime":59.845,"body":"it."},{"startTime":60.785,"endTime":63.965,"body":"We never make you pay for lectures, although donations are needed."},{"startTime":64.425,"endTime":65.805,"body":"All we ask in return is this."},{"startTime":66.315,"endTime":68.645,"body":"Send a link to this lecture to someone you think would benefit."},{"startTime":68.985,"endTime":72.635,"body":"And if you haven't already, click the follow or subscribe button from wherever you are"},{"startTime":72.635,"endTime":73.365,"body":"listening right now."},{"startTime":74.545,"endTime":76.365,"body":"Now, let's get back to the lecture."},{"startTime":78.855,"endTime":83.445,"body":"If you want to follow this stuff in more detail after my lecture, I do"},{"startTime":83.445,"endTime":88.035,"body":"note that there is two books I've written in Chinese as well as in English."},{"startTime":88.215,"endTime":89.675,"body":"So you're welcome to take a look at them."},{"startTime":89.825,"endTime":94.035,"body":"This is exactly the same thing as a lecture, but in considerably more detail."},{"startTime":95.225,"endTime":95.515,"body":"Okay?"},{"startTime":96.055,"endTime":98.035,"body":"So what are these six basic ideas?"},{"startTime":99.415,"endTime":103.99,"body":"The first idea, which we covered in the first lecture was that of what we"},{"startTime":103.99,"endTime":105.515,"body":"call net present value, right?"},{"startTime":105.735,"endTime":106.795,"body":"The idea is very simple."},{"startTime":107.055,"endTime":111.243,"body":"All it says is, if I want to pay for something, if I want to"},{"startTime":111.243,"endTime":114.595,"body":"invest in something, I have to get back more than I invest."},{"startTime":114.775,"endTime":115.835,"body":"That's it, right?"},{"startTime":115.945,"endTime":117.195,"body":"Very simple idea."},{"startTime":117.655,"endTime":121.272,"body":"If you, if I get back less than what I invest, it's not worth investing"},{"startTime":121.272,"endTime":121.755,"body":"in it."},{"startTime":123.415,"endTime":128.164,"body":"The second idea, which we covered in November, was called portfolio theory and the capital"},{"startTime":128.164,"endTime":129.115,"body":"asset pricing Model."},{"startTime":129.785,"endTime":134.106,"body":"That idea comes from the fact that when you calculate the net present value of"},{"startTime":134.106,"endTime":135.835,"body":"anything, you need a discount rate."},{"startTime":135.855,"endTime":136.995,"body":"You need an interest rate."},{"startTime":137.485,"endTime":139.155,"body":"Where does that interest rate come from?"},{"startTime":139.545,"endTime":143.872,"body":"Well, Markowitz and Sharp got a Nobel Prize for coming up with the concept of"},{"startTime":143.872,"endTime":145.315,"body":"the capital asset pricing model."},{"startTime":146.165,"endTime":151.415,"body":"Today you're gonna talk about the third big idea of finance that we call capital"},{"startTime":151.415,"endTime":152.115,"body":"Structure theory."},{"startTime":152.815,"endTime":158.44,"body":"And again, two people, Ani and Miller got Nobel Prizes in separate years for exactly"},{"startTime":158.44,"endTime":160.315,"body":"the same type of idea."},{"startTime":161.375,"endTime":165.235,"body":"Ani got it for a slightly different topic lifecycle theory, but it's very similar."},{"startTime":165.575,"endTime":168.315,"body":"So I'm combining them for this idea."},{"startTime":168.595,"endTime":173.595,"body":"\u003caffirmative\u003e."},{"startTime":170.215,"endTime":176.271,"body":"The fourth big idea is option pricing, which we'll cover next month, and shows on"},{"startTime":176.271,"endTime":176.675,"body":"Merton."},{"startTime":176.675,"endTime":177.995,"body":"Got a Nobel Prize for that one."},{"startTime":178.715,"endTime":182.605,"body":"Asymetic information, Olo, Spence and Stakes got a Nobel Prize for that one."},{"startTime":182.825,"endTime":187.325,"body":"And the final idea, market efficiency, where enormous number of people have Nobel Prizes, except"},{"startTime":187.325,"endTime":189.725,"body":"that nobody really knows what that means, right?"},{"startTime":189.785,"endTime":192.285,"body":"So the last idea is possibly the most controversial."},{"startTime":192.585,"endTime":195.725,"body":"So I'm gonna save that for the final lecture of this series."},{"startTime":196.825,"endTime":202.645,"body":"So at its core, what is finance all about, right?"},{"startTime":202.995,"endTime":208.405,"body":"Essentially, finance is about one thing, and that is basically promises."},{"startTime":209.025,"endTime":214.585,"body":"People are basically, you're saying to you, look, I'm going to give you some fantastically"},{"startTime":214.585,"endTime":219.405,"body":"large amount in the future if you give me money today, that's it."},{"startTime":219.405,"endTime":222.245,"body":"That's everything in finance is about that, right?"},{"startTime":222.625,"endTime":227.218,"body":"Invest in my company, I'll give you returns, invest in my investment project, whatever it"},{"startTime":227.218,"endTime":227.525,"body":"is."},{"startTime":227.755,"endTime":230.085,"body":"I'll give you some extraordinary sum of money back."},{"startTime":231.465,"endTime":235.205,"body":"And of course, the question is going to be, what are these promises worth?"},{"startTime":236.145,"endTime":241.22,"body":"So to understand that the first big idea of finance, net present value says, as"},{"startTime":241.22,"endTime":241.558,"body":"I said, the present value of all these promises today, you have to compare it"},{"startTime":241.558,"endTime":248.325,"body":"to the amount you're investing, right?"},{"startTime":248.325,"endTime":252.807,"body":"Because the key is some of these cash flows will be five, 10 years in"},{"startTime":252.807,"endTime":253.405,"body":"the future."},{"startTime":253.775,"endTime":256.725,"body":"Gimme money today and I'll give you money in the future."},{"startTime":257.225,"endTime":260.165,"body":"But how do you compare money in the future to money today?"},{"startTime":260.745,"endTime":263.005,"body":"You can't compare them because they're apples and oranges."},{"startTime":263.505,"endTime":268.321,"body":"So net present value allows you to bring all those cash flows together to one"},{"startTime":268.321,"endTime":269.285,"body":"point in time."},{"startTime":269.915,"endTime":270.645,"body":"Today's value."},{"startTime":270.705,"endTime":273.645,"body":"That's why we call it net present value, right?"},{"startTime":274.255,"endTime":277.965,"body":"Basic story in finance, it's used everywhere in finance."},{"startTime":278.505,"endTime":282.919,"body":"And the basic formula is the present value of something is the present value of"},{"startTime":282.919,"endTime":284.685,"body":"its cash flows in the future."},{"startTime":284.825,"endTime":288.858,"body":"So you've got somebody promising you a hundred dollars one year from now, you do"},{"startTime":288.858,"endTime":289.127,"body":"a hundred dollars divided by one plus a discount rate to the power one one"},{"startTime":289.127,"endTime":289.396,"body":"year from now, another thousand dollars two years from now, a thousand divided by one"},{"startTime":289.396,"endTime":299.885,"body":"plus r squared two years from now, and so on, right?"},{"startTime":300.635,"endTime":300.925,"body":"Okay."},{"startTime":301.865,"endTime":305.485,"body":"Now the problem here, of course, is you needed to have an interest rate, right?"},{"startTime":305.785,"endTime":307.525,"body":"So where did that interest rate come from?"},{"startTime":307.865,"endTime":309.445,"body":"That's the second big idea of finance."},{"startTime":309.875,"endTime":311.285,"body":"What is the right discount rate?"},{"startTime":312.705,"endTime":317.885,"body":"So here the problem is you're turning now to the investor side of the picture."},{"startTime":318.345,"endTime":321.725,"body":"The first idea was the firm choosing to invest in something."},{"startTime":322.265,"endTime":323.725,"body":"We are making an investment decision."},{"startTime":324.385,"endTime":329.52,"body":"The second idea is the people who are faced with providing the financing for that"},{"startTime":329.52,"endTime":330.205,"body":"investment decision."},{"startTime":330.985,"endTime":334.845,"body":"For example, somebody comes to you and says, please invest in my company."},{"startTime":334.985,"endTime":336.845,"body":"I'm gonna give you fantastic returns."},{"startTime":337.385,"endTime":340.801,"body":"Of course you can compute the cash flows, but the question is, what discount rate"},{"startTime":340.801,"endTime":341.485,"body":"do you use?"},{"startTime":342.105,"endTime":346.725,"body":"So here the answer is you want to ask yourself, if I don't invest in"},{"startTime":346.725,"endTime":349.805,"body":"this company, what am I gonna do with my money?"},{"startTime":350.105,"endTime":353.273,"body":"I'm not just gonna keep it under my bed, I have to invest it in"},{"startTime":353.273,"endTime":353.485,"body":"something."},{"startTime":354.065,"endTime":359.27,"body":"And so the, what I'm looking for is what's the opportunity cost of investing in"},{"startTime":359.27,"endTime":359.965,"body":"this company?"},{"startTime":360.145,"endTime":364.285,"body":"If I don't invest in this company, what opportunity am I giving up?"},{"startTime":364.535,"endTime":364.885,"body":"Right?"},{"startTime":365.025,"endTime":369.725,"body":"So the discount rate is interest rate on the next best available opportunity."},{"startTime":370.675,"endTime":372.765,"body":"That opportunity should have the same level of risk."},{"startTime":373.105,"endTime":378.236,"body":"And the entire lecture on portfolio theory said, risk is measured by looking at what"},{"startTime":378.236,"endTime":379.605,"body":"you are already holding."},{"startTime":380.385,"endTime":387.205,"body":"And basically, Marco and Sharp said, every rational investor should hold only two assets."},{"startTime":387.805,"endTime":392.285,"body":"A risk-free asset, a government bond, and a market portfolio, right?"},{"startTime":392.285,"endTime":394.245,"body":"Consisting of every asset in the world."},{"startTime":394.705,"endTime":399.709,"body":"So the risk is measured by how much additional risk do you take on by"},{"startTime":399.709,"endTime":402.045,"body":"adding your stock to this market portfolio?"},{"startTime":402.705,"endTime":407.778,"body":"And of course, the formula there is the standardized Covance is called the beta, and"},{"startTime":407.778,"endTime":408.116,"body":"the CAPM just says the discount rate is equal risk free rate plus the beta"},{"startTime":408.116,"endTime":414.205,"body":"times RM minus rf."},{"startTime":414.505,"endTime":417.445,"body":"That's a formula we concluded with last time."},{"startTime":417.795,"endTime":418.085,"body":"Okay?"},{"startTime":418.345,"endTime":421.365,"body":"So this is, all these ideas are connected."},{"startTime":421.585,"endTime":424.565,"body":"If one of these ideas fails, every idea fails."},{"startTime":424.985,"endTime":430.816,"body":"So finance is kind of, these six topics all have to hold, otherwise finance falls"},{"startTime":430.816,"endTime":431.205,"body":"apart."},{"startTime":431.625,"endTime":436.165,"body":"So you need to know this before we actually go to the next point here."},{"startTime":437.305,"endTime":442.645,"body":"So the third question we are gonna ask is, well, going back now to the"},{"startTime":442.645,"endTime":443.001,"body":"firm, so I'm now a firm manager, and as a manager, I'm asking, okay, where"},{"startTime":443.001,"endTime":449.765,"body":"should I get the money?"},{"startTime":450.055,"endTime":450.405,"body":"Right?"},{"startTime":450.525,"endTime":455.373,"body":"I need to invest in this opportunity, but I have all these investors to approach"},{"startTime":455.373,"endTime":458.605,"body":"which investor do I ask for to give me money?"},{"startTime":459.225,"endTime":462.805,"body":"And the reason is, it's not about which investor in particular."},{"startTime":462.995,"endTime":465.045,"body":"It's which contract I offer them."},{"startTime":465.825,"endTime":472.285,"body":"For example, I can have one choice, I can borrow, I can issue debt, okay?"},{"startTime":472.585,"endTime":477.956,"body":"So if I borrow money, basically I'm promising somebody a steady stream of interest, cash"},{"startTime":477.956,"endTime":478.315,"body":"flows and maybe the money back at the end, and in return I get their"},{"startTime":478.315,"endTime":484.045,"body":"money upfront."},{"startTime":484.595,"endTime":484.885,"body":"Okay?"},{"startTime":485.435,"endTime":486.765,"body":"What are the cons of this?"},{"startTime":487.155,"endTime":490.925,"body":"Well, the big coin is I have to pay interest every year, right?"},{"startTime":491.205,"endTime":492.165,"body":"I can't get away from that."},{"startTime":492.235,"endTime":493.405,"body":"It's a legal obligation."},{"startTime":494.505,"endTime":495.645,"body":"But what's the pro here?"},{"startTime":495.945,"endTime":498.165,"body":"The pro is I don't give up control of my company."},{"startTime":498.445,"endTime":500.325,"body":"I still own my company completely."},{"startTime":501.755,"endTime":502.045,"body":"Okay?"},{"startTime":502.315,"endTime":504.565,"body":"What about the second choice?"},{"startTime":505.625,"endTime":508.525,"body":"The second choice is issue equity, right?"},{"startTime":508.745,"endTime":511.405,"body":"Rather than issuing, uh, interest."},{"startTime":511.405,"endTime":514.369,"body":"And you have to, uh, issuing debt and you have to pay the same interest"},{"startTime":514.369,"endTime":514.765,"body":"every year."},{"startTime":515.025,"endTime":517.804,"body":"You say, I'll give you a share in my profits."},{"startTime":518.465,"endTime":522.222,"body":"So if I make a lot of money, you make a lot of money, I"},{"startTime":522.222,"endTime":523.725,"body":"lose money, you lose money, right?"},{"startTime":523.845,"endTime":525.325,"body":"I can't guarantee you anything."},{"startTime":525.705,"endTime":526.725,"body":"So what's the coin here?"},{"startTime":527.155,"endTime":531.045,"body":"Well, the coin here is you lose, might lose control of the company, right?"