Corporate Finance II: Financing Investments and

Managing Risk
Heitor Almeida

Coursera link: https://www.coursera.org/learn/corporate-finance-two/

Module 1

Module 1: Raising Financing: The Capital Structure Decision

Lesson 1-1 Objectives and Overview

[SOUND] So let's start talk about how companies finance investments. Corporate Finance 1 was
about spending cash, we talked about topics such as the net present value, the internal rates of
return, cost of capital. What we're going to do in this course is, we're going to talk about how
companies raise cash to finance the spending. Issues like debt financing, equity financing, risk
management, so this is going to be the topics we're going to talk about.

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After all, cash doesn't grow on trees, so it's very important to think about how companies raise
the cash there that is going to fund their activities.

Which investments are we thinking about? We're going to focus mostly on financing new
investments, such as research and development, R&D, and mergers and acquisitions, M&A. We

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actually have a couple examples in Module 4, where we're going to do some case studies
focussed on R&D and M&A. But it's important to notice upfront that companies also need to
raise capital for other activities. For example, refinancing existing debt, you may want to
refinance your debt to lower interest rates, for example. Debt forces companies to go to capital
markets. You might even have to raise capital to make payments to suppliers in some cases. All
right, or you might simply want to reoptimize your capital structure. Maybe you think you don't
have enough debt, you want to increase your leverage, or you want to reduce your leverage.
Debt, again, is going to force companies to go to capital markets and raise some finance.

In this module, Module 1, our initial step is going to be to think about the most basic decision
that companies have to make. Which is to think about whether companies are going to raise
capital by issuing debt, right, to get a loan from a bank, or to issue a bond in public markets, or
whether companies are going to issue equity.

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Companies are going to raise capital by giving ownership to investors and raise capital from
investors. Debt or equity, that's going to be the key topic of Module 1. What we'll learn first is
we're going to talk about how debt and equity financing affect the financial statements that we
were talking in Corporate Finance I.

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Right, so we're going to learn how debt and equity financing change income, cash flow
statements, how they change companies' profits. We're going to compute the net present value
of both debt and equity issuance. Remember that net present value is the key tool that we have
to analyze corporate decisions. We can also use NPV to think about that inequity. And then
we're going to talk about true mistakes that practitioners make, that students make, when they
are thinking about capital structure. The first one is that dilution is an illusion. There is no such
thing as dilution. The number of shares outstanding actually does not matter. We're going to
talk about that. And then we're going to talk about why that issuance is not mechanically going
to reduce the cost of capital. Our math, in this case, the math is actually misleading. Usually,
math is right, but math can also get, mathematics that I'm talking about, mathematics can also
get you to the wrong place. And here you are going to see that doing a simple calculation can
actually give you the wrong answer.

Then we're going to talk about the key relationship between debt and systematic risk, right?
The idea is that debt is going to increase a company's data, which is behind the logic in a key
result in Corporate Finance, which is the Modigliani and Miller proposition. The Modigliani and
Miller proposition is going to show you why issuing that will not necessarily reduce the cost of
capital. Then we're going to move on and talk about research. As I mentioned in the
introduction of this course, this course is going to draw a lot on the research that we
researchers have done about capital structure and other topics in the last few years. The first
issue you're going to learn is that equity issuance stands to cause a decrease in stock prices. I'm

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going to show you some data that shows this. Perhaps because of this effect of equity issuance
on stock prices, companies are reluctant to issue equity to finance projects.

Then we're going to talk about how that affects profits, and one of the key effects is going to be
through taxes. We're going to calculate the effect of leverage on taxes and how leverage affects
our ultimate measure of profitability, which is OPAT, operating profit after taxes. And then
we're going to talk about other effects that might mitigate disadvantage of that, like personal
taxes and cost of financial distress, right? Costs of financial distress are going to increase with
leverage because leverage increases distress risk.

