So, we've spent a lot of time today, I think on both concept and application. And I hope that you are able to pick problems on your own other that the assignment. Go just use the map to try to do these evaluations on your own. Pick a new interesting problem to evaluate and you basically, if you understood the example, you can do a lot of stuff on your own. Okay, so one lesson I want to take from what we have achieved, which is very important, when we compare things, projects, new ideas and so on, the risk of what is very important, so we get caught up in risk of the firm versus risk of the project. And then problem lesson here is that a lot of firms use their own cost of capital to evaluate new projects, so let me give you an example. I'll take an extreme example to make a point. I'll use the example of General Electric in this context. So think of General Electric, what's the difference fundamental between General Electric, and say, Microsoft, Apple, Oracle, Walmart? And in Walmart, what is the fundamental difference? The fundamental difference is Jack Welch was the jack of all trades, which is not a good idea typically. It's not a good idea to do different businesses under the same company because it violates one of the few lessons of economics that you can probably do much better if you specialize. However, I believe specialization also has its issues but we're not going to get into that right now. So what if GE were to say this, we are going to use own cost of capital, like the video game cost of capital, evaluate all project. And by the way this is done by a lot of folks. And I think this is really scary and dangerous. So let me explain to you. Let me just draw a graph and show you GE. So here's a return. Zero return, zero risk and here are returns and here is risk, beta. Would you agree with me that the relationship between risk and return is parted? This relationship was called capitalistic pricing model, but let's forget about that for a second and let's ask the following question. High risk, high return, almost everybody nod, yes, has to be the case. Let's assume that on average, GE's beta is 1, why? Because it covers just about every product under the sun. ITs in class they probably produce underwears, too, but they don't want to have a label saying GE's underwear. So anyway, for whatever it's worth, and what is the return here commensurate? The market return, so you can plot this one point, the return on the market and beta is 1. What is this point? Rf, why? Because the beta is zero, you're talking about the risk free rate, okay? And what I'm going to do, just for simplicity, I'm going to borrow from the previous example. Actually, let me just use round numbers so that we are all okay. Suppose this is 10% and suppose this is 5%, okay just for simplicity. So 10% is the return on average, return on the market, but it's also the average return on GE. So let's for simplicity assume no debt, so that you're not confused about return on asset was a return on market. So this is the return on assets, market return for GE. Again, why would it be approximately market return? Because let's assume GE does everything in the same proportions as the market. Now the quick question, suppose GE were to use this 10% to evaluate all new projects, quick question. A project walks in with a beta of 1, right? A project walks in with a beta of 1, and let's call that project beta B. Is this the right return to use? So the project has a beta of 1, project B, and your return is 10% because your beta is 1. Answer's yes. So 10% is right to use for any project whose beta is equal to GE's average beta, which is 1. But obviously not all GE projects are exactly 1 beta because then GE wouldn't be GE. It wouldn't be a conglomerate. Do you agree that some projects are here? In some projects I hear, yeah? Look at what will happen if GE starts using 10%. Let me ask you this, what should be the cost of capital for this? So let's assume that this beta is equal to close to 0.5 and this beta is 2, right? One is a low risk project. One is a high risk project. So for the low risk project, what should you be using? A very low rate of return, hurdle rate. But instead, what are you using? 10%. So all projects with IRR between this range, all these projects, are positive NPV, why? Because their return is beating what the competition suggests, low risk. But you're using what? High hurdle rate. You'll kill all these projects. And instead you call this value destruction. Why, because if you have a high hurdle rate, which is the average of your everything, really low risk projects that are value enhancing ones, we'll get killed. Go to the other extreme. What will happen about this project? The discount rate here should be greater than 10% clearly, because the beta is 2. Remember, 10% is the return on the market beta 1. If the beta is 2, the return should be substantially higher benchmark. But what benchmark are you using? 