},{"startTime":531.065,"endTime":533.725,"body":"So you issue too much equity, you don't control that."},{"startTime":533.725,"endTime":538.165,"body":"Equity people can say, we don't need you as a manager in the company anymore."},{"startTime":538.265,"endTime":540.765,"body":"You get fired even though it is your company."},{"startTime":541.075,"endTime":545.584,"body":"This is what happened, for example, to Steve Jobs in 1990s when, you know, apple"},{"startTime":545.584,"endTime":545.885,"body":"kicked came out, he later came back in and also happened to Sam Altman had"},{"startTime":545.885,"endTime":546.185,"body":"opened AI last year, even though that wasn't, you know, commercial company in that, in"},{"startTime":546.185,"endTime":555.205,"body":"that sense."},{"startTime":556.065,"endTime":558.965,"body":"Anyway, the pro of course is flexible."},{"startTime":559.465,"endTime":561.805,"body":"You don't have to pay dividends every year."},{"startTime":562.235,"endTime":565.485,"body":"Sometimes, you know, if you choose, you can pay dividends."},{"startTime":565.485,"endTime":567.565,"body":"If you don't choose, you need not pay dividends."},{"startTime":567.785,"endTime":570.125,"body":"So that's, these are the major choices."},{"startTime":570.385,"endTime":572.045,"body":"The two big choices you have."},{"startTime":572.505,"endTime":575.805,"body":"You have a whole, whole bunch of different types of subsidiary choices."},{"startTime":576.265,"endTime":578.605,"body":"You can issue particular types of debt."},{"startTime":579.065,"endTime":582.125,"body":"You can say, okay, this is a contingent form of debt."},{"startTime":582.425,"endTime":585.325,"body":"If I do really well, you can convert the debt to equity."},{"startTime":585.755,"endTime":588.765,"body":"That could be like a convertible bond, things like that, right?"},{"startTime":589.025,"endTime":592.045,"body":"But in essence, these are the two big choices."},{"startTime":592.645,"endTime":597.745,"body":"Companies have choice number one issue, debt, steady stream of cash flow, but you have"},{"startTime":597.745,"endTime":599.445,"body":"to pay those cash flows."},{"startTime":599.585,"endTime":600.845,"body":"You cannot get away from them."},{"startTime":602.025,"endTime":608.906,"body":"Choice two, issue equity, which can fluctuate depending on where they, how much money you're"},{"startTime":608.906,"endTime":609.365,"body":"making."},{"startTime":609.785,"endTime":613.005,"body":"But you know, you might lose control of a company, right?"},{"startTime":613.105,"endTime":616.685,"body":"So how do you choose what to finance a company with?"},{"startTime":616.945,"endTime":618.245,"body":"That's a question we are facing."},{"startTime":619.385,"endTime":625.685,"body":"Now, one way to look at this, let's just say, let's see what companies actually"},{"startTime":625.685,"endTime":626.525,"body":"do, right?"},{"startTime":626.785,"endTime":631.835,"body":"So what I have here is sort of like an aggregate balance sheet for manufacturing"},{"startTime":631.835,"endTime":632.845,"body":"companies in America."},{"startTime":634.105,"endTime":636.565,"body":"And on the left hand side, we see current assets."},{"startTime":636.785,"endTime":637.845,"body":"We see fixed assets."},{"startTime":638.145,"endTime":642.926,"body":"On the right hand side, we see liabilities, both short term and long term and"},{"startTime":642.926,"endTime":643.245,"body":"equity."},{"startTime":643.255,"endTime":645.485,"body":"Those are the major parts of a balance sheet."},{"startTime":645.715,"endTime":647.045,"body":"They equate each other."},{"startTime":647.785,"endTime":653.308,"body":"Now, if you look at this and say, Hmm, how much debt and how much"},{"startTime":653.308,"endTime":653.676,"body":"equity do firms issue on average, one might say, okay, well you can see that"},{"startTime":653.676,"endTime":654.045,"body":"the total amount of debt, both short and long term, is given by this number"},{"startTime":654.045,"endTime":666.565,"body":"here and this number here, right?"},{"startTime":666.565,"endTime":668.485,"body":"That's a total amount of debt you've issued."},{"startTime":668.875,"endTime":670.565,"body":"This is the total value of the company."},{"startTime":670.945,"endTime":675.303,"body":"So one way of looking at this is to say, debt over total assets is"},{"startTime":675.303,"endTime":675.885,"body":"about 60%."},{"startTime":677.235,"endTime":681.467,"body":"Another way of looking at it is to say, well, you know, the current liabilities,"},{"startTime":681.467,"endTime":683.725,"body":"they're sort of offset by the current assets."},{"startTime":684.385,"endTime":686.165,"body":"So what are current liabilities?"},{"startTime":686.395,"endTime":687.685,"body":"They're short term stuff."},{"startTime":687.905,"endTime":694.28,"body":"So for example, if you're running a restaurant, accounts receivable, accounts payable, accounts receivable, current"},{"startTime":694.28,"endTime":696.405,"body":"assets, accounts payable, current liabilities."},{"startTime":696.785,"endTime":700.835,"body":"So you can say, okay, people owe me money, and when they owe me money,"},{"startTime":700.835,"endTime":703.805,"body":"when they pay me, I can pay the people I owe."},{"startTime":703.825,"endTime":708.156,"body":"So they sort of cancel each other, account receivable, cancel the account payable and so"},{"startTime":708.156,"endTime":708.445,"body":"on."},{"startTime":708.705,"endTime":712.085,"body":"So another way of looking at it is the only thing that matters, you take"},{"startTime":712.085,"endTime":714.565,"body":"this out, you take this out, these two cancel each other."},{"startTime":714.865,"endTime":719.193,"body":"The only thing that matters is looking at the long-term liabilities of the company and"},{"startTime":719.193,"endTime":720.925,"body":"taking the sum of those two."},{"startTime":721.465,"endTime":727.405,"body":"So what you have here is long-term liabilities divided by long-term liabilities plus equity."},{"startTime":727.405,"endTime":731.245,"body":"Another way of looking at the debt equity ratio, okay?"},{"startTime":731.865,"endTime":739.881,"body":"So on average you can say in American companies, 60% total debt, maybe 45 to"},{"startTime":739.881,"endTime":741.485,"body":"50% long-term debt."},{"startTime":742.715,"endTime":743.005,"body":"Okay?"},{"startTime":743.145,"endTime":744.965,"body":"But that's not the whole story, right?"},{"startTime":745.305,"endTime":750.351,"body":"So if you actually go and in detail and look at what the pattern is"},{"startTime":750.351,"endTime":754.725,"body":"by industry, what we find is the numbers are all over the place."},{"startTime":755.305,"endTime":760.805,"body":"So for example, you can have internet information providers, almost no debt at all."},{"startTime":761.585,"endTime":768.907,"body":"We have, um, semiconductors, almost no debt, all the way down to hotels, significant amounts"},{"startTime":768.907,"endTime":772.325,"body":"of debt and airlines, 96% of debt."},{"startTime":772.945,"endTime":778.165,"body":"So different industries seem to finance themselves in different ways, okay?"},{"startTime":778.785,"endTime":779.805,"body":"So that's one problem."},{"startTime":780.465,"endTime":786.245,"body":"You have to explain the cross-sectional structure of debt within the firm, okay?"},{"startTime":787.665,"endTime":790.805,"body":"But the numbers also change over time."},{"startTime":791.305,"endTime":795.885,"body":"So that same number, the aggregate number I showed you, changes every year."},{"startTime":796.635,"endTime":801.444,"body":"What we have here is on the top part, we have the investments within the"},{"startTime":801.444,"endTime":801.765,"body":"firm."},{"startTime":803.825,"endTime":807.495,"body":"These investments need to be financed in some way or the other."},{"startTime":807.925,"endTime":811.975,"body":"Most of it comes from internal expenditure, right?"},{"startTime":812.075,"endTime":818.095,"body":"So basically you're looking at capital expenditure is much more significant than anything else."},{"startTime":818.195,"endTime":823.718,"body":"So big things the company does obviously uses up a lot more money than the"},{"startTime":823.718,"endTime":824.455,"body":"working capital."},{"startTime":824.765,"endTime":828.855,"body":"There's short term small stuff, but where is that financed?"},{"startTime":829.245,"endTime":835.053,"body":"Well, if you look at where it is financed, most of it comes from internally"},{"startTime":835.053,"endTime":836.215,"body":"generated cash, right?"},{"startTime":836.215,"endTime":840.215,"body":"So the company generate profits and they use the profit to plow it back into"},{"startTime":840.215,"endTime":842.615,"body":"the company, and they finance the investments that way."},{"startTime":843.245,"endTime":843.535,"body":"Okay?"},{"startTime":843.795,"endTime":845.335,"body":"But what about the remaining amount?"},{"startTime":846.485,"endTime":848.495,"body":"Well, do they issue debt?"},{"startTime":848.635,"endTime":849.535,"body":"Do they issue equity?"},{"startTime":850.075,"endTime":851.975,"body":"The answer is it depends on the year."},{"startTime":852.355,"endTime":856.375,"body":"So for example, if you look at this in 1992, what do we see?"},{"startTime":858.395,"endTime":862.855,"body":"We see that the companies issued a lot of debt and they bought back shares."},{"startTime":863.845,"endTime":864.135,"body":"Okay?"},{"startTime":864.445,"endTime":865.335,"body":"Okay, fine."},{"startTime":865.485,"endTime":866.815,"body":"What about 1993?"},{"startTime":867.365,"endTime":870.415,"body":"Well, they bought back debt and they issued shares."},{"startTime":870.965,"endTime":872.775,"body":"What about 1992?"},{"startTime":873.085,"endTime":875.415,"body":"Well, they issued both debt and equity."},{"startTime":875.525,"endTime":876.335,"body":"There's no pattern."},{"startTime":876.675,"endTime":878.455,"body":"And every year the numbers change."},{"startTime":879.155,"endTime":882.215,"body":"So what we have is cross-sectionally."},{"startTime":882.355,"endTime":885.895,"body":"The patterns are different in different industries in a time series."},{"startTime":886.035,"endTime":889.135,"body":"The numbers are different over time and gets worse."},{"startTime":890.155,"endTime":892.405,"body":"It changes according across countries as well."},{"startTime":892.475,"endTime":894.925,"body":"Different countries use different levels of debt."},{"startTime":895.375,"endTime":899.796,"body":"These were the problems that Mulani and Miller were faced with when they were trying"},{"startTime":899.796,"endTime":901.565,"body":"to come up with one idea."},{"startTime":902.155,"endTime":906.085,"body":"What explains the structure of capital within the company?"},{"startTime":906.315,"endTime":907.565,"body":"This is the problem they had."},{"startTime":909.425,"endTime":915.341,"body":"Now, if you went before moving, Glenn Miller came along, you went to a consultant"},{"startTime":915.341,"endTime":916.525,"body":"for advice, right?"},{"startTime":916.665,"endTime":918.805,"body":"You are a CEO of a company."},{"startTime":919.345,"endTime":923.497,"body":"So you go to your consultant and you say, look, I need to raise money"},{"startTime":923.497,"endTime":924.605,"body":"for my internal investment."},{"startTime":924.955,"endTime":925.725,"body":"What should I do?"},{"startTime":926.465,"endTime":927.605,"body":"Should I issue debt?"},{"startTime":927.665,"endTime":928.805,"body":"Should I issue equity?"},{"startTime":929.905,"endTime":932.165,"body":"One group of guys would say, borrow."},{"startTime":932.865,"endTime":933.925,"body":"And you say, why?"},{"startTime":934.355,"endTime":936.365,"body":"They say, well, I've done this study."},{"startTime":936.775,"endTime":941.565,"body":"There are 3000 companies in my sample and I've checked every time they issue debt."},{"startTime":941.635,"endTime":942.165,"body":"What happened?"},{"startTime":942.345,"endTime":944.685,"body":"The share price went up, the value increase."},{"startTime":945.145,"endTime":947.765,"body":"So this is a good thing to do."},{"startTime":948.155,"endTime":950.525,"body":"Issuing debt, the market seems to like it."},{"startTime":951.805,"endTime":954.175,"body":"Fine, you say, but you want a second opinion."},{"startTime":954.475,"endTime":955.815,"body":"So you go to a different consultant."},{"startTime":956.595,"endTime":959.415,"body":"The second consultant says, no, no, no, that's not a good idea."},{"startTime":959.585,"endTime":960.295,"body":"Issue equity."},{"startTime":960.555,"endTime":960.775,"body":"Why?"},{"startTime":960.775,"endTime":964.848,"body":"Because I've looked at a different batch of 3000 companies and whenever they issue debt,"},{"startTime":964.848,"endTime":965.935,"body":"the value went down."},{"startTime":967.435,"endTime":971.615,"body":"So you have different consultants all coming up with different pieces of advice."},{"startTime":971.995,"endTime":975.535,"body":"Nobody could tell what's the right thing to do, right?"},{"startTime":975.795,"endTime":979.71,"body":"So the issuing equity, people say, well, you know, if you borrow, you could go"},{"startTime":979.71,"endTime":981.015,"body":"bankrupt, you could lose everything."},{"startTime":981.225,"endTime":982.695,"body":"Don't borrow too much."},{"startTime":983.355,"endTime":984.935,"body":"But how much is too much?"},{"startTime":985.595,"endTime":989.495,"body":"20%, 40%, 80%, nobody knew."},{"startTime":990.915,"endTime":993.855,"body":"So this is where Molar Miller came in."},{"startTime":995.515,"endTime":998.175,"body":"Now, how do you think they approach that problem?"},{"startTime":998.665,"endTime":999.015,"body":"Right?"},{"startTime":999.315,"endTime":1002.852,"body":"One would imagine they would go and talk to a whole bunch of companies and"},{"startTime":1002.852,"endTime":1004.975,"body":"ask them how they issue debt and equity, right?"},{"startTime":1005.805,"endTime":1007.615,"body":"Yeah, I see a bunch of nodding heads."