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And ultimately, what we're going to end up with is a model that we call the tradeoff theory of
capital structure, which balances the costs and benefits of having higher leverage. And I'm
going to show you this model, talk about some data, some recent research about the trade-off
model. And then what we're going to do following up, in future models of this course, is to try
to use the trade-off theory to analyze firms' capital structure choices in the real world [SOUND]

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Lesson 1-2 Issuing Debt and Equity – The Mechanics

[MUSIC] So we are starting with this example from a corporate finance one, this example was in
module two when we talked about financial planning. I think it's simple enough that you can
understand this even if you haven't looked at that example, but if you have any questions or if
there's anything you want to check. The example is the module two of corporate finance one,
okay. And what the example is about it's a financial planning model for PepsiCo. Under the
assumption that PepsiCo wants to invest $3.5 billion in 2015. And $64.5 billion in 2016.
Assuming we are in the December 2014. And the question that we asked was whether PepsiCo
could finance this expansion without issuing new finances, right? Which is the key topic we're
going to talk about in this lesson is, how is PepsiCo going to get these new findings but
previously, what we done, so here you have our planning model, right.

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So you have the capital expenditures 6.5 billion in 2016 that's the big one. And then what we
did in this financial planning model was to think about whether PepsiCo could finance it using
only their own capital,. So can PepsiCo finance this out of it's own cash flow and cash balances,
right. So the way we did this is we forecasted cash flow from operations using a simple
forecasting model, right? We included the capital expenditures under the assumption that
there is no new financing in the next few years. So you can see that it's all zeros here in 2015
and 2016. The answer we got is that PepsiCo would have a negative change in cash of about 2.7
billion dollars by 2016.

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So the answer right is that, if PepsiCo does not want to reduce it's cash holding, right. Assuming
that the company has a target amount of cash holding that it wants to keep for example, right.
Then PepsiCo would need to raise new funds, right. Because of this expansion plans the
company would need to raise some money, right? Some new funds, let's say that the amount
that PepsiCo will raise is $5 billion. We talked about this in module one as well. It might make
sense for a company to raise a little bit more than what it needs, right? So that it has a little bit
of a financial cushion, okay? Again, we talked about this in module two of corporate finance
month, right. So this is the new question we are talking about now. We are going to think about
this very important choice that companies have to make when deciding how to raise new
financing, okay. Which is whether you are going to go to the debt markets or whether you're
going to issue equity, all right? So that's the major topic of this module, of this session, and
we're going to start with this example. The first thing we're going to do is to talk about
mechanics, okay? So we have the financial statements ready. We have our financial planning
model ready.

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So what I want to do with you, and I think it's a very useful exercise. Is to look at the financial
statements and figure out what will happen after PepsiCo issue debt in equity, okay. Let's start
with debt. Suppose that PepsiCo issues $5 billion in new debt, okay. And suppose that the
interest rate is 4%. I doesn't have to be exactly that, but let's say that those are the numbers,
right. That means that PepsiCo will pay new interest of $2 million per year, right. So how will
that affect the financial statements?

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You can check, this is the old financial statement, it has the interest expense here, right. That's
the item, okay. The new income statement is going to have an increased the amount of interest
expense. Right, so you have 200 million additional interest expense. So I have it here in bold.

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PepsiCo will have to pay additional interest, because you financed the new investment using
that. Right, so the interest expenses here. The interest expenses of course going to reduce your
earnings, right. So you pay interest, your earnings, your net income is going to go down. You
can check that. All right. In terms of the cash flow statement, right. So your earnings are lower,
it's in bold. That's the top of the cash flow statement, right.

And then we can just derive the other items of the cash flow statement, right. We're going to
lower the cash flow from operations as well, right. We have the capital expenditures, but this is
the key thing, right. Because PepsiCo borrowed $5 billion in the year of 2015. Let’s say that
PepsiCo did this right at the beginning of 2015, when you get to the balance sheet at the end of
2015, the balance sheet and in the cash flow statement we will also reflect that $5 billion, okay?
So the PepsiCo has net borrowing, a positive net borrowing of $5 billion, right? Which means
that now you're going to have a positive cash flow from financing and if you recalculate the
numbers, what will happen is that now we have a positive change in cash. They're right at the
bottom. They're either positive changing cash of $5.1 billion in 2015, so that will be more than
enough to compensate for the negative, right. The number is there. The negative changing cash
in 2016, so now PepsiCo could definitely have enough funding, right?

