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Â Now let's go back to the cost of debt and the cost of capital.

Â Why all this is important?

Â Well because remember, the interest rate,

Â does not change during the life of the bond.

Â The interest rate is always fixed at 10%.

Â The interest payments are always 100 million and the principal never change.

Â So if we're thinking about the cost of debt,

Â as what investors are requiring at each particular point in time.

Â Then the interest rate can never be a good indicator of the cost of debt.

Â And the reason it can never be a good indicator is because this

Â number never changes.

Â Obviously as time goes by companies become riskier or

Â less risky, but the interest rate is doesn't change.

Â And the coupon payments that don't change, so

Â the interest rate could never be a good approximation to the cost of debt.

Â But remember, the number that does change when prices change and when riskiness

Â change, and that is that mean annual return that we calculated, that why.

Â That you have in the slide.

Â And that y, which we call yield to maturity.

Â That's why we call it, and we put the notation as y,

Â that yield to maturity is basically the mean annual return that you get

Â by paying the market price for the bond, $939 in the example that we've seen,

Â and pocketing all the cashflows that you expect from the bond.

Â That is, if you pay the market price, and hold the bond until it

Â matures your mean annual return is what we call the yield to maturity.

Â And that is the measure of the cost of debt.

Â Because that yield to maturity will be changing all the time,

Â as market prices change and market prices will be

Â changing all the time when the riskiness of the company goes up or down.

Â So if we want to be accurate.

Â If we want to properly capture what the company needs to

Â deliver in terms of return today then we will be looking at a number.

Â That it actually fluctuates over time rather than a number that

Â is constant over time that can never gives us an updated.

Â Fresh estimate of, of the the cost of capital.

Â So if we want to know what the companies cost of capital today,

Â all we have to do is look at the yield to maturity that

Â the company's paying today in the bonds than the company has outstanding.

Â Bottom line, the cost of debt is a bond's yield to maturity.

Â So for a company that has only one bond in the market,

Â that cost of debt will be equal to the yield to maturity that

Â the company is paying at this particular point in time.

Â This is just to show you, this is just taken from the Financial Times iIt

Â is published every day you can find it in the Wall Street Journal,

Â you can find it online.

Â I just wanted to highlight very quickly.

Â Take a look at Australia.

Â These are government bonds.

Â And the only thing that I want to show you there, otice the,

Â the four columns that you have.

Â The first one is the, the one that says Redemption Date.

Â R-E-D.

Â A day that is Redemption Date.

Â And that is the day that the bond.

Â Or the date that the bond actually expires.

Â So the first bond.

Â The first Australian bond expires on June of 2016.

Â The second bond expires on April of 2024.

Â So that basically tells you that all bonds, or just about all bonds.

Â It's not, I mean, there are bonds that never expire, but

Â that's a little corner of the market.

Â But in general, all bonds have an expiration day.

Â And everybody knows that expiration day.

Â It's a public number.

Â It's a number that you need to know when you buy a bond.

Â All bonds.

Â We'll have a coupon.

Â Remember the coupon is what percentage of

Â the principle the company is going to be paying on an annual basis.

Â And so the second column is showing those numbers.

Â So for example in the bond that expires on June 16.

Â The coupon on that bond in the case of Australia is 4.75.

Â And that basically means that they will be paying 4.75% of the principle,

Â on an annual basis.

Â The second bond has a coupon of 2.75.

Â Well it means the same thing.

Â Between now and

Â April 2024 the Australian government will be paying 2.75% of the principle.

Â And the principle could be $100, $1,000, it doesn't really matter,

Â 2.75% of the principle every year until the bond expires.

Â The last two columns are the most important ones, and

Â they are most important because.

Â They show you how much you have to pay today for that bond.

Â And notice that next to each price, there's what's called a big yield.

Â Big yield is basically what we called before the yield to maturity.

Â That means that if you pay $104 for that bond,

Â then your mean annual return, if you hold a bond until maturity is 2.6%.

Â The second bond if you pay 9238 for that bond and

Â you hold that bond until maturity, your mean annual return is going to be 3.68.

Â And notice something that is important.

Â Compare for the first bond the coupon with the yield.

Â The coupon is 4.75.

Â The yield is 2.60.

Â In the second case the coupon is 2.75 and the Mm.

Â yield.

Â Is 3.68. So as you see the coupon and the yield.

Â And that again, again we're calling yield.

Â It's the yield to maturity.

Â But we always call it yield.

Â When you compare the coupon and

Â the yield to maturity these two numbers don't have to be the same.