},{"startTime":1007.845,"endTime":1008.135,"body":"Nope."},{"startTime":1008.285,"endTime":1009.095,"body":"They didn't do that."},{"startTime":1009.565,"endTime":1014.878,"body":"What they did was to lock themselves into their office and think, so this is"},{"startTime":1014.878,"endTime":1016.295,"body":"entirely a thought experiment."},{"startTime":1016.465,"endTime":1020.735,"body":"There was nothing there, which actually involved talking to a manager."},{"startTime":1021.485,"endTime":1023.175,"body":"They didn't do that, right?"},{"startTime":1023.325,"endTime":1028.655,"body":"They said in principle, how can we come up with this from first principles?"},{"startTime":1029.473,"endTime":1033.015,"body":"So what was their major insight, which got the, the Nobel Prize?"},{"startTime":1034.243,"endTime":1036.295,"body":"Well, what they said was very simple."},{"startTime":1037.765,"endTime":1043.855,"body":"When you issue debt or equity, the companies don't just keep the money, right?"},{"startTime":1044.005,"endTime":1048.063,"body":"It's not like, you know, remember the Uncle Scrooge comics where Uncle Scrooge takes a"},{"startTime":1048.063,"endTime":1048.333,"body":"whole bunch of money, uh, you know, coins and puts it in a swimming pool"},{"startTime":1048.333,"endTime":1054.015,"body":"and tries to swim in the money."},{"startTime":1054.125,"endTime":1055.175,"body":"They don't do that, right?"},{"startTime":1055.175,"endTime":1057.255,"body":"They actually invest the money."},{"startTime":1057.445,"endTime":1058.975,"body":"They do something with the money."},{"startTime":1059.835,"endTime":1064.615,"body":"So a company issues, debt does something with the money and the value goes up."},{"startTime":1065.715,"endTime":1065.935,"body":"Why?"},{"startTime":1066.995,"endTime":1067.455,"body":"One reason."},{"startTime":1068.195,"endTime":1069.685,"body":"The debt itself is valuable."},{"startTime":1070.305,"endTime":1075.125,"body":"Second reason, the stuff they invested in that was valuable."},{"startTime":1075.225,"endTime":1080.039,"body":"The debt was bad, but they invested in something which was so good, it counteracted"},{"startTime":1080.039,"endTime":1081.965,"body":"the negative impact on the debt."},{"startTime":1082.745,"endTime":1090.689,"body":"So the problem is by actually investing, you are using up, you're creating or destroying"},{"startTime":1090.689,"endTime":1097.045,"body":"value by investing in a positive or a negative NPV project, okay?"},{"startTime":1097.305,"endTime":1098.645,"body":"That's the issue they had."},{"startTime":1099.305,"endTime":1102.885,"body":"So, but the NPV of the project is the investment side."},{"startTime":1102.985,"endTime":1105.645,"body":"It has nothing to do with the financing side."},{"startTime":1106.025,"endTime":1108.885,"body":"The financing side is about the choice between debt and equity."},{"startTime":1109.265,"endTime":1113.245,"body":"The investment side is NPV, which you already talked about."},{"startTime":1114.865,"endTime":1121.376,"body":"So Morgan Miller said, what we need to do is not look at a typical"},{"startTime":1121.376,"endTime":1122.245,"body":"company situation."},{"startTime":1122.555,"endTime":1126.965,"body":"What we need to do is study what are called leverage recaps."},{"startTime":1128.105,"endTime":1130.285,"body":"So what is a leverage recapitalization?"},{"startTime":1131.425,"endTime":1132.485,"body":"The answer is very simple."},{"startTime":1133.295,"endTime":1134.725,"body":"Let's take a typical company."},{"startTime":1135.265,"endTime":1141.325,"body":"So you have assets and a mixture of debt and equity financing the assets, right?"},{"startTime":1141.425,"endTime":1143.685,"body":"So that's the, it's a balance sheet."},{"startTime":1143.905,"endTime":1146.925,"body":"So the assets are equal to the liabilities, fine."},{"startTime":1147.745,"endTime":1151.365,"body":"Now the company starts to do a recap."},{"startTime":1151.435,"endTime":1156.431,"body":"What it is does is it issues debt, but what does it do with the"},{"startTime":1156.431,"endTime":1156.765,"body":"money?"},{"startTime":1157.305,"endTime":1159.325,"body":"It doesn't invest in anything."},{"startTime":1159.835,"endTime":1163.605,"body":"What it does is takes the money and buy shares back."},{"startTime":1163.915,"endTime":1168.485,"body":"That means it adjusts the equity side of the balance sheet, right?"},{"startTime":1168.705,"endTime":1170.605,"body":"It never goes to the left hand side."},{"startTime":1170.865,"endTime":1172.285,"body":"It never touches the assets."},{"startTime":1172.825,"endTime":1175.565,"body":"So if it issues debt, it buys back shares."},{"startTime":1175.785,"endTime":1177.885,"body":"If it issues shares, it buys back debt."},{"startTime":1178.225,"endTime":1183.455,"body":"So essentially what's happening is that it is changing the right hand side of the"},{"startTime":1183.455,"endTime":1186.245,"body":"balance sheet without touching the left hand side."},{"startTime":1187.065,"endTime":1194.925,"body":"So now if this happens and the value goes down, why is it going down?"},{"startTime":1195.145,"endTime":1197.205,"body":"It can only be because of the debt."},{"startTime":1198.665,"endTime":1202.965,"body":"It can't be because the company's investing, because the company is not investing, right?"},{"startTime":1203.025,"endTime":1204.165,"body":"We have fixed that part."},{"startTime":1204.705,"endTime":1208.685,"body":"So everything that's happening is done on the right hand side."},{"startTime":1208.945,"endTime":1212.885,"body":"So one possibility could be you issue debt and the value goes down."},{"startTime":1213.545,"endTime":1217.965,"body":"The other possibility could be you issue debt and the value goes up."},{"startTime":1219.385,"endTime":1224.498,"body":"But all of this will be due entirely to that mixture of debt and equity,"},{"startTime":1224.498,"endTime":1226.885,"body":"which you have within the firm, right?"},{"startTime":1227.065,"endTime":1228.325,"body":"So that's what they did."},{"startTime":1228.355,"endTime":1230.925,"body":"That was the entire insight they had."},{"startTime":1231.075,"endTime":1235.805,"body":"They said, let's look at a world where all the firm is doing issues."},{"startTime":1235.965,"endTime":1239.445,"body":"Debt buys, back, shares, issue shares, buys back debt."},{"startTime":1239.945,"endTime":1240.845,"body":"I'm not going to invest."},{"startTime":1241.065,"endTime":1242.125,"body":"I'm not touching that side."},{"startTime":1242.125,"endTime":1243.325,"body":"There's no NPV involved."},{"startTime":1243.625,"endTime":1247.325,"body":"If there's a change in value, it must be because of capital structure."},{"startTime":1249.155,"endTime":1249.445,"body":"Okay?"},{"startTime":1250.745,"endTime":1254.805,"body":"So we need a little bit of notation here."},{"startTime":1254.875,"endTime":1256.405,"body":"I'll explain that notation too."},{"startTime":1256.865,"endTime":1259.485,"body":"The notation is gonna be a little complex."},{"startTime":1259.585,"endTime":1262.765,"body":"So I'll show you what the notation means in a pictorial format in a bit."},{"startTime":1263.305,"endTime":1267.005,"body":"So at the moment, I'm gonna call a firm, which has no debt at all."},{"startTime":1267.065,"endTime":1269.405,"body":"We start with a completely unlevered firm."},{"startTime":1269.745,"endTime":1270.805,"body":"The firm has no debt."},{"startTime":1270.805,"endTime":1272.325,"body":"That's why it's called unlevered."},{"startTime":1272.915,"endTime":1273.205,"body":"Okay?"},{"startTime":1273.665,"endTime":1277.736,"body":"So the value of that firm must be equal to the value of equity because"},{"startTime":1277.736,"endTime":1279.365,"body":"it has no debt, it's unlevered."},{"startTime":1279.505,"endTime":1281.445,"body":"So the assets must be equal to equity."},{"startTime":1281.465,"endTime":1282.005,"body":"That's it."},{"startTime":1282.075,"endTime":1282.845,"body":"Balance sheet."},{"startTime":1284.225,"endTime":1290.741,"body":"Second thing, we have a levered firm, which is identical in the asset side to"},{"startTime":1290.741,"endTime":1292.045,"body":"the unlevered firm."},{"startTime":1292.395,"endTime":1293.205,"body":"What does that mean?"},{"startTime":1293.585,"endTime":1297.605,"body":"It means they have similar growth opportunities, they have similar investment projects."},{"startTime":1297.835,"endTime":1301.925,"body":"They, the CEOs are clones of each other, right?"},{"startTime":1302.595,"endTime":1309.916,"body":"Identical among all lines, except firm two is partly financial debt and partly financial with"},{"startTime":1309.916,"endTime":1310.405,"body":"equity."},{"startTime":1311.555,"endTime":1312.045,"body":"Alright?"},{"startTime":1312.655,"endTime":1317.891,"body":"Third thing, the company can choose to borrow, and if it borrows, it pays a"},{"startTime":1317.891,"endTime":1320.685,"body":"cost of rd, cost of debt on it."},{"startTime":1320.725,"endTime":1321.845,"body":"Borrowing rate, right?"},{"startTime":1322.665,"endTime":1327.336,"body":"Fourth thing is the cost of equity, and that's derived by the capital asset pricing"},{"startTime":1327.336,"endTime":1329.205,"body":"model, which we did last time."},{"startTime":1329.625,"endTime":1334.341,"body":"The cost of equity is how much do shareholders want if you choose to invest"},{"startTime":1334.341,"endTime":1335.285,"body":"in that company."},{"startTime":1337.115,"endTime":1340.988,"body":"Finally, we have the cost of assets of the firm, which is the same as"},{"startTime":1340.988,"endTime":1341.247,"body":"the cost of equity for a firm which has zero debt, because the assets for"},{"startTime":1341.247,"endTime":1347.445,"body":"that firm is equal to the equity in that firm."},{"startTime":1347.515,"endTime":1348.805,"body":"I'll show you this a little bit."},{"startTime":1349.985,"endTime":1355.45,"body":"The weighted average cost of capital is our final number, and that's a weighted average"},{"startTime":1355.45,"endTime":1358.365,"body":"of every form of financing the firm has."},{"startTime":1359.025,"endTime":1365.475,"body":"For example, it's paying RD on his debt, but this is the level of debt"},{"startTime":1365.475,"endTime":1366.765,"body":"within the firm."},{"startTime":1367.185,"endTime":1372.295,"body":"So that's the weight which you put on the debt, and similarly, the weight you"},{"startTime":1372.295,"endTime":1377.405,"body":"put on the equity, that's an overall weighted average cost of capital on the firm."},{"startTime":1379.705,"endTime":1382.525,"body":"Now, let's ex, let's explain this a little better."},{"startTime":1383.465,"endTime":1385.925,"body":"So what we have here is straightforward."},{"startTime":1386.465,"endTime":1389.165,"body":"You have an unlevered firm firm with no debt at all."},{"startTime":1389.555,"endTime":1389.845,"body":"Okay?"},{"startTime":1390.105,"endTime":1393.365,"body":"So the assets are generating returns, right?"},{"startTime":1393.485,"endTime":1394.565,"body":"I mean, they are assets."},{"startTime":1394.585,"endTime":1396.725,"body":"So you're investing in them, they're generating returns."},{"startTime":1397.345,"endTime":1402.913,"body":"So those returns are called ra, the cost, the return on the assets of the"},{"startTime":1402.913,"endTime":1403.285,"body":"firm."},{"startTime":1404.305,"endTime":1408.172,"body":"But because the firm has no debt, it's the same as writing the cost of"},{"startTime":1408.172,"endTime":1411.525,"body":"equity when the firm has no debt, or E, when debt is zero."},{"startTime":1411.995,"endTime":1413.085,"body":"Okay, fine."},{"startTime":1413.635,"endTime":1416.645,"body":"What about firm Levi firm?"},{"startTime":1416.865,"endTime":1418.725,"body":"The asset side is still the asset side."},{"startTime":1418.755,"endTime":1421.365,"body":"It's ra, but it's just generating the same assets."},{"startTime":1421.425,"endTime":1422.805,"body":"So generating the same returns."},{"startTime":1423.505,"endTime":1426.845,"body":"But on the right hand side, we've got debt and we've got equity."},{"startTime":1427.985,"endTime":1431.245,"body":"The debt is, has an interest rate of rd."},{"startTime":1431.825,"endTime":1434.205,"body":"The equity has an interest rate of re."},{"startTime":1435.265,"endTime":1440.756,"body":"So that's what we have is the weighted average cost of capital is a weighted"},{"startTime":1440.756,"endTime":1443.685,"body":"average of the RD and the re, right?"},{"startTime":1443.705,"endTime":1444.565,"body":"And what are the weights?"},{"startTime":1444.825,"endTime":1446.045,"body":"How much debt is there in the firm?"},{"startTime":1446.145,"endTime":1447.525,"body":"How much equity is there in the firm?"},{"startTime":1448.635,"endTime":1448.925,"body":"Okay?"},{"startTime":1449.265,"endTime":1451.685,"body":"So very straightforward formula."},{"startTime":1452.025,"endTime":1455.89,"body":"And if that's the overall cost of capital for the firm, weighted average with the"},{"startTime":1455.89,"endTime":1458.725,"body":"debt and the equity, there's only two forms of debt here."},{"startTime":1459.395,"endTime":1461.125,"body":"Only two forms of financing here."},{"startTime":1461.225,"endTime":1466.213,"body":"If you had more firms, you would add them on preferred shares, convertible debt, whatever"},{"startTime":1466.213,"endTime":1470.205,"body":"cost of each take the weighted average of all those costs together."},{"startTime":1470.505,"endTime":1472.805,"body":"That's a relevant cost of capital for this firm."},{"startTime":1473.635,"endTime":1473.925,"body":"Fine."},{"startTime":1474.425,"endTime":1475.885,"body":"So what are the questions we wanna answer?"},{"startTime":1477.025,"endTime":1479.085,"body":"The value of the endeavored firm is vu."},{"startTime":1479.585,"endTime":1481.645,"body":"The value of the levered firm is vl."},{"startTime":1482.745,"endTime":1486.767,"body":"So the first question you wanna answer is, the value of the levered firm different"},{"startTime":1486.767,"endTime":1488.645,"body":"from the value of the unlevered firm."},{"startTime":1488.795,"endTime":1494.645,"body":"That means in some way, has issuing debt changed the value of the firm?"