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So that was that. Let's talk about equity, okay? Issuing equity, of course means going to the
market and selling new shares, at least for a public company, right. Where the public company
would do, is to sell new shares of the company in the marketplace. The current stock price of
PepsiCo at the time that we did the financial planning. Although it's not necessarily when you
are watching this lecture but at that time. PepsiCo stock was trading at $94 a share. So what
that means is that if PepsiCo wants to get $5 billion dollars in new equity. It will have to issue
[COUGH] 53.191 million share. Okay, so you can do the math there quite straightforward. Just
dividing five billion by $94 of a share, okay? So what changes? Now there is no new interest
experience, right?

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So the income statement if you think about it. The income statement is going to be exactly the
same, you're operating income, by definition doesn't depend on financial cash flow, right? Your
interest is not changing. That means that your earnings is going to be the same. There is no
change in your earnings, right? Cash flow statement. So instead of the borrowing, right? So we
have $5 billion for net borrowing here. Now we're going to have $5 billion for the net issuance
of stock. That means that PepsiCo is going to the market to raise new equity, right?

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And that's reflected in the cash flow statement. Right again, when you to the bottom of the
casual statement, what we'll see is that, now PepsiCo is going to have a positive changing cash.
So definitely the company have enough funding, right? To finance this, the expansion plan, right?
But now think about the following but there is a little trick here. We saw the income statement,
the casual statement, it all seems good, right?

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Now PepsiCo has a higher changing cash now, so you have enough cash to finance the new
investment, right. Your profits haven't changed, right. So you might be wondering at the point
what is the cost of issuing new equity? So I want to give you a little bit of time to think about
that. What's the cost of issuing new equity? The cost of issuing new equity is that the number
of shares outstanding is going to go up, right.

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So as we figure out and we're doing these calculations, PepsiCo is going to have to increase the
number of shares outstanding by 53.19 million, right. So the company has more shares
outstanding. What that means is that, the profits that people produce they haven't changed it,
right. But they are going to have to be divided among a larger number of shares, right. Issuing
equity is the same thing as bringing new owners, right. To own the same company, right. So if
you bring new owners and the company hasn't changed it then the old owners. The people who
already owned Pepsico and shares are going to own a smaller size, a smaller fraction of the pie,
right? So the cost of issuing equity is that you are issuing new shares, in this case, right? And
you might be thinking about dividends.

I'm sure that some of you thought, the cost of issuing equity is that we're going to increase,
somehow we're going to have to increase dividends, right? That would be the counterpart to of
that, you issue that you pay interest. You issue equity you exchange dividends, right? You
should look at all financial planning model we actually assume that total dividends were
constant. Dividends were not changing at all, right. And if you think about this it actually makes
sense. Paying dividends is a choice of the company. It's another choice, right? In principle it's
unrelated to the choice of issuing equity, right. And if you think about the fact that PepsiCo
wants to bring new money into the company. Maybe it doesn't make sense for PepsiCo to
increase dividends at the same time, right? So if PepsiCo had increased dividends, then it did
this would consume part of the new funds that PepsiCo brought in from the equity market. So
maybe it wouldn't make sense for PepsiCo to increase dividends at that point. In fact, it's a

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topic of it's own, right? In Module 2 of Corporate Finance 2, right? We're going to spend a lot of
time talking about payout policy, right? So it's exactly the decision of how much dividends to
pay. And then we're going to have more to say about that. [SOUND]

Lesson 1-3 Should a Company Issue Debt or Equity?

