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[SOUND] This is the calculation that

Â we've just done trying to figure out

Â what happens to the cost of capital for

Â Pepsico when leveraging is, right?

Â So it appears that the cost of capital is going down to 4.5%,

Â but what we already learned is that this calculation is wrong, okay?

Â One way to think about it is that this a mechanical effect, right?

Â It's a simple algebraic equation, right?

Â That couldn't possibly be right.

Â It's too mechanical to be described in the real world, right?

Â And in fact it is, right?

Â So you can think of this mechanical effect as also an illusion.

Â Just like the illusion, this mechanical effect of debt in the cost of capital is

Â also an illusion that you should avoid, okay?

Â In fact, this problem that we're talking about this is really cool,

Â because that is the motivation for research that won a Nobel Prize.

Â Back in the 60s, there were two people called Modigliani and

Â Miller who are the winners of

Â the first Nobel Prize that was given to researchers in corporate finance.

Â There has been others since then, but Modigliani and

Â Miller won the first Nobel Prize that is attributed to corporate finance resource.

Â So we really love these guys, okay?

Â And the motivation for

Â the research is that they got really mad with this mistake that people were making.

Â They got tired of hearing the argument that

Â because debt is cheaper than equity, right?

Â Then a company should issue that to reduce the cost of capital, okay?

Â What they showed in their research is why this mechanical effect is an illusion.

Â And the reason, right?

Â The reason is that the increasing leverage, if Pepsico issues more debt.

Â What will happen is that the cost of debt and the cost of equity are going to go up.

Â The company becomes risky.

Â So the right equation for

Â the WACC actually does not have a clear answer, okay?

Â The right equation is not what we had before.

Â The right equation is here, okay?

Â We know that leverage is going to 40% and 1 minus the leverage

Â ratio is going to 60%, the company can try to control that.

Â But what the company cannot control is what will happen to the required

Â return on debt and what will happen to the required return on equity, okay?

Â In fact, both will go up in the end, right?

Â Because the cost of debt and the cost of equity are going up,

Â you don't know what happens to the cost of capital, okay?

Â The reason why the risk is going up,

Â is an idea that we talked about in corporate finance one, right?

Â Is the idea of systematic risk, okay?

Â What happens is that the increasing debt is going to increase

Â the company's expose to systematic risk.

Â So a high debt company is also going to be a high data company, okay?

Â Debt increases beta.

Â In order for us to see why, what I want to do is to move away from Pepsico a bit.

Â It would be a bit difficult to do it using Pepsico,

Â it would probably involve too many numbers that you don't want to look at.

Â I'm going to use a simple example here, okay?

Â Where we have a boom and a downturn, right?

Â So here, the boom happens with probability 75%, 0.75.

Â The downturn happens with probability 0.25, okay?

Â And what we have here, is a cashflow to the company of 50 in the boom and

Â 30 in the downturn, right?

Â So the company makes a profit of 50 in the boom and

Â a lower profit of 30 in the downturn, right?

Â If you figured out the expected value of equity today, would be 45, right?

Â It's just a weighted average,

Â we've done calculations like that in corporate finance as well, right?

Â To calculate the expected value,

Â what you do is you take the average between the boom and the downturn, right?

Â Another way to express this data is that

Â the current value of companies 45, right?

Â If times are good, right?

Â If you are in a boom, your value is going to go up by 11%, okay?

Â So 50 is 11% higher than 45.

Â If you are in a downturn, your value is 30 instead of 45.

Â You went down from 45 to 30 so that is a loss of -33%, okay?

Â So gains, losses, right?

Â You have the percentages there.

Â Now let's think about what happens if there is a debt payment?

Â So suppose we have the same company, but the company now promised to pay the debt

Â payment of $15 million let's say, the unit here doesn't matter, right?

Â What will happen to the cash flow?

Â So now, you have to make the debt payment so your cash flow is not 50.

Â It's 50 minus 15 goes down to 35.