},{"startTime":1496.305,"endTime":1499.645,"body":"Second question, what happens to the cost of equity?"},{"startTime":1500.065,"endTime":1501.005,"body":"If you issue debt?"},{"startTime":1501.475,"endTime":1502.925,"body":"Does the cost of equity change?"},{"startTime":1503.985,"endTime":1508.553,"body":"And a third question is, what happens to the firm's overall cost of capital as"},{"startTime":1508.553,"endTime":1510.685,"body":"you add debt to the capital structure?"},{"startTime":1511.215,"endTime":1511.565,"body":"Right?"},{"startTime":1511.705,"endTime":1513.125,"body":"So three big questions."},{"startTime":1513.705,"endTime":1516.765,"body":"Is the value of the levered firm equal to the value of the unlevered firm?"},{"startTime":1516.785,"endTime":1518.325,"body":"Or is it different in some way?"},{"startTime":1518.865,"endTime":1521.165,"body":"Second question, what happens to the cost of equity?"},{"startTime":1521.345,"endTime":1524.205,"body":"Do shareholders care about this?"},{"startTime":1524.735,"endTime":1527.925,"body":"Third question, what happens to the firm's overall cost of capital?"},{"startTime":1528.915,"endTime":1529.205,"body":"Okay?"},{"startTime":1529.585,"endTime":1534.966,"body":"And the answers to these three questions was what got Ani and Miller the Nobel"},{"startTime":1534.966,"endTime":1535.325,"body":"Prize?"},{"startTime":1536.585,"endTime":1538.125,"body":"So let's see what they did."},{"startTime":1541.855,"endTime":1544.285,"body":"Let's start with a perfect world."},{"startTime":1545.145,"endTime":1550.565,"body":"Now, remember, Moland and Miller were both economists from the University of Chicago, right?"},{"startTime":1550.825,"endTime":1554.828,"body":"For those of you who are familiar with economists from the University of Chicago, their"},{"startTime":1554.828,"endTime":1558.565,"body":"idea of a perfect world is very different from our idea of perfect world."},{"startTime":1559.025,"endTime":1562.685,"body":"So what do Chicago economists think makes a perfect world?"},{"startTime":1563.295,"endTime":1566.445,"body":"First thing they say is, there should be no government, right?"},{"startTime":1567.545,"endTime":1570.045,"body":"Of course, that means no taxes, right?"},{"startTime":1570.515,"endTime":1579.486,"body":"That means no lawyers, no bankruptcy costs, no transaction costs, and of course, efficient markets,"},{"startTime":1579.486,"endTime":1580.085,"body":"right?"},{"startTime":1580.185,"endTime":1584.765,"body":"So this is the ideal world for an economist from the University of Chicago."},{"startTime":1585.785,"endTime":1587.445,"body":"So let's start with this world."},{"startTime":1587.635,"endTime":1594.961,"body":"Perfect, fine in this world, the proposition one, which they came up with, let's just"},{"startTime":1594.961,"endTime":1600.335,"body":"say, and by the way, the perfect world doesn't exist, right?"},{"startTime":1600.475,"endTime":1603.175,"body":"So that's why they, it was a thought experiment."},{"startTime":1603.505,"endTime":1608.123,"body":"The beauty of their approach was that they said, let's start with this perfect world"},{"startTime":1608.123,"endTime":1608.431,"body":"and then relax one assumption at a time to see how far we can get"},{"startTime":1608.431,"endTime":1615.205,"body":"with what's the optimal structure of the firm."},{"startTime":1615.555,"endTime":1615.845,"body":"Okay?"},{"startTime":1616.025,"endTime":1621.5,"body":"So initially, all these assumptions, perfect world, and they said in that world, the value"},{"startTime":1621.5,"endTime":1623.325,"body":"of the firm doesn't change."},{"startTime":1624.515,"endTime":1628.002,"body":"That means, in other words, the value of the levered firm is equal to the"},{"startTime":1628.002,"endTime":1629.165,"body":"value of the unlevered firm."},{"startTime":1630.345,"endTime":1634.725,"body":"Second thing they said was, shareholders think it's riskier now."},{"startTime":1635.465,"endTime":1636.765,"body":"So what do shareholders do?"},{"startTime":1637.035,"endTime":1641.845,"body":"They ask for higher returns, otherwise they won't invest in the company, right?"},{"startTime":1642.225,"endTime":1646.141,"body":"So the rate of return to demand by equity holders goes up and it's given"},{"startTime":1646.141,"endTime":1646.402,"body":"by the cost of assets, plus cost of assets minus the cost of debt, times"},{"startTime":1646.402,"endTime":1651.885,"body":"the debt equity ratio of the company."},{"startTime":1652.555,"endTime":1657.25,"body":"I'll come back to this, the third one says, but even then, even though the"},{"startTime":1657.25,"endTime":1657.563,"body":"shareholders are asking for more money, the weighted average cost of capital of the firm"},{"startTime":1657.563,"endTime":1662.885,"body":"stays the same."},{"startTime":1662.985,"endTime":1663.685,"body":"It never changes."},{"startTime":1665.505,"endTime":1666.725,"body":"So let's prove this."},{"startTime":1666.955,"endTime":1667.245,"body":"Okay?"},{"startTime":1667.545,"endTime":1672.965,"body":"So we are now coming up on proving three Nobel prize winning formula."},{"startTime":1673.665,"endTime":1678.885,"body":"So you have to dust off all the mathematics we did in our high school."},{"startTime":1679.335,"endTime":1679.685,"body":"Ready?"},{"startTime":1679.685,"endTime":1680.885,"body":"Everybody, right?"},{"startTime":1681.365,"endTime":1681.645,"body":"Excellent."},{"startTime":1681.695,"endTime":1682.365,"body":"Let's do it."},{"startTime":1683.505,"endTime":1687.045,"body":"So proposition one and the proof is actually very simple."},{"startTime":1687.695,"endTime":1689.405,"body":"We'll call it the pizza proof."},{"startTime":1690.315,"endTime":1690.605,"body":"Okay?"},{"startTime":1691.265,"endTime":1694.565,"body":"So you have here a pizza which cost 10 pounds."},{"startTime":1695.715,"endTime":1696.205,"body":"Alright?"},{"startTime":1696.705,"endTime":1701.325,"body":"So you decide to sell one fourth of that pizza."},{"startTime":1702.635,"endTime":1702.925,"body":"Okay?"},{"startTime":1703.185,"endTime":1708.204,"body":"So the question for you, and I'm gonna start over here, is how much would"},{"startTime":1708.204,"endTime":1711.885,"body":"you start for selling that one fourth slice to the pizza?"},{"startTime":1712.185,"endTime":1718.515,"body":"You can use that QR code and slide on on your phone to try to"},{"startTime":1718.515,"endTime":1724.845,"body":"figure out exactly how much you would pay for one quarter of the pizza, right?"},{"startTime":1724.865,"endTime":1729.965,"body":"You can charge any price you want, what price would you charge?"},{"startTime":1740.965,"endTime":1741.205,"body":"Excellent."},{"startTime":1741.405,"endTime":1747.057,"body":"I can say that a lot of you would be charging about four pounds for"},{"startTime":1747.057,"endTime":1748.565,"body":"a slice of pizza."},{"startTime":1749.485,"endTime":1749.725,"body":"Excellent."},{"startTime":1749.725,"endTime":1750.525,"body":"That's totally fine."},{"startTime":1751.145,"endTime":1756.139,"body":"Of course, remember, this is University of Chicago, and remember the first assumption we made"},{"startTime":1756.139,"endTime":1756.805,"body":"perfect competition."},{"startTime":1757.225,"endTime":1761.59,"body":"The moment you charge four pounds for one quarter of the pizza, what is the"},{"startTime":1761.59,"endTime":1763.045,"body":"immediate thing which will happen?"},{"startTime":1763.225,"endTime":1769.405,"body":"If the market is perfect, somebody else will jump in and undercut you, right?"},{"startTime":1769.665,"endTime":1773.882,"body":"So you charge four pound, they'll charge 3 99, you charge 3 99, they'll charge"},{"startTime":1773.882,"endTime":1774.445,"body":"3 98."},{"startTime":1775.105,"endTime":1780.407,"body":"And so literally the only price at which you cannot, you know, uh, make a"},{"startTime":1780.407,"endTime":1780.761,"body":"profit or a loss is 2.5, which you can't charge less than 2.5, but then"},{"startTime":1780.761,"endTime":1789.245,"body":"you're giving up money, you're leaving money on the table."},{"startTime":1789.585,"endTime":1793.225,"body":"So literally what they said was, you want to sell a quarter of the pizza,"},{"startTime":1793.225,"endTime":1794.925,"body":"you have to sell it for 2.5."},{"startTime":1794.925,"endTime":1797.605,"body":"You cannot sell it for more than that 'cause of competition."},{"startTime":1797.865,"endTime":1801.085,"body":"You can't sell it for less than that because you're not stupid, right?"},{"startTime":1801.385,"endTime":1803.245,"body":"So that's the basic story here."},{"startTime":1803.625,"endTime":1806.005,"body":"So the only price is 2.5."},{"startTime":1807.465,"endTime":1811.565,"body":"So what that means is, now what do you have?"},{"startTime":1812.425,"endTime":1818.391,"body":"You sold your pizza originally, 10 pound sold a quarter, you ended up with 2.5,"},{"startTime":1818.391,"endTime":1823.165,"body":"and you end up with three quarters of a pizza worth 7.5."},{"startTime":1823.665,"endTime":1827.725,"body":"The question is, are you wealthier than before?"},{"startTime":1829.165,"endTime":1830.565,"body":"Hmm, not really, right?"},{"startTime":1831.185,"endTime":1835.403,"body":"One pizza worth 10 pounds, three quarters of pizza worth two, 7.5 plus 2.5 in"},{"startTime":1835.403,"endTime":1835.685,"body":"cash."},{"startTime":1835.995,"endTime":1837.485,"body":"Exactly the same thing."},{"startTime":1837.825,"endTime":1841.325,"body":"So really you're not better off than before, and that's the proof."},{"startTime":1843.265,"endTime":1845.823,"body":"Now, I can see a lot of faces say, wait, what kind of proof was"},{"startTime":1845.823,"endTime":1846.165,"body":"that, right?"},{"startTime":1846.325,"endTime":1848.085,"body":"I mean, they got a Nobel Prize for that."},{"startTime":1848.745,"endTime":1851.125,"body":"So let me get a little more sophisticated here."},{"startTime":1852.115,"endTime":1852.405,"body":"Okay?"},{"startTime":1853.025,"endTime":1857.495,"body":"So by the way, that's how they actually explained their thing to the, um, so"},{"startTime":1857.495,"endTime":1857.793,"body":"when Miller got the prize, a whole bunch of journalists went to him and they"},{"startTime":1857.793,"endTime":1865.245,"body":"said, professor, can you explain your why you got the prize?"},{"startTime":1865.705,"endTime":1868.605,"body":"You know, in ways that our readers can understand."},{"startTime":1868.865,"endTime":1870.125,"body":"And he used the pizza proof."},{"startTime":1870.705,"endTime":1871.685,"body":"It was not in the paper."},{"startTime":1871.795,"endTime":1873.885,"body":"This is how he described to the journalist."},{"startTime":1874.665,"endTime":1876.925,"body":"And the journalist said, oh, interesting."},{"startTime":1877.545,"endTime":1878.885,"body":"Um, can we talk to someone else?"},{"startTime":1880.115,"endTime":1881.525,"body":"Because they're like, what the hell?"},{"startTime":1881.525,"endTime":1881.765,"body":"Right?"},{"startTime":1881.765,"endTime":1882.885,"body":"They didn't understand this proof."},{"startTime":1883.345,"endTime":1886.165,"body":"So let's talk about a different way of doing it."},{"startTime":1886.635,"endTime":1886.925,"body":"Okay?"},{"startTime":1887.465,"endTime":1891.485,"body":"So imagine that you have an unleavened firm and this is what you have, right?"},{"startTime":1891.505,"endTime":1893.605,"body":"So the firm has no debt at all."},{"startTime":1893.825,"endTime":1898.643,"body":"So it makes a hundred dollars in earnings every year pays zero interest because it's"},{"startTime":1898.643,"endTime":1898.965,"body":"unlevered."},{"startTime":1899.425,"endTime":1902.565,"body":"And that money goes to the net income of the firm."},{"startTime":1902.755,"endTime":1903.965,"body":"What does the firm do with it?"},{"startTime":1904.015,"endTime":1905.765,"body":"Gives it out in the form of dividends."},{"startTime":1906.235,"endTime":1906.525,"body":"Okay?"},{"startTime":1906.635,"endTime":1910.885,"body":"This is an unlevered firm, no interest done, okay?"},{"startTime":1911.705,"endTime":1913.405,"body":"You own 10% of the shares."},{"startTime":1914.385,"endTime":1919.045,"body":"So that means your income every year is $10 and you are happy, okay?"},{"startTime":1919.295,"endTime":1921.205,"body":"Maybe not ecstatic, but you are happy."},{"startTime":1921.795,"endTime":1922.285,"body":"Alright?"},{"startTime":1922.785,"endTime":1928.845,"body":"Now, the firm says, I'm going to issue $200 of debt paying 10%."},{"startTime":1930.075,"endTime":1930.365,"body":"Okay?"},{"startTime":1930.585,"endTime":1932.285,"body":"So what happens to the balance sheet of the firm?"},{"startTime":1932.715,"endTime":1937.685,"body":"Well, earnings are still the same, but interest goes up from zero to 20."},{"startTime":1938.595,"endTime":1943.085,"body":"That means the net income drops to 80 and reform pays that out."},{"startTime":1943.825,"endTime":1947.405,"body":"So you have $80 of dividends, which you're getting."},{"startTime":1948.125,"endTime":1949.965,"body":"Remember, you own 10% of the shares."},{"startTime":1950.145,"endTime":1952.525,"body":"So your income is now $8."},{"startTime":1954.155,"endTime":1954.445,"body":"Okay?"},{"startTime":1954.785,"endTime":1958.205,"body":"The question I'm gonna ask you is, would you be happy?"},{"startTime":1971.065,"endTime":1971.505,"body":"Somebody is happy?"},{"startTime":1971.685,"endTime":1981.32,"body":"Oh, that's nice, \u003claugh\u003e two people, okay, I, I really want to speak to these"},{"startTime":1981.32,"endTime":1985.175,"body":"people off the cliff seminar, right?"},{"startTime":1989.965,"endTime":1993.842,"body":"Okay, so we see it's a sort of even thing would mean I'm angry and"},{"startTime":1993.842,"endTime":1995.135,"body":"it doesn't matter to me."},{"startTime":1995.755,"endTime":1999.175,"body":"But the actual answer is correct, it shouldn't matter."},{"startTime":1999.405,"endTime":2000.095,"body":"I'll tell you why."},{"startTime":2001.475,"endTime":2003.375,"body":"And this seems obvious, right?"