10%, so all these projects with IRR in between are actually value destruction again. So what do you end up doing? If you use one hurdle rate, i.e., risk of what, if you use risk of your total firm to evaluate every new project walking in what do you do? You chase high risky businesses, high risk businesses, which may actually be value destroyed. So you lose track of the fundamental lesson we learned today. Risk and return always go hand in hand. When you break that connection you end up making really bad mistakes. Why doesn't the world know about this? Because in spite of all the availability of information firms are now managed by managers. They're closed boxes. They're held by investors all over the world. And you really don't realize what's happening until the world figures out that's been going on and stock price starts going down, the newest examples of value destructive activities of firms. And one of the reflections of this is this. If you use one hurdle rate to valuate all projects, you probably are going to make a lot of bad mistakes. So I just wanted you to understand this that risk goes with return. Risk goes with return. You cannot compare going to our own example. You cannot compare video gaming with software. If you do that, it's apples versus oranges, makes no sense whatsoever. So if you use your company's hurdle rate for every new project, you are violating that every time. It's not going to help you. So hope this makes sense, think about it. I'm going to wrap up things with a little bit more additional information because to be honest with you, this class ends here technically. But I want to leave you one thought about the real world financing issues. Two reasons why capital structure may actually affect firm value in the real world. Remember what have you done till now? We have realized that financing is irrelevant to value creation. But there's something about the real world, which by they way textbooks are written about. So if I took out this real world angle, finance textbooks would fall in less than half. So there's a whole business created by tax laws of the government. And textbooks become thicker and thicker because of it. So let me tell you one. First is that there is a tax benefit given to debt that is not given to equity at the corporate level. So I'll show you what that means. What that means is if we take debt, you get a tax break on the interest you pay, so your government gives you some return back if you borrow that encourages borrowing. However, that as you borrow more, there are some costs of borrowing, and we as a society are seeing what has happened in the last five years. And that cost of borrowing can show up as financial distress, perverse incentives, and so on when borrowing is very high. One thing you'll see, and which I wanted to emphasize is, remember if you stare at this equation and I let it stay there, what has happened? The weighted average cost of capital has a new term in there because of the tax law I just said. This, this is what? If the tax rate is Tc, say the corporate tax rate is 35% and suppose the data rate is 10%, you're paying your debt holders. You're actually not paying 10%. How much are you paying? 6.5%, if tax rate is 35%. Why, because the government has chosen to let you deduct the interest as an expense from your accounts. Because of this what happens, that becomes attractive. This is artificial guys, this is not what nature said. Nature never distinguished it between inequity. It didn't say let debt have a subsidy, no. So what does this do? This encourages you to take on some debt. Same is true of house financing, right? So when you buy a house and you take on debt, what happens? The interest you pay on the debt is tax deductible, right? It encourages you to take debt. However, what I want to go on and talk about is if this is the case, if debt is very attractive, why don't everybody have only debt in financing things? So the tax-deductibility of interest should push debt towards 100%. However, firms do not borrow even close to 100%. As I said earlier, there may be some industries at 50, 60% leverage as a total value of the company. Many firms don't borrow at all and so on. So why is it that firms don't have a lot of debt, given debt gets this favorite child treatment? Personal taxes actually may favor equity. So, personal taxes may favor equity. So taxes, when you think about, you shouldn't just think about just the personal level. Second reason is, backing on debt can be extremely costly if there is default and more the debt, the more the chances of default. Again, society is facing costs of this now. What I don't like the way finance treats debt is that it focuses too much on the tax-deductibility part and not on possible costs of debt. And therefore I'm at the point where it's almost I believe that debt and equity are relevant again, because though we emphasize the tax deductibility cost of debt, bankruptcy cost and other costs are extremely important, which may happen rarely. But recent times have shown us that when they happen, they can be pretty severe, okay? So having said that what I want to do is I just want to wrap up today and say it was nice to cover the whole class. It was nice to be able to talk about an example right at the end, which put everything together. And I sincerely hope that you take the time, in this week, to revisit this video, to do the example in detail and to do the assignments. I promise you that next week will not be content-driven. I will talk about the main key learnings of this class that you need to equip yourself with and keep going back to, why finances are awesome. I'll also give you some hints about how to think about other resources, classes that you need to do to make your financial knowledge even better. And I will also give you time to do prepare for the final. For the next week you will not have a ten-question heartbreaking, sweating, work to do but to prepare for the final. See you next week and may the force be with you.