Â Again, in the debt stage, right?

Â In the downturn, your cash flow goes from 30 to 15, right?

Â If you redo the math, what you'll see is that the debt payment is

Â increasing the percentage gain, right?

Â So if you are levered company and you hit a boom, right?

Â You're going to have a higher percentage gain in your value.

Â But if you hit the doubter the percentage loss is also going to increase.

Â It's now -50% instead of -33%, okay?

Â So just putting all this number together, right?

Â If you have no debt, 0 debt, right?

Â Those cash flows go to the equity holders, right?

Â They make a gain of 11% a loss of -33, right?

Â If you have leverage, what happens is that the percentage gain increases.

Â But the percentage loss will also increase, okay?

Â So debt is increasing the fluctuations in the value of the company, right?

Â And if these are aggregate states, right?

Â So if this is really a boom in the whole economy or a downturn in the whole

Â economy, what this means is that debt is going to increase daily, okay?

Â 6:34

Bottom line is that debt,

Â an increase in leverage is going to increase systematic risk, right?

Â There are greater losses for shareholders in a downturn.

Â A company that is highly levered is going to amplify losses for

Â shareholders, if times turn bad.

Â So that increase the systematic risk, because systematic risk goes up,

Â shareholders are going to demand a higher return to hold equity net compliment,

Â right?

Â So now we can think again of a low debt, high debt situation that,

Â we're back to our classical example, right?

Â So just to repeat the point we've made, but

Â now I think with more confidence, we understand better what's going on, right?

Â Because that increase is systematic risk, the cost of equity will

Â go up and the cost of debt, the required return on debt, will also go up.

Â The end effect on the cost of capital is not clear, okay?

Â In fact, what Modigliani-Miller show which seem might a surprising result.

Â But it's true, it turns out to be directly correct at least,

Â is that in the some conditions the cost of capital does not depend on leverage, okay?

Â So under some conditions, which we're going to talk about,

Â the right equation is actually here.

Â You don't know exactly what will happen to the cost,

Â to the required return on debt and to the required return on equity.

Â But what we do know is that the cost of capital for

Â Pepsico is going to remain the same, okay?

Â The cost of capital stays at 5% no matter what Pepsico does to its leverage.

Â That is M&M's cost of capital equation, okay?

Â So what is the intuition, what is the condition under which result,

Â it is exactly the same example we started with, right?

Â Remember, we started this lecture trying to figure out what is the NPV,

Â what's the net present value of debt and equity issuance, right?

Â And it seems that a zero NPV would be reasonable, right?

Â The benefits and the cost compensate for each other, right?

Â And this is actually the same condition here, the condition is that and

Â equity have to be fairly priced.

Â If that and equity are fairly priced, then issuing that or

Â issuing equity generates the zero NPV.

Â If the NPV is zero, the cost of capital shouldn't change either, okay?

Â And the M&M result also relies on the absence of other friction such as

Â the ability to deduct interest payments from taxable

Â income which is something we're going to about soon, okay?

Â Of course, these conditions do not always hold, right?

Â However, M&M is an essential benchmarking corporate finance, right?

Â I mean we wouldn't have given a Nobel Price to a result that doesn't make sense.

Â This uses a very important benchmark, okay?

Â Let me tell you how I like to think about M&M.

Â The way I like to think about M&M is that M&M helps us avoid mechanical argument.

Â Mechanical argument, right?

Â Such as the argument that because that debt is cheaper,

Â issuing debt is going to reduce the cost of capital.

Â These are mechanical effect, what M&M really say is that there is no

Â mechanical effect of leverage on the cost of capital.

Â So if you want to figure out why debt or equity matter for our company,

Â we're going to have to do extra work.

Â It's not as easy as grabbing some

Â chocolate from that bag of M&Ms, right?

Â So these are M&Ms, that's why I used it here, right?

Â So we're going to have to do extra work to figure out why debt and

Â equity might matter for the company.

Â