},{"startTime":2003.495,"endTime":2009.028,"body":"I mean, as you can see over here, um, the angry part overwhelms the, it"},{"startTime":2009.028,"endTime":2010.135,"body":"doesn't matter, right?"},{"startTime":2010.245,"endTime":2015.652,"body":"This is again why they got a Nobel prize and because it's not intuitive, okay,"},{"startTime":2015.652,"endTime":2017.455,"body":"let's go back in here."},{"startTime":2018.935,"endTime":2024.158,"body":"Remember the key part is if your firm is issuing debt, the money has to"},{"startTime":2024.158,"endTime":2024.855,"body":"go somewhere."},{"startTime":2024.915,"endTime":2026.255,"body":"It cannot invest this money."},{"startTime":2026.995,"endTime":2028.655,"body":"So what does it do with this money?"},{"startTime":2030.195,"endTime":2034.71,"body":"It has to give it to the shareholders that she gives it to the shareholders"},{"startTime":2034.71,"endTime":2036.215,"body":"as a special dividend, okay?"},{"startTime":2036.395,"endTime":2040.189,"body":"It can't touch the asset side because remember, it's a leverage recap with a firm"},{"startTime":2040.189,"endTime":2040.695,"body":"issues debt."},{"startTime":2040.755,"endTime":2043.175,"body":"It has to do something with that money."},{"startTime":2043.355,"endTime":2047.011,"body":"So you assume it either buys back shares, or it gives the money to the"},{"startTime":2047.011,"endTime":2047.255,"body":"shareholders."},{"startTime":2048.514,"endTime":2051.882,"body":"So if I give the money to you as a shareholder, you own 10% of"},{"startTime":2051.882,"endTime":2053.455,"body":"the company, how much do you get?"},{"startTime":2053.875,"endTime":2055.614,"body":"210% of the company."},{"startTime":2055.795,"endTime":2056.815,"body":"You get $20."},{"startTime":2057.594,"endTime":2059.335,"body":"Now what do you do with this $20?"},{"startTime":2061.225,"endTime":2062.085,"body":"You put it into the bank."},{"startTime":2062.625,"endTime":2063.725,"body":"How much is the bank paying?"},{"startTime":2064.864,"endTime":2066.804,"body":"10% perfectly competitive."},{"startTime":2067.225,"endTime":2071.005,"body":"So you get $2 of interest now and $8 of income."},{"startTime":2071.545,"endTime":2072.045,"body":"Are you happy?"},{"startTime":2072.355,"endTime":2073.364,"body":"It's the same as before."},{"startTime":2073.945,"endTime":2076.245,"body":"It hasn't changed, okay?"},{"startTime":2076.594,"endTime":2081.329,"body":"That was the intuition Mother, Glen and Miller said the firm decides to take on"},{"startTime":2081.329,"endTime":2081.645,"body":"leverage."},{"startTime":2081.784,"endTime":2085.965,"body":"You can undo whatever the firm does by doing exactly the opposite."},{"startTime":2086.185,"endTime":2091.565,"body":"The firm issues that you say, fine, I lend exactly that amount."},{"startTime":2092.505,"endTime":2095.995,"body":"Okay, let's go to a slightly different scenario here."},{"startTime":2096.545,"endTime":2101.435,"body":"There's a levered firm, which is giving you $120 of interest."},{"startTime":2101.535,"endTime":2105.035,"body":"$80 is your net income, and the dividend is $80."},{"startTime":2105.335,"endTime":2108.435,"body":"So you're going along and you own 10% a share."},{"startTime":2108.695,"endTime":2112.515,"body":"You getting an income of $8 a share, okay?"},{"startTime":2112.515,"endTime":2113.115,"body":"It's pretty good."},{"startTime":2113.975,"endTime":2115.795,"body":"And now the firm says, you know what?"},{"startTime":2115.995,"endTime":2116.915,"body":"I don't like bond holders."},{"startTime":2117.075,"endTime":2117.715,"body":"I don't like debt."},{"startTime":2117.835,"endTime":2118.715,"body":"I think debt is bad."},{"startTime":2118.895,"endTime":2120.435,"body":"I'm gonna buy back all my debt."},{"startTime":2122.175,"endTime":2122.465,"body":"Fine."},{"startTime":2123.485,"endTime":2124.625,"body":"So what happens?"},{"startTime":2125.615,"endTime":2127.225,"body":"Your earnings now is still a hundred."},{"startTime":2127.655,"endTime":2128.505,"body":"That hasn't changed."},{"startTime":2128.685,"endTime":2129.985,"body":"The interest is going to zero."},{"startTime":2130.335,"endTime":2134.385,"body":"Your dividends is a hundred and your own 10% of the shares."},{"startTime":2134.445,"endTime":2138.245,"body":"So your income is now $10 higher than before."},{"startTime":2139.725,"endTime":2140.085,"body":"Question is"},{"startTime":2158.685,"endTime":2159.005,"body":"Brilliant."},{"startTime":2159.475,"endTime":2161.165,"body":"Everybody got the story right?"},{"startTime":2161.425,"endTime":2163.765,"body":"So the answer is, again, it shouldn't matter."},{"startTime":2164.385,"endTime":2164.605,"body":"Why?"},{"startTime":2164.605,"endTime":2166.405,"body":"Because the firm is buying back debt."},{"startTime":2166.715,"endTime":2171.725,"body":"This person here is still a little angry, but \u003claugh\u003e I would say don't worry"},{"startTime":2171.725,"endTime":2172.06,"body":"too much about it because the key part is the firm needs the money from"},{"startTime":2172.06,"endTime":2177.405,"body":"somewhere, right?"},{"startTime":2177.435,"endTime":2178.405,"body":"It's buying back debt."},{"startTime":2178.865,"endTime":2180.605,"body":"So where does it get that money from?"},{"startTime":2181.105,"endTime":2182.405,"body":"It has to be from the shareholders."},{"startTime":2183.065,"endTime":2184.405,"body":"You own 10% of the company."},{"startTime":2184.585,"endTime":2187.285,"body":"So it's going to put you on the hook for 20 bill dollars."},{"startTime":2187.865,"endTime":2190.085,"body":"So you give the firm $20, right?"},{"startTime":2190.775,"endTime":2192.005,"body":"Where do you get the money from?"},{"startTime":2192.865,"endTime":2193.805,"body":"You have to borrow it."},{"startTime":2194.105,"endTime":2196.005,"body":"If you borrow it, you pay 10%."},{"startTime":2196.185,"endTime":2200.365,"body":"So yes, you get $10 of dividends, but you pay $2 of interest."},{"startTime":2200.465,"endTime":2204.085,"body":"So you still end up with the same $8 as before."},{"startTime":2206.355,"endTime":2206.645,"body":"Okay?"},{"startTime":2206.665,"endTime":2209.605,"body":"So the income never changes here."},{"startTime":2209.785,"endTime":2211.805,"body":"The firm has reduced its debt."},{"startTime":2211.985,"endTime":2215.205,"body":"So you take on debt, you undone whatever the firm has done."},{"startTime":2215.755,"endTime":2220.705,"body":"That was the essence of Molan Miller proposition one, it shouldn't matter in a perfect"},{"startTime":2220.705,"endTime":2225.325,"body":"world what the firm does because the money has to come from somewhere, right?"},{"startTime":2225.825,"endTime":2228.445,"body":"You can't create money, it has to come from somewhere."},{"startTime":2230.035,"endTime":2230.325,"body":"Okay?"},{"startTime":2230.665,"endTime":2236.405,"body":"The proposition two said the shareholders are asking for more money, right?"},{"startTime":2236.985,"endTime":2241.696,"body":"The shareholders in some way, their risk has gone up and it's given by this"},{"startTime":2241.696,"endTime":2242.325,"body":"formula here."},{"startTime":2243.225,"endTime":2244.645,"body":"So why is that happening?"},{"startTime":2244.865,"endTime":2246.245,"body":"Why are they asking for more money?"},{"startTime":2249.365,"endTime":2252.685,"body":"Remember, it's a perfect word, which means no bankruptcy costs."},{"startTime":2252.685,"endTime":2253.925,"body":"It's not about bankruptcy."},{"startTime":2254.115,"endTime":2254.965,"body":"There's something else."},{"startTime":2255.935,"endTime":2261.563,"body":"Let's imagine that you have an investment opportunity that costs you a hundred dollars and"},{"startTime":2261.563,"endTime":2264.565,"body":"it can either give you $101 or $99."},{"startTime":2266.235,"endTime":2270.485,"body":"That means essentially your returns are either 1% or minus 1%."},{"startTime":2270.545,"endTime":2272.045,"body":"You make one or you lose one."},{"startTime":2273.065,"endTime":2276.885,"body":"But suppose you don't actually put in the entire a hundred dollars yourself."},{"startTime":2277.195,"endTime":2282.079,"body":"What you do is you go to your mother and you borrow $99 from your"},{"startTime":2282.079,"endTime":2282.405,"body":"mother,"},{"startTime":2284.835,"endTime":2285.125,"body":"Okay?"},{"startTime":2285.345,"endTime":2286.045,"body":"Why your mother?"},{"startTime":2286.045,"endTime":2290.645,"body":"Because your mother's a nice person and she will not charge you any interest, okay?"},{"startTime":2290.785,"endTime":2293.845,"body":"So making putting interest in makes it a little more difficult."},{"startTime":2293.905,"endTime":2297.125,"body":"So I'm gonna assume mother because nice people, right?"},{"startTime":2298.315,"endTime":2300.485,"body":"Okay, so now you own 101."},{"startTime":2300.545,"endTime":2304.162,"body":"So you have to, only thing you have to do is give your mom her"},{"startTime":2304.162,"endTime":2304.645,"body":"money back."},{"startTime":2304.775,"endTime":2307.485,"body":"She's not asking for interest, she just wants some money back."},{"startTime":2308.025,"endTime":2311.325,"body":"So 101, you return 99, your profit is two."},{"startTime":2311.915,"endTime":2314.765,"body":"Here you own 99, return 99, your profit is zero."},{"startTime":2315.025,"endTime":2317.045,"body":"But how much money had you put in $1?"},{"startTime":2317.665,"endTime":2318.725,"body":"$1 becomes two."},{"startTime":2318.945,"endTime":2321.405,"body":"That's the return of 100%."},{"startTime":2322.225,"endTime":2323.405,"body":"$1 becomes zero."},{"startTime":2323.545,"endTime":2326.005,"body":"That's the return of minus 100%."},{"startTime":2326.315,"endTime":2327.525,"body":"Same investment opportunity."},{"startTime":2327.785,"endTime":2331.125,"body":"But leverage boosts the positive and the negative."},{"startTime":2331.505,"endTime":2333.485,"body":"That's why leverage is risky."},{"startTime":2333.855,"endTime":2336.725,"body":"Makes returns much more volatile than before."},{"startTime":2338.395,"endTime":2338.685,"body":"Okay?"},{"startTime":2338.955,"endTime":2341.325,"body":"What happens to the firm's overall cost of capital?"},{"startTime":2342.275,"endTime":2345.965,"body":"Well, let's say you are the CFO of an all equity finance firm."},{"startTime":2346.465,"endTime":2350.376,"body":"Uh, your CEO comes to you and says, our cost of equity, which is the"},{"startTime":2350.376,"endTime":2353.245,"body":"cost of assets, because the firm has no debt, it's 12%."},{"startTime":2354.395,"endTime":2354.685,"body":"Okay?"},{"startTime":2354.825,"endTime":2356.525,"body":"The cost of debt is 6%."},{"startTime":2357.265,"endTime":2359.805,"body":"Why don't we borrow the shareholder's asking for 12."},{"startTime":2359.945,"endTime":2363.285,"body":"The bond holders are asking for six, let's issue 50% debt."},{"startTime":2363.915,"endTime":2364.645,"body":"What do you say?"},{"startTime":2365.355,"endTime":2367.285,"body":"This is a great idea, a terrible idea."},{"startTime":2367.425,"endTime":2368.085,"body":"It doesn't matter."},{"startTime":2372.325,"endTime":2376.485,"body":"Remember, the cost of debt is 6%, the cost of equity is 12%."},{"startTime":2382.195,"endTime":2383.535,"body":"You guys are very, very good."},{"startTime":2386.685,"endTime":2386.975,"body":"Okay?"},{"startTime":2388.155,"endTime":2391.17,"body":"It does look like it's a great idea because the cost of debt is lower"},{"startTime":2391.17,"endTime":2392.175,"body":"than the cost of equity."},{"startTime":2392.435,"endTime":2397.385,"body":"The key point, of course, is the moment you issue the debt, the shareholders ask"},{"startTime":2397.385,"endTime":2398.375,"body":"for more money."},{"startTime":2398.405,"endTime":2400.135,"body":"They say, look, it's riskier for us."},{"startTime":2400.515,"endTime":2401.295,"body":"How much more money?"},{"startTime":2401.665,"endTime":2402.935,"body":"Let's take proposition two."},{"startTime":2403.715,"endTime":2408.015,"body":"It says that's a 12% plus 12% minus 6% times one."},{"startTime":2408.015,"endTime":2412.855,"body":"Because 50% debt, 50% equity, the shareholders are going to immediately ask for 18%."},{"startTime":2413.435,"endTime":2417.718,"body":"The more orders are still asking for six, but the average of six and 18"},{"startTime":2417.718,"endTime":2418.575,"body":"is still 12%."},{"startTime":2420.595,"endTime":2422.175,"body":"So what does the CEO say?"},{"startTime":2422.485,"endTime":2427.293,"body":"Well, the CEO might say what stupid shareholders, they keep so greedy they're asking for"},{"startTime":2427.293,"endTime":2428.255,"body":"more and more."},{"startTime":2428.605,"endTime":2430.615,"body":"Fine, I'm gonna get rid of more of them."},{"startTime":2431.075,"endTime":2433.775,"body":"I'm going to get rid of all except for one guy."},{"startTime":2433.885,"endTime":2438.495,"body":"That means I'm gonna go for 99.99999% debt."},{"startTime":2439.565,"endTime":2442.095,"body":"What happens to the cost of Capital One shareholder?"},{"startTime":2442.125,"endTime":2447.169,"body":"Everybody else a bond holder who's asking for 6%, but that one shareholder now ask"},{"startTime":2447.169,"endTime":2447.505,"body":"for a million and a half percent, the average of a million and a half"},{"startTime":2447.505,"endTime":2453.895,"body":"and 6% is still 12%."},{"startTime":2454.595,"endTime":2456.935,"body":"So then the CEO says, let's get rid of the last guy."},{"startTime":2459.915,"endTime":2461.415,"body":"All buy back all the shares."},{"startTime":2462.565,"endTime":2463.975,"body":"What do the bond holders ask for?"},{"startTime":2465.235,"endTime":2470.224,"body":"Well, one might say 6%, but remember the definition of an equity holder is somebody"},{"startTime":2470.224,"endTime":2472.885,"body":"who's paid after everybody else is paid off."},{"startTime":2473.505,"endTime":2477.615,"body":"So if there are no bond, if there are no shareholders in the firm who's"},{"startTime":2477.615,"endTime":2477.889,"body":"lost in line the bond holders, which means the bond holders become the equity holders,"},{"startTime":2477.889,"endTime":2483.645,"body":"which means they ask for 12%, right?"