So, we have gone through the financial statements, right, and you learned the mechanics of
debt and equity, right? So, how would the debt issuance change the financial statement? How
would an equity issuance change the financial statement? What's the benefit? What's the cost
between debt and equity, right? But we still have to make the decision. Is the company right?
Which choice, steps you're going to make, steps you're going to issue that, or steps you're going
to issue equity right? And in Corporate Finance I, we actually learned a tool that is the right tool
to guide managers when managers are making financial decisions like that, right? Which is the
Net present value, right? So, essentially, what companies would do is to take investments that
have positive Net present value, right? If you applied the Net present value idea to the
financing decision, we are talking about now, the answer would be that the company is going to
issue debt when the NPV of issuing debt is greater than the NPV of issuing equity, right? Let's
try to apply that idea and see how far we get.

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We're not going to get the answer from here and just telling you upfront, but I think it's going
to be useful, very important for us to think about this culturally, okay? Let's start with debt, all
right? We already figured out that there is a benefit and a cost, right? The cost, of course, is
that you're going to pay interest. The interest is $200 million per year, right? The benefit is that
you're going to get a $5 million e flow of capital, right? So, the 4% interest payment, right, is
also the yield to maturity of this bond, right? That's another concept we talked about in
Corporate Finance I that might be used to recap here, right? It's also the yield to maturity or the
expected return on this bond, right? So, what this means is that it would be very reasonable, it's
actually theoretically correct, to discount. If we're figuring out the NPV of the debt issuance, the
correct discount rate to use would also be 4%. We would be discounting the interest payments
exactly at the 4% rate. So, the NPV would the positive five there at the beginning. Right, you
have the money coming in the company, and in the future years, the interest payments go out,
minus 0.2 every year with discount for five years. If you do the math, the answer you'll get is
that the NPV is going to be zero, right?

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Does that make sense to you or not? Let's talk about it. Okay, think about what we've done,
right? The idea here is that if the debt is fairly priced, right?

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Meaning that if the interest rate is the same as the discount rate, so if PepsiCo is paying interest,
exactly at the required rate of return, right? Then what's going to happen, this is what the math
is reflecting, what's going to happen is that the cost of issuing new debt, which is this $200
million annual interest, is going to exactly compensate for the benefits, right? So, the benefits
are exactly the same as the present value of the cost, right? That's why we have a zero NPV,
right? And of course, what's going on here is that we are relying on the assumption of efficient
markets, which again, is something we talked about a lot in Corporate Finance I, right? So, we
are relying on the assumption that the debt is going to be fairly priced by the marketplace, that
PepsiCo is issuing debt exactly at the required rate of return. Right, if the debt, for some reason,
is not fairly priced, then obviously the NPV would not be zero. So, if PepsiCo can issue debt at a
cheaper rate, for example, then it might be positive NPV to issue debt. But if you think about it,
why would that be the case? If the debt issuance, it should be correctly priced by the market.
The zero NPV is actually a very reasonable answer to this problem. What about equity, right?
We covered debt. What about equity? Now we have $5 billion of cash coming in, and we have
the new shares being issued, right?

I put a couple more numbers there that we're going to need. The first is the current market
value of equity, right, and the second one is the number of shares outstanding. We're going to
need those numbers. Right, and the question is what is the NPV of equity issuance? This is a
little bit trickier, right, because as we already figured out, we don't really have the counterpart
of the interest payments. The cost of issuing equity is that the number of shares is going up,
right? So here, what we're going to use is we're going to think in terms of stock prices, right?

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Remember that maximizing the net present value is exactly the same thing as maximizing the
stock price. This is another idea we covered in Corporate Finance I the equivalent between net
present value and stock price. So, NPV and stock price are the same thing, and we can actually
think in terms of stock prices here. Let me show you, right, we have the old stock price, which
I'm expressing as the market capitalization divided by the number of shares, $94. With 138
billion divided by 1.468 billion shares, right? And then what's going to happen? If PepsiCo issues
new shares, right, PepsiCo is going to get $5 billion in cash. Right, the cash is going to come in,
right? Who owns the cash, the cash is going to be owned by the shareholders. Right, so the cash
that PepsiCo gets is going to increase the company's market capitalization, right? And then
what I've done, so that's the numerator, what I've done in the denominator, you can see there
is to add the number of new shares, right? So, PepsiCo receives cash, but the counterpart is
that their new shares being issued, right? If you do the math, what you get is that the stock
price is $94 a share, okay? Okay, so the stock price hasn't changed.

