Welcome back again. In this lesson, we're going to better understand the required rate of return and how this can be optimized using debt. Returning to a conceptual model of this course in this lesson, we will look at the various financing and investment instruments. Companies issue these instruments to investors to raise capital to grow their business. Companies have the objective of minimizing their cost of capital, and they do so by optimizing their capital structure. capital structure refers to the mix of debt and equity instruments they issue.

Investors on the other hand, by the securities looking to maximize their returns, but in doing so, assume different levels of risk depending on the securities they invest in. There's an infinite world of investment and financing possibilities which all boil down to two and a half categories debt, equity and hybrid instruments, which is an instrument that has characteristics of both debt and equity, which I count as a half a category by my reckoning. These hybrid instruments also happen to be beyond the scope of this course. All of these investment options come in the form of what are called securities securities are little pieces of paper that entitle you to something as we discussed during the course introduction, debt always ranks before equity in a liquidation scenario. And for this reason, debt always carries less risk than the associated equity. lower risk comes with a lower return expectation.

However, don't walk away thinking that all debt is cheap financing. Risk is relative and can vary considerably. at the low end of the risk range, you have a debt security that may be well secured. Or backed directly or indirectly by various levels of government. at the high end of the range, you may have debt securities, which are unsecured and had no such guarantees. You may have heard of the colloquial term junk bond, which refers to a low grade debt security with a high risk of default.

For argument's sake, let's just put some ballpark numbers on the spectrum of returns one might expect from debt securities. at the low end The floor is set by government t bills, and at the high end, the rate of return might be 10% or more for unsecured loans. Debt securities pay interest to the investor. The interest paid divided by the investors cost base is called yield. While it's the investor who is the buyer of a debt security to hold it as an investment. The company is the seller or the issuer who is looking to raise cash.

Proceeds to reinvest into their business. Both parties get what they want, if all goes according to plan, let's talk about equity securities for a moment. And equity security entitles the holder to a residual interest in the business. If you've got a crappy business, this isn't a fun place to be, and there's a more than fair probability that you'll likely lose all of your investment. On the other hand, if you've invested in a fabulous business, the upside is all yours. This advantage compares to the biggest disadvantage of a debt security, which is that you can never make more than the interest promised.

There are various types of finance theories that attempt to mathematically devise the expectation of return for the shareholders. The theories only have limited application and vary widely in practice, but they all boil down to something along the lines of a risk free rate plus some equity risk premium. This equity risk premium can and does vary for dozens of reasons. So here I present you with the sort of spectrum of required rates of returns on equity for various sorts of business. at the low end, you have relatively safer types of businesses, such as those that aren't rate regulated like electric utilities and gas pipelines. As you move up the scale.

You have other large public companies, followed by private companies. Both may be established businesses, but by being both large and publicly traded, helps investors mitigate what is called liquidity risk, and that is the risk that they can't sell their investment position. And for this benefit, investors expect a lower required rate of return for the company who has their shares freely traded. As you get further to the right of the spectrum, you start getting into businesses that are smaller And perhaps in startup or trying to develop a business in a new market, as the risk of failure is significantly higher, so to is the required rate of return. If you plot this spectrum on a chart, it gives you another perspective of how the required rate of return impacts value of any investment security. Small rates of return create much higher valuations then large rates of return, the value of a $10 cash flow stream at 10% is $100, where the same cash flow stream valued at 40% is just $25.

Secondly, the smaller the discount rate the more sensitive it is to any change. In this chart, I have varied the rate of return by just 1% one way or another at the 10% cost at Equity level, you see that this made a huge difference in value almost $10 one way or the other. Whereas at the 40% rate of return, the difference in value was only $1. The dilemma often confronting investors and companies alike is that the rates of return aren't high enough to meet expectations. The solution to this dilemma is to just add debt. Wait a minute, isn't debt bad?

Why is this a solution? debt isn't bad in the finance world. debt is a tool of arbitrage. That is to say by replacing or supplementing more expensive equity with lower cost debt, you can increase the return generated on the equity investment. The reasoning comes back to the fact that equity is always more expensive than debt by using other people's money, not the share. holders and generating a return that exceeds the interest cost.