},{"startTime":2483.785,"endTime":2486.005,"body":"So the cost of capital never changes."},{"startTime":2486.905,"endTime":2489.936,"body":"So the traditional view of the cost of capital was as you issue more debt,"},{"startTime":2489.936,"endTime":2492.765,"body":"the cost of equity goes up, but the cost of debt goes up too."},{"startTime":2492.865,"endTime":2496.377,"body":"So the weighted average cost of capital kind of goes down a little bit in"},{"startTime":2496.377,"endTime":2498.485,"body":"the beginning and then goes up in the end."},{"startTime":2498.995,"endTime":2503.31,"body":"What Molan Miller said, in a perfect world, cost of equity does go up, but"},{"startTime":2503.31,"endTime":2505.325,"body":"the cost of debt stays the same."},{"startTime":2505.665,"endTime":2507.885,"body":"So the weighted average cost of capital never changes."},{"startTime":2509.035,"endTime":2512.925,"body":"Alright, now let's add the first imperfection taxes."},{"startTime":2513.625,"endTime":2517.577,"body":"If you remember this from the first lecture this year, what I said was this"},{"startTime":2517.577,"endTime":2519.685,"body":"is the flow of finance within the firm."},{"startTime":2520.025,"endTime":2524.405,"body":"And what I have here is a leakage, right?"},{"startTime":2524.595,"endTime":2525.565,"body":"From the point of view."},{"startTime":2525.735,"endTime":2530.978,"body":"Again, going back to Chicago, the point of view is if I pay money here,"},{"startTime":2530.978,"endTime":2534.125,"body":"that means I have less money to pay here."},{"startTime":2534.265,"endTime":2537.245,"body":"If I pay less money here, these guys will give me less money."},{"startTime":2537.505,"endTime":2539.765,"body":"So this is a problem, right?"},{"startTime":2539.965,"endTime":2542.245,"body":"I wanna minimize the amount I pay."},{"startTime":2543.305,"endTime":2545.965,"body":"So basically, how do they do that?"},{"startTime":2546.585,"endTime":2547.565,"body":"So they're gonna relax."},{"startTime":2547.565,"endTime":2548.365,"body":"Assumption one."},{"startTime":2548.705,"endTime":2551.845,"body":"Now there's a government and there are taxes, but only corporate taxes."},{"startTime":2552.145,"endTime":2555.125,"body":"And the corporate taxes is a tax rate of Tao C."},{"startTime":2555.715,"endTime":2556.005,"body":"Okay?"},{"startTime":2556.345,"endTime":2560.576,"body":"So again, we have a weighted average cost of capital, but now I've added one"},{"startTime":2560.576,"endTime":2564.525,"body":"minus tax rate because now I'm looking at the after tax cost of debt."},{"startTime":2565.275,"endTime":2569.005,"body":"Debt cost me 10%, but I'm saving 40% of taxes."},{"startTime":2569.265,"endTime":2571.085,"body":"So it actually only costs me 6%."},{"startTime":2571.225,"endTime":2572.005,"body":"That's the idea."},{"startTime":2573.155,"endTime":2573.445,"body":"Fine."},{"startTime":2574.275,"endTime":2575.205,"body":"Same three questions."},{"startTime":2575.465,"endTime":2576.885,"body":"Is VL different from vu?"},{"startTime":2577.265,"endTime":2581.129,"body":"How do the cost of equity change and what happens to the firm's overall cost"},{"startTime":2581.129,"endTime":2581.645,"body":"of capital?"},{"startTime":2582.825,"endTime":2588.525,"body":"And in this corporate tax world proposition one says, debt is good, take as much"},{"startTime":2588.525,"endTime":2590.045,"body":"debt as you can."},{"startTime":2590.675,"endTime":2591.725,"body":"More debt the better."},{"startTime":2591.945,"endTime":2592.165,"body":"Why?"},{"startTime":2592.165,"endTime":2593.565,"body":"Because it reduces your taxes."},{"startTime":2595.505,"endTime":2599.567,"body":"The second one says the, the formula is the value of the levered form, value"},{"startTime":2599.567,"endTime":2599.837,"body":"of the unlevered form, plus the tax shield in the debt proposition two says the"},{"startTime":2599.837,"endTime":2600.108,"body":"cost of equity goes up, but not as much as before because the shareholders are"},{"startTime":2600.108,"endTime":2609.045,"body":"protected by a tax sheet."},{"startTime":2609.045,"endTime":2610.485,"body":"They're getting money back from the government."},{"startTime":2611.385,"endTime":2615.79,"body":"And the third one says that the firm's overall cost of capital goes down is"},{"startTime":2615.79,"endTime":2616.965,"body":"given by that formula."},{"startTime":2616.965,"endTime":2620.565,"body":"There are variance for this formula, depending on the assumptions you make about the type"},{"startTime":2620.565,"endTime":2622.725,"body":"of debt, but we will ignore that for now."},{"startTime":2623.555,"endTime":2624.925,"body":"Okay, so how do we prove it?"},{"startTime":2625.555,"endTime":2628.864,"body":"Well assume you have an all equity firm and you have a levered firm on"},{"startTime":2628.864,"endTime":2629.085,"body":"here."},{"startTime":2630.145,"endTime":2633.845,"body":"So you come in, let's say it's again the pizza proof."},{"startTime":2634.785,"endTime":2639.603,"body":"You go in every day to your school and you're carrying this big pizza with"},{"startTime":2639.603,"endTime":2639.925,"body":"you."},{"startTime":2640.105,"endTime":2644.816,"body":"And this is giant bully at the door who stops you and takes away half"},{"startTime":2644.816,"endTime":2645.445,"body":"your pizza."},{"startTime":2645.625,"endTime":2648.085,"body":"The bullies, of course, the government, right?"},{"startTime":2648.865,"endTime":2652.365,"body":"So, but you realize that the bully only checks for pizza."},{"startTime":2652.395,"endTime":2653.765,"body":"Doesn't actually check for cash."},{"startTime":2654.065,"endTime":2657.858,"body":"So what you do is before the bully gets in, right, you sell half the"},{"startTime":2657.858,"endTime":2658.111,"body":"pizza to your teacher and then you keep the money in your shoe and walk"},{"startTime":2658.111,"endTime":2658.364,"body":"through the pizza, sees only half the bully, only sees half the pizza and takes"},{"startTime":2658.364,"endTime":2666.205,"body":"half of that."},{"startTime":2666.505,"endTime":2669.786,"body":"So the bully only takes a quarter of the pizza, not the half of the"},{"startTime":2669.786,"endTime":2670.005,"body":"pizza."},{"startTime":2670.265,"endTime":2674.679,"body":"You are left with cash, plus the quarter of the pizza you have left, which"},{"startTime":2674.679,"endTime":2676.445,"body":"means you're better off than before."},{"startTime":2676.675,"endTime":2677.365,"body":"Essentially."},{"startTime":2677.585,"endTime":2678.765,"body":"That's the scenario here."},{"startTime":2678.825,"endTime":2679.885,"body":"That's the scenario here."},{"startTime":2680.145,"endTime":2681.405,"body":"And that's the idea."},{"startTime":2681.745,"endTime":2684.765,"body":"The what's left over for the shareholder, the bond holder is bigger."},{"startTime":2685.145,"endTime":2687.805,"body":"You pay less taxes to prove that."},{"startTime":2689.195,"endTime":2690.005,"body":"Very straightforward."},{"startTime":2690.145,"endTime":2691.805,"body":"You've got same thing unlevered firm."},{"startTime":2692.065,"endTime":2696.171,"body":"But the key difference here is the taxes are 40% and the firm is paying"},{"startTime":2696.171,"endTime":2696.445,"body":"that."},{"startTime":2697.145,"endTime":2699.845,"body":"You own 10% of the shares, your income is $6."},{"startTime":2701.225,"endTime":2704.125,"body":"The firm issues $200 of debt paying 10%."},{"startTime":2704.675,"endTime":2705.165,"body":"What happens?"},{"startTime":2706.435,"endTime":2710.805,"body":"Well, you pay the debt, but your taxes go down from 40 to 32."},{"startTime":2711.155,"endTime":2712.605,"body":"Your net income is 48."},{"startTime":2713.085,"endTime":2714.485,"body":"Dividends are therefore 48."},{"startTime":2714.745,"endTime":2717.005,"body":"And so your income is 4.8."},{"startTime":2717.465,"endTime":2719.165,"body":"If you ask the question, are you happy?"},{"startTime":2719.345,"endTime":2720.405,"body":"The answer is yes."},{"startTime":2720.905,"endTime":2721.125,"body":"Why?"},{"startTime":2721.125,"endTime":2723.645,"body":"Because you get $2 of interest from that debt."},{"startTime":2724.685,"endTime":2727.685,"body":"Remember the form has to issue the debt and gives you the 20 bucks."},{"startTime":2727.865,"endTime":2730.885,"body":"So you use that to invest and you got 4.8."},{"startTime":2730.945,"endTime":2735.005,"body":"So you end up with 8 cents more than 80 cents more than before."},{"startTime":2736.185,"endTime":2738.845,"body":"So every year you get 80 cents more."},{"startTime":2739.715,"endTime":2741.165,"body":"Where's the 80 cents coming from?"},{"startTime":2741.475,"endTime":2743.605,"body":"Well look at the taxes, right?"},{"startTime":2743.625,"endTime":2748.845,"body":"$20 of interest saves you 20 times 40% of taxes on 10% of the share."},{"startTime":2748.905,"endTime":2750.805,"body":"So you save 80 cents every year."},{"startTime":2751.625,"endTime":2754.925,"body":"So you wanna find out every year you're saving 80 cents."},{"startTime":2755.355,"endTime":2757.685,"body":"What is the present value of that stream?"},{"startTime":2758.285,"endTime":2759.805,"body":"Infinite stream of 80 cents a year."},{"startTime":2760.745,"endTime":2763.045,"body":"How do you find the present value of an infinite stream of cash flows?"},{"startTime":2763.795,"endTime":2768.27,"body":"Basically you're looking for a formula that goes on like the same NPV formula, but"},{"startTime":2768.27,"endTime":2769.165,"body":"goes on forever."},{"startTime":2770.225,"endTime":2771.085,"body":"How do you solve that?"},{"startTime":2771.355,"endTime":2772.445,"body":"Well, it's very straightforward."},{"startTime":2772.825,"endTime":2777.64,"body":"You say the present value is that number multiply both sides by one plus R,"},{"startTime":2777.64,"endTime":2779.245,"body":"that first one becomes C."},{"startTime":2780.145,"endTime":2784.965,"body":"So this cancels, this becomes one, this becomes two, and so on."},{"startTime":2785.265,"endTime":2789.84,"body":"So what you see is the second formula, but this whole bit here is the"},{"startTime":2789.84,"endTime":2791.365,"body":"famous, the first top formula."},{"startTime":2791.745,"endTime":2797.729,"body":"So PV times one plus C plus pv, and you can solve that to just"},{"startTime":2797.729,"endTime":2799.325,"body":"say present value CR."},{"startTime":2799.905,"endTime":2802.405,"body":"Now you're getting 80 cents every year."},{"startTime":2802.425,"endTime":2804.205,"body":"So that's the cashflow you're getting every year."},{"startTime":2804.905,"endTime":2806.645,"body":"So what is the value of that?"},{"startTime":2806.645,"endTime":2807.245,"body":"80 cents?"},{"startTime":2807.555,"endTime":2812.845,"body":"Well, 80 cents divided by R, 200 times 10% times 40% divided by R."},{"startTime":2813.225,"endTime":2813.845,"body":"But what's cr?"},{"startTime":2814.755,"endTime":2818.645,"body":"Well, you only get the tax shield if you can pay your interest."},{"startTime":2818.945,"endTime":2822.605,"body":"So the risk of the tax shield is exactly the risk of the interest."},{"startTime":2823.155,"endTime":2825.405,"body":"That means the R must be 10%."},{"startTime":2826.385,"endTime":2831.542,"body":"So putting that in the formula, you get the 10% cancels, the RD cancels, and"},{"startTime":2831.542,"endTime":2833.605,"body":"that was Ani Miller proposition one."},{"startTime":2834.155,"endTime":2835.445,"body":"Okay, fine."},{"startTime":2836.585,"endTime":2838.125,"body":"So what can we conclude so far?"},{"startTime":2838.875,"endTime":2841.605,"body":"Well, in a perfect world, capital structure doesn't matter."},{"startTime":2842.465,"endTime":2848.221,"body":"But in a world where taxes, debt is good, borrow as much as you can,"},{"startTime":2848.221,"endTime":2848.605,"body":"right?"},{"startTime":2849.795,"endTime":2852.725,"body":"Okay, are they really important in corporate policy?"},{"startTime":2853.475,"endTime":2854.765,"body":"Well, let's take an example."},{"startTime":2855.085,"endTime":2857.445,"body":"A Belgian tax reform in 1982."},{"startTime":2858.275,"endTime":2863.31,"body":"What happened here was, for some reason, I'm not quite sure why the Belgian government"},{"startTime":2863.31,"endTime":2865.325,"body":"decided that debt has a cost."},{"startTime":2865.665,"endTime":2871.68,"body":"Equity will give you a cost of 13%, and every firm can deduct that cost"},{"startTime":2871.68,"endTime":2873.285,"body":"from its income statement."},{"startTime":2873.905,"endTime":2874.645,"body":"So what happened?"},{"startTime":2875.295,"endTime":2879.885,"body":"Turns out more equity was issued in those two years than the previous 13 years."},{"startTime":2881.265,"endTime":2884.925,"body":"The entire Belgian stock market went up by 40% in one month."},{"startTime":2885.145,"endTime":2885.365,"body":"Why?"},{"startTime":2885.365,"endTime":2890.125,"body":"Because everybody said, whoa, tax shield and shock."},{"startTime":2890.135,"endTime":2893.428,"body":"Every time an equity announcement happened, the share price went up because they said, oh,"},{"startTime":2893.428,"endTime":2895.405,"body":"these guys are taking advantage of a tax shield."},{"startTime":2896.655,"endTime":2897.005,"body":"Right?"},{"startTime":2897.305,"endTime":2898.565,"body":"So what about personal taxes?"},{"startTime":2899.245,"endTime":2901.845,"body":"Remember, you're getting $2 a winter, but you're paying taxes on that, right?"},{"startTime":2902.065,"endTime":2904.165,"body":"So shouldn't it affect the value of the form?"},{"startTime":2904.915,"endTime":2907.325,"body":"Well, unfortunately, now it starts getting complicated."},{"startTime":2907.785,"endTime":2911.645,"body":"The problem is we don't know what the shareholders are paying."},{"startTime":2912.585,"endTime":2917.554,"body":"So for example, if you have, if you are paying heavy personal taxes, you may"},{"startTime":2917.554,"endTime":2920.205,"body":"want the firm to pay taxes, not you."