Â In fact more often than not, They're going to be different.

Â So here's important thing, if you actually look at this in the paper today and

Â tomorrow, and the day after, and the day after, those coupons will not change

Â until the bond expire, none of those number in the coupon column will change.

Â But if you actually look every day, today, tomorrow, and

Â the day after, to the price and the yield, the last two columns.

Â Those will change every day.

Â That's why it's important that you keep in mind that the coupon, or

Â the interest rate of the bond, could never be a good estimate of the cost of capital.

Â Because.

Â Companies riskiness change over time, but that is never reflected in the coupon,

Â unless that the company has to issue it, or the bond has to issue it, or

Â the government has to issue a, a new bond.

Â But the prices, and the yields that go with those prices,.

Â Those one change all, all the time.

Â So bottom line.

Â When we think of the cost of debt we need to think of the yield to maturity of

Â the bond that the company may have out, outstanding in the market.

Â Now you can say well but not every company issue bonds.

Â Well that is true.

Â Some companies actually borrow money directly from a bank a, and

Â we'll get to that in just a second and we'll get to that in just a second because

Â we need to now start talking a little bit about the cost of equity.

Â But the first point that we need to make about the cost of equity is related cost

Â of debt and that is think about the numbers we've just seen, you now,

Â if you look at the bond of any company the price that you have to pay.

Â And the yield to maturity that goes with that price,

Â that's a number that is given by traders in the market, and that number for,

Â from the point of view from the company, it's sort of given.

Â You know, the company is doing things everyday,

Â the investors are reacting to whatever the company is doing and

Â they fix the prices, and they fix those yields to maturities.

Â But from a managerial, if you will,

Â perspective, what that means is my cost of debt is observable.

Â By observable, I mean that I can always go to a trading screen and

Â say that's my bond today and that's the yield to maturity that I have to pay.

Â And because it is observable, as some people would also call it objective.

Â Why objective?

Â Well because I may like or not like the number but

Â if you, I look at the number, and you look at the number, and

Â someone else look at the number, that number is not going to change.

Â It's going to be the same at a particular point in time.

Â The number is whatever it is.

Â Some people refer to the cost of debt as observable,

Â some people refer to the cost of debt as objective.

Â And some people actually refer to the cost of debt as observable and

Â objective, both of them at the same time.

Â Why had I brought up the issue of banks before?

Â Well again because some companies may not have a bond trading in the market and

Â they may do business with a bank.

Â Whenever they need, need debt they call their banker and

Â they say, you know, we need 100 million.

Â How much would you charge me today?

Â And the bank would say well for

Â that we'll charge you 8%, 7%, 6%, whatever the number.

Â But again notice that the same thing.

Â That, that cost of debt now becomes observable.

Â Someone tells me, what that cost is going to be, and again, it's subjective.

Â They give me the number.

Â I may like it or not.

Â But if I'm hearing the number,

Â you're hearing the number, we're going to be hearing the same number.

Â So that becomes my cost of debt.

Â So whether I have a bond trading in the market, or whether I'm borrowing money

Â from the bank, in both cases, the cost of debt is both observable and objective.

Â And the reason that this is important now that we start talking about the cost of

Â equity, is because the cost of equity or the require return on equity is neither.

Â That is first it's not observable.

Â That means that we need to estimate it and that means that because you and

Â I may be using different models.

Â Or you and I may be using the same model but with different values for

Â the parameters, then that cost of equity becomes subjective.

Â Your number and my number may be different.

Â That, will never happen with the cost of debt.

Â So that is a fundamental asymmetry that you need to keep in mind.

Â That as far as the cost of debt is concerned, I observed that number and

Â it becomes objective, but as far as the cost of equity is concerned I do not

Â observe that number, I must estimate it and therefore it becomes subjective.

Â Now, of course there are many ways of estimating the cost of

Â equity that many models have been proposed a by far,

Â the most widely used model is what we call the CAPM.

Â And CAPM is just an abbreviation for the capital asset pricing model.

Â And if you actually ask around, and by ask around I'm saying you do

Â surveys of what models people tend to use, as you can see in that picture by far.

Â Of the model most widely used to calculate the cost of equities this campaign that,

Â that we're going to explore.

Â So again, this is not the only way of calculating the cost of equity, but

Â what is important is two things.

Â One.

Â That we need to estimate somehow the cost of equity.

Â And two, the CAPM is not the only model.

Â But it's by far the most widely used.

Â And it's also very intuitive as you'll see in a minute in order to

Â estimate that cost of A.

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Â