JAMES P. WESTON: Hi. Welcome back to Finance for Non-Finance Professionals. This week, we're talking about the cost of capital. In this lesson, we're going to talk about the difference between different sources of capital. We're going to talk about debt capital versus equity capital and how the firm finances itself with those two different kinds. OK, so let's look at a very simple balance sheet where I've got a T account and on the left I've got a bunch of stuff, the assets of the firm, and then on the right I've got where that stuff comes from. It could come from debt financing or it could come from equity financing. And basically everything else in between, whether it's convertible preferred debt or convertible shares or some kind of preferred stock or common stock or all different kinds of capital, everything is really some combination of basic debt and basic equity. So we're going to base our talk really today just on basic debt and basic equity. And the idea here is that those two different sources of capital have very different risks. So if I think about discounting cash flows what that's going to be based on, in the past, in the first three weeks we really just used one discount rate, one R that we were smashing down on cash flows in order to take present values. And what we're going to have now are two sources of capital. And so there's going to be an R that's associated with debt capital and there's going to be an R that's associated with equity capital. And when we put those two together in combination we're going to have a weighted average of those two sources of capital. The return acquired to the debt holders are D, the return that's required by the equity holders are E, and when we put those two together that's going to form-- in our last lesson this week-- the weighted average cost of capital, or the firm's WACC. And that little balance sheet gives us sort of a roadmap for where we're headed this week. We're going to spend a bunch of time talking about the cost of equity, the cost of debt, and then putting those together in our assessment of the weighted average cost of capital. OK, so let's talk first about debt financing. Debt financing is in finance or economics what we call a non-contingent claim. It's not contingent on what happens to the firm. No matter what happens, you have to pay back your interest in principal. You can't say to the bondholders, well, we had a bad quarter so I'm going to skip this payment or else the bondholders are going to force you into bankruptcy. It's like missing a payment on your mortgage. You've got to pay that. It's a non-contingent claim. Doesn't matter what happened, whether you were profitable or unprofitable this month or this quarter. OK, you have to repay principal interest. Debt financing is usually collateralized in the sense that there's some asset that backs up. If you miss a debt payment, if you miss a mortgage payment, the bank can come and take your house. Your house is collateral on the loan. Debt financing also has what we call priority in bankruptcy. If the firm ever enters bankruptcy, there is sort of a hierarchy of who gets paid first. Who gets paid first are the senior debt holders. They have first claim in bankruptcy. Junior debt holders are below them, junior unsecured debt holders below them, then preferred stock, and at the very bottom common stock, equity. The way we sort of think about risk in terms of default and repayment in the existence of default is what we call the priority structure of claims in bankruptcy, and a lot of what we talk about in assessing risk for debt has to do with where you line up if things go real bad. OK. Of course, there's also a lot of monitoring and restrictions on debt. Those are called restrictive covenants. Debt contracts are often very thick with a lot of rules and regulations on what the firm can do and can't do. If you borrow money to buy a house, somewhere in that debt contract, if you read it carefully, is you have to actually use the money to buy the house. You cant take the money from the bank that you said you were going to buy a house with and go to Las Vegas and bet it in a casino. That's against the rules in the debt contract. So debt contracts often have a lot of rules, whereas equity contracts are always like, well, here's the money, give me a piece of ownership and good luck. Debt contracts have a lot of monitoring and restrictions on them, often. OK. Debt can take very, very-- lots of different forms in terms of its maturity structure, the way payments get structured with balloon payments or coupon payments. We're going to talk very simply about straight debt. OK. Where does debt financing come from? Most of it comes from banks. Most of it is straight loans or lines of credit, mortgages on commercial property, commercial industrial loans that go to support the building of machinery or shipyards or drilling rigs-- commercial industrial loans. Also, if I don't raise money from the bank, I can go to the public and raise money from individuals that want to give me money through bond issues. So, firms, those are the main two sources of debt capital that firms use. They either go to the bank and get a line of credit or a straight loan, mortgage, or they go to the public or private sets of investors and issue debt more broadly to a diversified set of investors through bond issues. OK. An important part of debt financing is that interest payments are made pretax. That's a nice thing. In a sense, the tax code, at least in the US, creates a tax shield for debt. That's an important cash flow, because really what that does means that if I'm paying 5% on my debt but I get to subtract it before I pay my taxes, levering up, taking lots of debt, can help me reduce my tax. And if you remember from the lessons in last week, taxes are real cash flow. So, in a sense, the US tax code subsidizes debt. Debt is cheaper than it ought to be in the absence of that tax shield. The fact that we can expense debt pre-tax creates a subsidy for debt. OK. That subsidy lowers the effective interest rate. Let's talk about equity financing. Equity financing is the ownership of the company, ownership and control. When you issue equity, you're issuing shares in the company, you're issuing ownership of the company. That's a contingent claim, meaning you get paid off when things go well and you don't get paid off if things don't go well. The equity holders get all the residual cash, everything that's left over. They get all the upside. Think about that. The equity holders, if the firm does extraordinarily well, you don't go and you don't pay the bank extra interest. You don't pay them back more than you owe. You only pay them back exactly what you said you would. All the gravy, all the residual, all that money on top trickles down to the equity holders at the bottom. But, of course, the equity holders are taking all the risk. They get wiped out in bankruptcy. OK, good. So let's talk about the difference between debt and equity. That mix of how much debt I use and how much equity is what we call the firm's capital structure. This is an important part to remember, that capital structure doesn't change the risk of the firm at all. This is something that is kind of awkward to think about. But if I lever up, if I take a lot of debt, if I really take on a lot, a lot, a lot of debt, people think that that makes the company riskier but, of course, it doesn't. All it really does is shift the risk. The firm is risky enough as it is. What the capital structure does is slice that risk up into different pieces. If I take on a whole lot of debt, that doesn't make the company riskier. What it makes is the equity riskier. So, really, the underlying capital structure doesn't change whether things are good or things are bad. If I'm running a fast food chain, if I'm running a McDonald's franchise, does taking on a whole bunch of risk make people want to buy my French fries? Does it make them not want to supersize their Cokes or their burgers? Of course not. It doesn't change the underlying business risk. But taking on a lot of debt does push the risk over to the equity holders. Capital structure doesn't change the risk of the firm. It changes how that risk of the firm gets sliced up among different investors. That's an important concept. Moves risk between investor classes. The debt gets none of the upside risk, but it gets protected on the downside through its collateralization. The equity gets all the upside but gets wiped out in the existence of bankruptcy. So what we're doing between debt and equity is taking all the outcomes of the firm that had sort of a distribution-- maybe the McDonald's franchise does really, really well, maybe it goes under and can't service its debt. What we're doing is slicing up all those different possibilities and selling those risks to different classes of investors. And the way that we sort of slice up the debt contracts and the equity contracts is what we call the firm's capital structure. And what we're going to do is think this week about how we slice up that risk and how we put discount rates on the different kinds of risk. OK. Equity has ownership and control. Debt is a safer bet than equity. It's got a lower cost of capital. And how we mix up those two is called the firm's capital structure. And what we're going to do for the rest of the week is try to figure out how that risk, how those different classes of risk, are related to the different returns that investors require for providing debt and equity financing.