},{"startTime":2921.065,"endTime":2924.925,"body":"But if you're a pension fund or an endowment, you're tax exempt."},{"startTime":2924.945,"endTime":2927.605,"body":"So you don't really care that much about what the firm is doing."},{"startTime":2927.665,"endTime":2929.685,"body":"You're happy to take the interest upfront."},{"startTime":2931.145,"endTime":2936.525,"body":"Or it can be, well, the firms can balance some shareholders pay taxes, some don't."},{"startTime":2936.585,"endTime":2939.285,"body":"But this requires you to know who your shareholders are."},{"startTime":2939.545,"endTime":2942.565,"body":"So really, Ani Miller didn't have an answer to this."},{"startTime":2942.775,"endTime":2947.176,"body":"Their basic story was, if you have a big enough pool and you the shareholders"},{"startTime":2947.176,"endTime":2947.47,"body":"have to pay taxes, they will go away from your company, but somebody else will"},{"startTime":2947.47,"endTime":2952.165,"body":"replace them."},{"startTime":2952.345,"endTime":2956.386,"body":"So in effect, you can treat it like a certain thing holds in the presence"},{"startTime":2956.386,"endTime":2956.925,"body":"of taxes."},{"startTime":2958.035,"endTime":2960.325,"body":"Alright, so what is the optimal amount of debt?"},{"startTime":2960.355,"endTime":2961.765,"body":"What if we con, can we conclude?"},{"startTime":2962.875,"endTime":2968.883,"body":"Well, Mo Miller one says, take as much debt as you can, but we don't"},{"startTime":2968.883,"endTime":2969.685,"body":"see this."},{"startTime":2970.585,"endTime":2973.965,"body":"We don't see companies with a hundred percent debt or even 99% debt."},{"startTime":2974.305,"endTime":2974.885,"body":"So why not?"},{"startTime":2975.555,"endTime":2978.405,"body":"Well, we have to relax assumption too, right?"},{"startTime":2978.825,"endTime":2980.685,"body":"No lawyers, no bankruptcy costs."},{"startTime":2981.025,"endTime":2983.685,"body":"Now we have lawyers and bankruptcy costs."},{"startTime":2984.145,"endTime":2985.325,"body":"So what do these guys do?"},{"startTime":2986.315,"endTime":2990.565,"body":"Well, the first thing it does is it reduces your flexibility, right?"},{"startTime":2990.995,"endTime":2994.925,"body":"Imagine a company has a lot of debt, you think it's gonna go bankrupt."},{"startTime":2995.265,"endTime":2996.925,"body":"Are you gonna buy the products of this firm?"},{"startTime":2997.095,"endTime":2999.405,"body":"Let's, let's say it's making laptops, right?"},{"startTime":2999.545,"endTime":3003.163,"body":"Are you gonna buy a laptop from a company which has a severe amount of"},{"startTime":3003.163,"endTime":3003.405,"body":"debt?"},{"startTime":3003.825,"endTime":3006.245,"body":"No, because you don't know what the after sale service can be."},{"startTime":3006.245,"endTime":3008.565,"body":"You don't even know the company will exist one year from now."},{"startTime":3009.065,"endTime":3012.248,"body":"So even the presence of too much debt means that people will back away from"},{"startTime":3012.248,"endTime":3012.885,"body":"the company people."},{"startTime":3013.865,"endTime":3017.393,"body":"You will not be able to hire a good employees because nobody wants to join"},{"startTime":3017.393,"endTime":3018.805,"body":"a company which might go bankrupt."},{"startTime":3019.515,"endTime":3019.805,"body":"Okay?"},{"startTime":3020.155,"endTime":3020.645,"body":"Alright."},{"startTime":3020.905,"endTime":3025.285,"body":"Second problem is excessive risk taking companies going bankrupt."},{"startTime":3025.435,"endTime":3027.805,"body":"What they will do is take all sorts of risks."},{"startTime":3028.225,"endTime":3028.445,"body":"Why?"},{"startTime":3028.445,"endTime":3033.205,"body":"Because the costs are born by the bond holders or they might underinvest."},{"startTime":3033.865,"endTime":3037.942,"body":"So that means basically, if a good opportunity arises, they won't take it because the"},{"startTime":3037.942,"endTime":3039.845,"body":"benefits will go to the bond holders."},{"startTime":3039.905,"endTime":3040.805,"body":"The company will be safer."},{"startTime":3041.345,"endTime":3043.845,"body":"Why should they choose to invest in that project?"},{"startTime":3044.575,"endTime":3047.365,"body":"These are called the agency costs of debt."},{"startTime":3048.585,"endTime":3052.045,"body":"So this leads to what we call the trade off theory of capital structure."},{"startTime":3052.865,"endTime":3057.505,"body":"The trade off theory of capital structure says the value of firm is the value"},{"startTime":3057.505,"endTime":3057.815,"body":"unlevered firm plus the present value of the interest tax sheet, plus the incentive benefits"},{"startTime":3057.815,"endTime":3062.765,"body":"of debt."},{"startTime":3063.515,"endTime":3069.845,"body":"Some debt is good because managers know that they have to service that debt."},{"startTime":3069.845,"endTime":3071.205,"body":"Otherwise the company goes bankrupt."},{"startTime":3071.205,"endTime":3072.085,"body":"They all lose their jobs."},{"startTime":3072.945,"endTime":3077.445,"body":"If you have too much cash, you attempted to spend it on yourself, right?"},{"startTime":3077.445,"endTime":3081.285,"body":"Think about all of us, when we have our annual budgets and you don't use"},{"startTime":3081.285,"endTime":3083.845,"body":"your budget before the end of the year, what happens?"},{"startTime":3083.865,"endTime":3084.845,"body":"The budget disappears."},{"startTime":3085.025,"endTime":3087.619,"body":"So a lot of us, towards the end of the year, we buy a lot"},{"startTime":3087.619,"endTime":3087.965,"body":"of stuff."},{"startTime":3087.965,"endTime":3090.565,"body":"We don't need new laptops, new whatever, right?"},{"startTime":3091.085,"endTime":3093.802,"body":"'cause otherwise the money goes and next year they say, oh, you didn't use it"},{"startTime":3093.802,"endTime":3094.165,"body":"last year."},{"startTime":3094.165,"endTime":3095.285,"body":"We cut your budget this year."},{"startTime":3095.615,"endTime":3096.285,"body":"Sound familiar?"},{"startTime":3096.575,"endTime":3096.925,"body":"Right?"},{"startTime":3097.285,"endTime":3097.725,"body":"A lot of people."},{"startTime":3098.035,"endTime":3098.325,"body":"Okay."},{"startTime":3098.625,"endTime":3100.285,"body":"So that's the incentive."},{"startTime":3100.645,"endTime":3106.045,"body":"Benefits of debt, financial distress costs, and the agency costs of debt, reduce that value."},{"startTime":3106.345,"endTime":3107.445,"body":"So who has high debt?"},{"startTime":3108.065,"endTime":3110.725,"body":"If you have high fee cash flow, you need the tax shield."},{"startTime":3111.185,"endTime":3114.525,"body":"If you have stable cash flow, there's a low property of financial distress."},{"startTime":3114.785,"endTime":3118.565,"body":"If you have lots of tangible capital, financial distress, less costly."},{"startTime":3118.565,"endTime":3120.525,"body":"So you might choose to have that level of debt."},{"startTime":3120.905,"endTime":3123.205,"body":"Few growth opportunities, you don't need fundraising."},{"startTime":3123.205,"endTime":3124.605,"body":"So debt overhang is not a problem."},{"startTime":3125.065,"endTime":3127.885,"body":"So these are the companies which has high levels of debt."},{"startTime":3128.675,"endTime":3128.965,"body":"Okay?"},{"startTime":3129.305,"endTime":3136.136,"body":"So this theory of capital structure basically says that if you go with Molan Miller"},{"startTime":3136.136,"endTime":3139.325,"body":"proposition one, you end up here, right?"},{"startTime":3139.385,"endTime":3144.335,"body":"In the perfect in the world with taxes, if you are thinking about agency costs"},{"startTime":3144.335,"endTime":3149.285,"body":"and the value of distress costs, firms balance the two together in the trade off."},{"startTime":3149.285,"endTime":3149.925,"body":"One was the other."},{"startTime":3150.255,"endTime":3153.245,"body":"Every firm has an optimal level of debt."},{"startTime":3153.835,"endTime":3154.125,"body":"Okay?"},{"startTime":3154.905,"endTime":3157.485,"body":"So how to form the established capital structure in reality."},{"startTime":3157.955,"endTime":3162.624,"body":"Well, there's some people that, there's a survey being done by Graham and Harvey at"},{"startTime":3162.624,"endTime":3162.935,"body":"Duke, and they say that most companies do actually have a target capital structure in"},{"startTime":3162.935,"endTime":3167.605,"body":"mind."},{"startTime":3167.625,"endTime":3168.405,"body":"How much to borrow."},{"startTime":3168.635,"endTime":3170.685,"body":"They know what is good for them and what is not."},{"startTime":3171.385,"endTime":3173.165,"body":"And you ask them what effects that policy."},{"startTime":3173.275,"endTime":3177.965,"body":"They will tell you things like credit rating, insufficient internal forms, level of interest rate."},{"startTime":3177.965,"endTime":3182.165,"body":"These are all things which work with Mo Grani Miller, right?"},{"startTime":3182.865,"endTime":3188.252,"body":"But the second, so most corporations in general have low debt asset ratios, changes in"},{"startTime":3188.252,"endTime":3191.485,"body":"financial leverage have been shown to affect form value."},{"startTime":3193.585,"endTime":3198.12,"body":"And they seem to be differences in capital structure across industries, which we can now"},{"startTime":3198.12,"endTime":3198.725,"body":"explain, right?"},{"startTime":3198.945,"endTime":3200.125,"body":"For example, airlines."},{"startTime":3200.705,"endTime":3205.125,"body":"The assets are leased, uh, uh, assets, they can easily be taken away."},{"startTime":3205.915,"endTime":3207.165,"body":"It's stable things."},{"startTime":3208.045,"endTime":3210.885,"body":"Internet information providers, the assets are the engineers."},{"startTime":3210.985,"endTime":3212.885,"body":"You can't handcuff them to their desks."},{"startTime":3213.035,"endTime":3217.007,"body":"They won't want debt because if they take too much debt, the engineers will leave"},{"startTime":3217.007,"endTime":3217.272,"body":"if they think the form is gonna go bankrupt and the form will definitely go"},{"startTime":3217.272,"endTime":3221.245,"body":"bankrupt."},{"startTime":3221.745,"endTime":3223.205,"body":"So that's it, right?"},{"startTime":3223.785,"endTime":3228.72,"body":"And there's evidence that firms behave as if they had a target debt equity ratio,"},{"startTime":3228.72,"endTime":3230.365,"body":"but it doesn't explain everything."},{"startTime":3230.945,"endTime":3235.325,"body":"For example, lots of profitable firms have no leverage at all."},{"startTime":3235.945,"endTime":3242.405,"body":"For example, from 1962 to 2009, about 10% had zero debt, no debt at all."},{"startTime":3243.225,"endTime":3246.405,"body":"Um, zero leverage firm, and they stay year after year."},{"startTime":3246.405,"endTime":3248.885,"body":"They never take that, right?"},{"startTime":3249.065,"endTime":3251.565,"body":"And they pay higher, higher dividends."},{"startTime":3251.565,"endTime":3253.485,"body":"They have the money, they pay higher taxes."},{"startTime":3253.865,"endTime":3255.085,"body":"Why are they paying higher taxes?"},{"startTime":3255.705,"endTime":3259.857,"body":"That's called, that was a paper called the Mystery of Zero Leverage Firms, which is"},{"startTime":3259.857,"endTime":3260.965,"body":"a very American thing."},{"startTime":3261.105,"endTime":3262.885,"body":"Why are these guys paying taxes when they don't have to?"},{"startTime":3264.785,"endTime":3267.125,"body":"So what can we conclude about capital structure?"},{"startTime":3268.145,"endTime":3270.365,"body":"In a perfect world, capital structure doesn't matter."},{"startTime":3270.545,"endTime":3271.685,"body":"So what's a perfect world?"},{"startTime":3272.755,"endTime":3274.885,"body":"Capital structure shouldn't affect a fee cash flow."},{"startTime":3274.885,"endTime":3279.151,"body":"The asset side of the balance sheet is completely independent of the liability side of"},{"startTime":3279.151,"endTime":3280.005,"body":"the balance sheet."},{"startTime":3280.395,"endTime":3284.445,"body":"Capital structure decision doesn't reveal any new information, right?"},{"startTime":3284.975,"endTime":3289.54,"body":"Third thing, investors and firms can trade the same set of securities at the same"},{"startTime":3289.54,"endTime":3289.845,"body":"price."},{"startTime":3291.025,"endTime":3293.645,"body":"No taxes, no transaction costs, no issuance costs."},{"startTime":3294.425,"endTime":3298.085,"body":"But even in perfect capital markets, capital structure does affect something."},{"startTime":3298.305,"endTime":3301.165,"body":"The risk of equity increases when you shoot debt."},{"startTime":3303.775,"endTime":3306.755,"body":"So in a world with taxes, it pays to borrow."},{"startTime":3306.855,"endTime":3310.407,"body":"So borrow as much as you can, but of course, companies do not borrow as"},{"startTime":3310.407,"endTime":3311.355,"body":"much as they can."},{"startTime":3311.545,"endTime":3316.235,"body":"They trade off the tax benefits of debt from the financial distress, cost of too"},{"startTime":3316.235,"endTime":3319.675,"body":"much debt, and they end up with an optimal capital structure."},{"startTime":3320.025,"endTime":3322.675,"body":"Unfortunately, this doesn't explain everything."},{"startTime":3322.945,"endTime":3326.933,"body":"Some firms don't even appear to think about this tax benefit they can borrow even"},{"startTime":3326.933,"endTime":3328.795,"body":"when they can easily pay their debts."},{"startTime":3329.615,"endTime":3333.765,"body":"So that last example is a different theory of capital structure, which I'm not gonna"},{"startTime":3333.765,"endTime":3334.595,"body":"talk about today."},{"startTime":3334.705,"endTime":3337.555,"body":"That will be in the topic of asymmetric information."},{"startTime":3337.575,"endTime":3342.303,"body":"So the informational effects when you start issuing debt, we'll spend some time talking about"},{"startTime":3342.303,"endTime":3344.195,"body":"it, I believe in May, right?"},{"startTime":3344.375,"endTime":3348.115,"body":"But for now, this is what we can conclude about capital structure."