That excess return all gets added to the shareholders return without having them invest any more money. So your next question might be if that's so damn good, let's just add more. There are limits imposed by lenders and other limits that are imposed by financial theory, which I think are integral to understanding this concept of financial leverage. financial leverage is the degree to which your operations are financed with debt. Let's plot this along the x axis at zero percent. You're entirely financed with equity at 100%.

You're entirely financed with debt. on the y axis, let's put the cost of capital. These are the rates of return we just discussed for debt and equity instruments. Now we need to plot two curves that represent the cost of equity and the cost of debt at different levels of financial leverage, the cost of equity is generally an upward sloping curve because as the degree of financial leverage increases, the risk of default on debt increases, and the equity investors will be more sensitive to the risk and then demand a higher rate of return. Let's look at the cost of debt. curb debt is generally a cheaper source of financing when the company has strong security to offer.

So as we replace equity with debt or add debt incrementally into our capital structure, the cost of debt stays constant until the company runs out of good assets to provide as collateral, then debt starts getting expensive and quickly because it's largely unsecured at that point. When we plot a composite of these two curves, we create a curve that calculates the weighted average cost of capital or whack. This is a U shaped curve at 100% equity your whack is this Same as your cost of equity, as cheap debt replaces expensive equity. This is a downward sloping curve. As debt gets increasingly more expensive though, the curve turns and becomes upward sloping. The lowest point on the curve represents the optimal capital structure for a firm set another way it represents the ideal amount of debt that a firm should incorporate into its mix of financing instruments.

Whack is an important calculation in both theory and practice, because it represents the true discount factor that should be applied when you're doing present value analysis. So previously, when we left Bob, we recognized that he needed a 15% return on his money to achieve his $1 million investment goal. Let's say however, that the best he's able to do with his risk return appetite is identify an opportunity that is expected to yield a 9% return over the next five years. Let's cash flow this out and look at the future value. Sadly, and not unexpectedly, this is not enough. But what if Bob was able to leverage this investment using some debt?

Let's say that the bank has offered him to to one leverage, which is probably more than most banks would offer him today. But when you consider that banks themselves operate at 10 to one leverage, then it's not exactly stretching the concept. The downside of high financial leverage is that any losses get magnified by the same degree of leverage as we see profits getting magnified. So let's build a model for this two to one leverage. In other words, the bank has now given us a million dollars at a cost of 4% to invest alongside our own $500,000 with the expectation that we're going to repay the million dollar loan at the end of five years. Our investment opportunity still yields 9%.

But because our investment has tripled in size, so has our income. However, not all that income attributes to us because we need to pay the bank on the loan at 4% that spread between the 9% return and the 4%. Interest accrues or attributes to the investor as the holder of the residual interest. Lo and behold, we have a pool of funds of $1,068,548 at the end of year five after repaying the bank loan Mission accomplished. In fact, using ratio analysis, we can now prove the effect leverage had on our returns by calculating return on equity, which is calculated as our net income divided by our shareholders equity. As you can see the ROI in the first year is 19% 17% and So on down the line, here's a question to test your understanding.

Why is the return on equity decreasing? The answer is because the capital structure is slowly getting thicker with equity, while the balance of debt remains the same. In other words, the firm is de leveraging even though it's not paying back any of the debt until the end of year five. In this lesson, we learned about the tools of investing and financing which are just opposites of one another depending on your perspective as either an investor or an issuer. investors buy securities issued by companies to give them financing for their business. You need to keep in mind that first equity of a firm is always going to be more expensive than its debt because it has greater risks.

Each debt and equity instrument has their own required rate of return based on video. Various underlying characteristics of the instrument and of the issuer. Secondly, we talked about capital structure, and how the introduction of debt can reduce the cost of capital, which is also the discount factor we use in present value analysis. And finally, we talked about financial leverage and how it can be used to augment our return on equity. Keep in mind, however, that in the same way returns get magnified losses well as well. Setting capital structure is an imprecise science at best, and many entrepreneurs will weigh the decision by asking themselves do I feel better sleeping at night with a pillow of equity, or the double edged sword of leverage?

It boils down to an individually determined level of risk tolerance. That's all for this lesson. So until next time, I'm Blair cook.