We are after the cost of capital. Remember, we are orange at the back of our minds, similar company is Apple. You'd look for many companies that are similar because remember now we are going to deal with data, and more data you have is always better. So you'll look for other companies doing similar things, trying to produce iPhones or phones similar to iPhones and tablets and so on. Maybe Samsung is another company to think about. Then average numbers so that you get rid of the noise. But everything boils down to this. Measuring the risk of a comparable is the only way you'll have an idea of your risk. Who is a comparable is obviously a critical choice, it shows a deep understanding of your business, and that's what I mean, it's not just numbers, it's not just science. In fact, finance is scientific approach of studying human behavior, which may or may not be scientific. Determining the return that would compensate investors for their risk, so first is measuring that risk through a comparable, determining the return that compensates. For simplicity, assuming that there's only equity financing for now, and in our case, what did you see about Apple? No debt. Why? Because what that does is it allows us to directly run with the cost of equity as our cost of capital because there's no debt. What is risk? Remember our goal is to go and try to look at Apple and figure out risk and so on. Now we have to take a journey on what is risk. I'm going to start off with, again, something you already know and build on it. But then today, especially next few days, keep going back as I do statistics to the notes, to any book you love, Google statistics, do examples. I've given you a assessments and assignments, please stay on top of this. Today is a little bit intense in terms of non-finance work to do. Actually I don't think there's any such thing, everything has finance. But work to do on your own. What is risk? Why is a treasury bill riskless? Remember what is a treasury bill? A treasury bill is an instrument that IOU, that the government issues, and let's take a very simple case; zero, one year from now, and you'll get $1,000. You bought this here and there is no coupon and you're going to hold it till maturity. Why do you think this is riskless? Why do you think it's riskless? Because here's a fundamental part about life. Tomorrow is not known. Do you agree? Tomorrow is not known. Let's assume tomorrow could be good, normal, by that I mean average, or bad. Do you agree? What do I mean by that? Let's take it in an economic sense only. You couldn't care less about the $1,000 and be happy regardless. We are talking about good in the context of economics or what's happening in the real world in the context of your investment. Let me ask you this, quote, good. How many possible things could happen tomorrow in the broader context of things? Millions of possibilities, right? Let's keep them three. Let's assume for the time beings that there are probabilities associated with it, so there's a chance of good, there's a chance of normal, and there is a chance of bad. Does everybody recognize that there is a certain probability that a good things could happen tomorrow? Certain probability things could be same as normal, average. Certain probability, that thing. If these are the only three probabilities, how much would they add up to? Simples, we haven't even gone in statistics, they'll add up to one. You have to exhaust all possibilities when you're thinking of a scenario in the future, and we have made it simple, just three. Let me ask you this; does anyone have control over these things? Does anybody have control over these things? No. That can be a reflection of the fact that life just goes up and down. Maybe us collectively have some impact on it, but no single individual does. So I'll call these states of nature, and that's what we call them: states of nature. Please remember that these states of nature, these chances of things happening have very little to do with your control over them, but why is a treasury bill riskless? Because you believe this $1,000 will be on your doorstep whether the world is good, normal, or bad. Why do you believe that? Because you believe the government will pay you $1,000 regardless, so you see the perception? Everything is truly perception. You believe that the probabilities have been made irrelevant. In other words, what's the probability of this happening now? One, so you in your head have convinced yourself or we collectively which is even more powerful, we collectively believe the government will pay. So what is the risk of this? Nothing if you hold it till maturity. This is very important. Do you understand what I just did? I hope you did. Is that the world is going to change, but the 1,000 bucks is not, therefore it's riskless. Look how hypocritical are we. Our fear about risk is not usually the upside, it's the downside, so whenever things go down, we say, "Oh, things are bad." If things are going up, it's still changing, but they don't call it risk. Anyway that's just a side silly show. Let me ask you this. What about an identical bond issued by an average corporation? Now it turns out treasury bills which are zero-coupon bonds are not issued by corporations, they issue coupon bonds that's just a matter of detail. At this level, I want to ask you this: suppose this bond also promised one year from now $1,000, and today is zero. Same as this bond: 0, 1, 1,000. Let me ask you this. Do you think this bond is riskless? Average corporation. Chances are no, and chances are because you believe that good, normal, bad states of the world with the probabilities, good, normal, bad matter now. They matter. Why? Because if things go bad which could happen here if the economy is going bad or which could happen even if the world is good, but somehow your company gets into some kind of a roadblock. Not every company failed during the crisis. So it could happen for whatever reason that you do not get the 1,000, you get only 500 or you get zero, whatever. That is risk. So what have you done? You have this $1,000. In spite of the real-world being identical, this $1,000, you convinced the probability was one. Now what have you convinced yourself? There is the chances of getting $1,000 probabilities is less than one. There is some chance that you may not get the $1,000. This simple example tells you what risk is, and risk is fundamentally this. The world is changing tomorrow and my investment's value that I think I'll get in the future, whether it's cash flows or whether it's face value, whether it's coupons. Or more importantly, whether it's stocks because that's where value's [inaudible] will change depending on what the state of the world is. Not knowing the future drives us crazy, that's what creates our unease with not knowing and not knowing is what risk is all about. I hope everything is clear. What is the only thing I know today? One last comment. Suppose I knew $1,000 for sure a government bond, and let me say this was selling for 900. Government says going, going 1,000, going, going one year from now, how much will you pay? It became in an auction 900 bucks. Now, you ask yourself the question, suppose an average corporation issues then an identical bond, how much will you pay for it directionally? It has to be less than 900. The reason is why? Because that's how you take care of your risk aversion. Very important. You want a higher return from this second instrument. The way you get a higher return is not by waiting for the future and hoping you'll get more money. You can't, in this case, because $1,000 is the upper side. The way you do it is by paying less. What I want to do is introduce another concept, very simple, that there are two fundamental sources of risk. Remember, things could get better or worse in the future, except in the case of treasury bill, the amount you're going to get paid $1,000 future or now is identical. In the real world, things do change and what you get from your investment changes. But there are two fundamental sources of risk. One is macro, economy, systematic. These words, we use a lot in finance. Let me just quickly tell you what these are like. A big oil shock, would I call a macro event, why? Because it affects everything. There was a time when we weren't oil-dependent when a shock to oil we wouldn't have cared a lot, but now we do. What are specific shocks? Let's think about our company. Remember Orange we are trying to evaluate? Now, it's true that even Orange will be impacted by a big oil shock or economy-wide interest rates, government policy, and so on. But what is specific about things going up or down for the future of your phone? Something specific could be something totally technology-based. By technology here, I don't mean the Internet because Internet has now become a macro phenomena. I mean technology specific to your product, something specific. The most important specific source of risk is who? The management of the company. This is a very profound thing because the management of the company is by definition largely affecting the company, it's not effecting the economy. To think that you could change the world through your company is being a little too megalomaniac-like. To give you two simple phrases, some things that change your future economy-wide that you have very little control over, and some things that are more specific to you. Those are the two types of risks we'll talk about. But now, let's take a break. Now then when we come back, we'll get into statistics. But I just wanted to give you a backdrop of risk.
