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[SOUND] This is the calculation that

we've just done trying to figure out

what happens to the cost of capital for

Pepsico when leveraging is, right?

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

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

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

It's a simple algebraic equation, right?

That couldn't possibly be right.

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

And in fact it is, right?

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

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

also an illusion that you should avoid, okay?

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

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

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

Miller who are the winners of

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

There has been others since then, but Modigliani and

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

So we really love these guys, okay?

And the motivation for

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

They got tired of hearing the argument that

because debt is cheaper than equity, right?

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

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

And the reason, right?

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

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

The company becomes risky.

So the right equation for

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

The right equation is not what we had before.

The right equation is here, okay?

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

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

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

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

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

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

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

The reason why the risk is going up,

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

Is the idea of systematic risk, okay?

What happens is that the increasing debt is going to increase

the company's expose to systematic risk.

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

Debt increases beta.

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

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

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

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

Where we have a boom and a downturn, right?

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

The downturn happens with probability 0.25, okay?

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

30 in the downturn, right?

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

a lower profit of 30 in the downturn, right?

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

It's just a weighted average,

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

To calculate the expected value,

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

Another way to express this data is that

the current value of companies 45, right?

If times are good, right?

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

So 50 is 11% higher than 45.

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

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

So gains, losses, right?

You have the percentages there.

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

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

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

What will happen to the cash flow?

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

It's 50 minus 15 goes down to 35.

Again, in the debt stage, right?

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

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

increasing the percentage gain, right?

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

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

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

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

So just putting all this number together, right?

If you have no debt, 0 debt, right?

Those cash flows go to the equity holders, right?

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

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

But the percentage loss will also increase, okay?

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

And if these are aggregate states, right?

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

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

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Bottom line is that debt,

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

There are greater losses for shareholders in a downturn.

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

shareholders, if times turn bad.

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

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

right?

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

we're back to our classical example, right?

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

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

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

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

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

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

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

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

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

the right equation is actually here.

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

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

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

Pepsico is going to remain the same, okay?

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

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

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

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

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

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

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

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

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

equity have to be fairly priced.

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

issuing equity generates the zero NPV.

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

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

the ability to deduct interest payments from taxable

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

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

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

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

This uses a very important benchmark, okay?

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

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

Mechanical argument, right?

Such as the argument that because that debt is cheaper,

issuing debt is going to reduce the cost of capital.

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

mechanical effect of leverage on the cost of capital.

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

we're going to have to do extra work.

It's not as easy as grabbing some

chocolate from that bag of M&Ms, right?

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

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

equity might matter for the company.