},{"startTime":3349.535,"endTime":3350.075,"body":"And that's it."},{"startTime":3355.545,"endTime":3359.007,"body":"What I'm gonna do is take a couple of the questions online first, and then"},{"startTime":3359.007,"endTime":3361.315,"body":"our colleague will, um, will bring the mic to before."},{"startTime":3362.015,"endTime":3363.635,"body":"So Professor Rao, a couple of questions."},{"startTime":3363.975,"endTime":3369.206,"body":"You spoke about promises and, um, the perfect world, and it's something that resonated with"},{"startTime":3369.206,"endTime":3369.555,"body":"myself."},{"startTime":3370.015,"endTime":3371.355,"body":"And one of the questions online."},{"startTime":3372.285,"endTime":3372.995,"body":"First question."},{"startTime":3373.335,"endTime":3379.161,"body":"How do you account for such poor returns in the real world versus the assumptions"},{"startTime":3379.161,"endTime":3380.715,"body":"in the perfect world?"},{"startTime":3382.305,"endTime":3385.125,"body":"Well, the perfect world is a pure thought experiment, right?"},{"startTime":3385.125,"endTime":3389.791,"body":"There's nothing, I mean, it's not like, um, it's not like we are expected to"},{"startTime":3389.791,"endTime":3390.725,"body":"believe it exists."},{"startTime":3391.035,"endTime":3395.056,"body":"It's the thing about this is this mythical paradise, which we are supposed to live"},{"startTime":3395.056,"endTime":3395.325,"body":"in."},{"startTime":3395.545,"endTime":3397.485,"body":"And in a mythical paradise, nothing matters."},{"startTime":3397.485,"endTime":3398.845,"body":"Capital structure doesn't matter."},{"startTime":3399.545,"endTime":3402.125,"body":"In the real world, our returns are very different."},{"startTime":3402.435,"endTime":3407.045,"body":"It's not just taxes, it's bankruptcy costs, it's informational effects."},{"startTime":3407.625,"endTime":3412.787,"body":"In this class, in this session, I haven't talked about information because moment you issue"},{"startTime":3412.787,"endTime":3417.605,"body":"something that reveals information to the market and the market reacts to that information."},{"startTime":3417.905,"endTime":3423.461,"body":"So returns in the real world have very little connection with returns in the perfect"},{"startTime":3423.461,"endTime":3427.165,"body":"modig gani, Miller world, and they just tap the beginning."},{"startTime":3427.385,"endTime":3431.262,"body":"But it was a good way to think about how do you separate the investment"},{"startTime":3431.262,"endTime":3434.365,"body":"issue of the firm from the capital structure decision of the firm."},{"startTime":3434.915,"endTime":3436.885,"body":"What you present tonight is very rational."},{"startTime":3438.025,"endTime":3441.285,"body":"How do you account for irrational behavior and decisions?"},{"startTime":3442.305,"endTime":3446.19,"body":"That's a very good question, and in fact, I'm going to address those in my"},{"startTime":3446.19,"endTime":3447.485,"body":"final lecture on market efficiency."},{"startTime":3447.705,"endTime":3449.405,"body":"So we'll hold off on that there."},{"startTime":3449.505,"endTime":3450.645,"body":"And there are a lot of factors."},{"startTime":3450.785,"endTime":3455.165,"body":"For example, there's a paper by Ricki mal menier, and there's another paper by me."},{"startTime":3455.165,"endTime":3458.525,"body":"We show that CEOs, as we know, are humans."},{"startTime":3458.595,"endTime":3461.165,"body":"They are not Chicago rational economists."},{"startTime":3461.545,"endTime":3466.159,"body":"So there are lots of things that affect their choice to do something or not"},{"startTime":3466.159,"endTime":3466.467,"body":"based on purely behavioral factors such as they were born during the Great Depression, or"},{"startTime":3466.467,"endTime":3472.005,"body":"even that they're married."},{"startTime":3472.315,"endTime":3476.365,"body":"Married CEOs take less risk than, you know, unmarried CEOs."},{"startTime":3476.615,"endTime":3480.306,"body":"Maybe one reason for that is they've used up their quota of risk when they"},{"startTime":3480.306,"endTime":3481.045,"body":"got married, right?"},{"startTime":3481.065,"endTime":3482.925,"body":"Or maybe they're more risk averse, who knows?"},{"startTime":3483.265,"endTime":3487.645,"body":"But that those are things, those are, those are behavioral factors that affect capital structure."},{"startTime":3487.745,"endTime":3490.685,"body":"We look forward to the, the sick lecture in the series for that."},{"startTime":3491.225,"endTime":3496.338,"body":"Uh, my questions is about the, yeah, you mentioned, uh, earlier about the, uh, principle"},{"startTime":3496.338,"endTime":3498.725,"body":"agent of the problem of the CEO."},{"startTime":3499.185,"endTime":3505.662,"body":"Uh, it's lead, uh, open to the offer financialization while, uh, what society expect from"},{"startTime":3505.662,"endTime":3510.845,"body":"the firm is the value that, uh, they created, not just earned."},{"startTime":3511.425,"endTime":3517.377,"body":"So how, how to like balance, uh, the value that firm created, uh, uh, versus"},{"startTime":3517.377,"endTime":3518.965,"body":"the offer financial decision."},{"startTime":3518.975,"endTime":3519.405,"body":"Thank you."},{"startTime":3522.015,"endTime":3522.305,"body":"Okay."},{"startTime":3523.205,"endTime":3529.542,"body":"So the, as I mentioned in my first lecture, the idea of what firms are"},{"startTime":3529.542,"endTime":3533.345,"body":"for has changed a lot since the 1920s, right?"},{"startTime":3533.525,"endTime":3537.462,"body":"In the 1920s, there were a lot of people who believed that the reason people"},{"startTime":3537.462,"endTime":3539.825,"body":"were firms were there were also to help society."},{"startTime":3540.485,"endTime":3545.777,"body":"But as I pointed out over the last, from 20 19, 20 to 1970, when"},{"startTime":3545.777,"endTime":3546.13,"body":"Friedman was, uh, was the culmination of all this, they basically said, it's not our"},{"startTime":3546.13,"endTime":3546.483,"body":"business to talk about, you know, whether to help society or not, which our business"},{"startTime":3546.483,"endTime":3559.185,"body":"is to do what's good for our shareholders."},{"startTime":3559.485,"endTime":3563.205,"body":"If the shareholders want to do what's good for the society, that's their issue."},{"startTime":3563.385,"endTime":3567.325,"body":"But they were, you're right, focus principally on principle agent problems."},{"startTime":3567.325,"endTime":3571.262,"body":"You let the managers do whatever they want, they will help themselves, rather help anybody"},{"startTime":3571.262,"endTime":3571.525,"body":"else."},{"startTime":3572.025,"endTime":3575.165,"body":"So that was the overriding focus of those guys."},{"startTime":3575.905,"endTime":3577.845,"body":"You can't trust anybody literally."},{"startTime":3578.475,"endTime":3578.765,"body":"Okay."},{"startTime":3579.035,"endTime":3579.325,"body":"Okay."},{"startTime":3579.405,"endTime":3584.411,"body":"So can, um, mo Glan and Miller's principles be expanded into other forms of issuing"},{"startTime":3584.411,"endTime":3589.085,"body":"finance other than issuing debt and just equity and used by real life companies?"},{"startTime":3590.275,"endTime":3590.565,"body":"Okay."},{"startTime":3592.175,"endTime":3597.565,"body":"Molan and Miller actually followed in a long tradition of what we call separation principles,"},{"startTime":3597.565,"endTime":3597.925,"body":"right?"},{"startTime":3598.065,"endTime":3602.645,"body":"So everything in finance involves separating one decision from another."},{"startTime":3603.425,"endTime":3607.415,"body":"So for example, last time when we talked about portfolio theory and the capital asset"},{"startTime":3607.415,"endTime":3611.405,"body":"pricing model, we were, oh, we talked about, start with our first lecture and pv."},{"startTime":3611.705,"endTime":3616.805,"body":"We separated the investment decision of the firm from the consumption decision of the shareholders."},{"startTime":3616.825,"endTime":3620.01,"body":"The shareholders want something they can borrow and land in the capital market to where"},{"startTime":3620.01,"endTime":3621.285,"body":"they want to go be, be."},{"startTime":3621.635,"endTime":3623.125,"body":"This is exactly the same idea."},{"startTime":3623.435,"endTime":3624.325,"body":"It's a separation."},{"startTime":3624.925,"endTime":3628.896,"body":"I can separate the investment decision of the firm from the financing decision of the"},{"startTime":3628.896,"endTime":3630.485,"body":"firm, like independent of each other."},{"startTime":3631.015,"endTime":3636.745,"body":"Everything in finance, and we see this in the next class as well, is about"},{"startTime":3636.745,"endTime":3640.565,"body":"showing that each decision is independent of every other decision."},{"startTime":3640.625,"endTime":3644.43,"body":"So we don't need to worry about all the other ramifications, we can just focus"},{"startTime":3644.43,"endTime":3645.445,"body":"on one particular area."},{"startTime":3646.025,"endTime":3652.502,"body":"Um, uh, your models earlier about the difference between debt and equity did not take"},{"startTime":3652.502,"endTime":3657.685,"body":"account of the behavior of shareholders who buy and sell quite quickly."},{"startTime":3657.985,"endTime":3662.76,"body":"So a company that borrowed to buy its own shares to increase the share values,"},{"startTime":3662.76,"endTime":3663.079,"body":"some people will be in there quick, get their 10% 'cause of the share value's"},{"startTime":3663.079,"endTime":3669.765,"body":"gone up and then sell again \u003caffirmative\u003e."},{"startTime":3669.765,"endTime":3672.805,"body":"And so you are not taking account of what shareholders do."},{"startTime":3672.805,"endTime":3675.205,"body":"They don't stay for a very long time in many cases."},{"startTime":3675.745,"endTime":3679.329,"body":"Um, as somebody like me who's bought in Nvidia and sold and bought again has"},{"startTime":3679.329,"endTime":3680.285,"body":"made lots of money."},{"startTime":3680.635,"endTime":3682.605,"body":"Yeah, that is an excellent point."},{"startTime":3682.675,"endTime":3685.885,"body":"This is a question about fairness and those kind of issues here."},{"startTime":3686.235,"endTime":3689.765,"body":"Unfortunately, finance doesn't concern itself very much about fairness."},{"startTime":3690.145,"endTime":3694.645,"body":"So for example, if the company, you know, a company issue shares or whatever, or"},{"startTime":3694.645,"endTime":3694.945,"body":"makes a tender offer to buy back shares, and some shareholders are on holiday, some"},{"startTime":3694.945,"endTime":3703.045,"body":"shareholders haven't, you know, kept up with the stuff, they will lose off."},{"startTime":3703.045,"endTime":3704.525,"body":"Some people will take advantage of that."},{"startTime":3704.525,"endTime":3706.605,"body":"They will make money, other people will lose money."},{"startTime":3706.605,"endTime":3708.805,"body":"So it's a wealth transfer between shareholders."},{"startTime":3709.705,"endTime":3715.485,"body":"So there is a technical term for shareholders like this and that is suckers, right?"},{"startTime":3715.665,"endTime":3720.412,"body":"So finance calls them, you know, you don't, you don't do, you're not alert all"},{"startTime":3720.412,"endTime":3721.045,"body":"the time."},{"startTime":3721.215,"endTime":3723.485,"body":"Tough luck your problem, not mine, right?"},{"startTime":3723.545,"endTime":3730.365,"body":"So this is again, as I said, a very peculiarly, heartless way to believe, right?"},{"startTime":3730.505,"endTime":3731.925,"body":"But that's finance for you."},{"startTime":3732.415,"endTime":3734.565,"body":"There are no nice people in finance, I'm afraid."},{"startTime":3735.715,"endTime":3736.005,"body":"Okay."},{"startTime":3736.155,"endTime":3736.445,"body":"Well,"},{"startTime":3736.445,"endTime":3741.258,"body":"I think we're running short of time, so I'm just gonna take one question online,"},{"startTime":3741.258,"endTime":3741.579,"body":"um, which may, maybe I'll train this in a good way, which is, are there"},{"startTime":3741.579,"endTime":3750.245,"body":"any real world economies that come close to the perfect world you've described?"},{"startTime":3752.025,"endTime":3755.685,"body":"No, I can't think of a single one."},{"startTime":3758.715,"endTime":3763.029,"body":"Well, I really can't think of a single one that fits exactly all the criteria"},{"startTime":3763.029,"endTime":3763.605,"body":"we have."},{"startTime":3764.745,"endTime":3769.215,"body":"It is a, but as I, most models start with that world because then you"},{"startTime":3769.215,"endTime":3773.685,"body":"can see by relaxing each assumption, how do we get closer to the real world?"},{"startTime":3773.905,"endTime":3776.125,"body":"And what is the impact of each assumption?"},{"startTime":3776.355,"endTime":3776.645,"body":"Half,"},{"startTime":3777.365,"endTime":3780.541,"body":"I think the questionnaire here is probably asking to find a country which didn't have"},{"startTime":3780.541,"endTime":3780.965,"body":"a government,"},{"startTime":3781.745,"endTime":3782.365,"body":"I'm sorry, close."},{"startTime":3782.365,"endTime":3782.605,"body":"Sorry."},{"startTime":3782.945,"endTime":3786.313,"body":"The, the questionnaire is probably trying to find a country that didn't have a government"},{"startTime":3786.313,"endTime":3787.885,"body":"and came close to happiness for them."},{"startTime":3788.425,"endTime":3789.005,"body":"Ah, okay."},{"startTime":3789.325,"endTime":3794.325,"body":"\u003claugh\u003e."},{"startTime":3789.765,"endTime":3794.765,"body":"\u003claugh\u003e."},{"startTime":3790.595,"endTime":3790.885,"body":"Yeah."},{"startTime":3791.865,"endTime":3796.125,"body":"But on that note, I think press out many thanks again for your rich insights."},{"startTime":3796.125,"endTime":3800.405,"body":"Thank you, Ian, and for, for simplifying the, the complex world of capital structures."},{"startTime":3800.715,"endTime":3801.845,"body":"Professor Rao, thank you."},{"startTime":3802.175,"endTime":3802.605,"body":"Thank you."}]}