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Again, the answer then is since the stock price hasn't changed, what this means is that the NPV
of the equity insurance, again, is 0. And it's exactly the same idea, right, that made the NPV of
debt equal to 0. The idea is that, the new cash that comes into the company exactly
compensates for the issuance of new shares. So, the stock price remains constant, and again,
this notion relies on the assumption of efficient market, or at least on the assumption that the
equity is fairly priced. Of course, if Pepsi Cola manages to sell shares at a higher price than what
the shares should be worth, of course, that's going to be a good deal. If you're selling a product,
you want to sell at a high price. Right, if you sell the product at a low price, you can think of the
equity of the product, then PepsiCo is going to make money. But if you sell just at the right price,
you know the NPV is zero. You don't lose money, you don't make money. At this point, you may
be wondering.

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So, PepsiCo is raising cash to finance this new investment. That was our original assumption,
and you might be an hour complaining in your mind or your mind might be complaining with
you that we're not talking about the NPV of the new investment at all, right? We're just talking
about interest payment, shares, cash coming in, where is the net present value of the new
investment? That, of course, has to matter, right? So, think about that question for a while.

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The answer is that the NPV of the new investment is not incremento. Right, again, that's
another concept that we talked about in Corporate Finance I, is the idea that cash flows, that
matter for the NPV are the incremental cash flow. The only cash flow that matters is a cash flow
that changes, like what happens in the company. So, when you think about that in equity, right,
the NPV of that was zero, right, when you think about Interest payment and cash coming in.
And then there is the NPV of investment, right, because the company is going to invest its
money, and hopefully make a positive NPV. What is PepsiCo going to do with equity? The same
thing, right? So, if you issue equity, you're going to take the $5 billion and invest in the company.
So, the NPV of investment is the same, irrespective of whether you're issuing debt or equity,
right? So, it's not incremental. The NPV of the investment will not affect the decision of
whether PepsiCo is going to issue debt, or whether PepsiCo is going to issue equity. In fact, it's
safe for us to completely ignore what companies are going to do with the money. We just have
to think about the immediate consequences of issuing new securities. That's a very useful idea
that we're going to follow up later.

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Lesson 1-4 Two Misconceptions

We have made some progress, right? Now we know how debt and equity issuance affect the
financial statement. We covered this zero MPV idea, right? But we haven't answered our
question yet, right? Should PepsiCo issue debt or should PepsiCo issue equity? So far, if both
have zero MPV, then maybe it doesn't matter, right? We are going to have more to say about
that, of course. But before we do that, I want to talk about two misconceptions. So there are
two ways that people think about the debt and equity decision that actually turn out to be
incorrect. And it's as important to learn what's wrong, right, than to learn what is right. So the
goal of this lecture here is to tell you about these two misconceptions that I think are very
important for you to understand. The first one is this notion of dilution, okay? It's a very
common argument, we see that all the time, okay?

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And it always drives me mad because it's wrong, okay? It's the idea that issuing new equity
reduces the stock price because the number of shares outstanding go up, right? So the dilution
story goes as follows, right? That's why I put it in quotation marks, it's not what I'm saying. It's
what I hear other people say, is that issuing new equity reduces the stock price because of
dilution. The number of shares outstanding goes up. And thus the stock price must come down,
right? Why is this wrong? We've already done the math to show why this is wrong. Yes, it's true,
issuing equity increases the number of shares.

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But the company is receiving cash in exchange for that, right? There is cash coming in, the cash
is going to increase the market value of equity, right? The stock price is a ratio of the market
value of equity and the number of shares outstanding. The numerator goes up, the
denominator goes up. In fact, in our example, nothing happened. The stock price remained
constant, right? There is, in fact, no dilution if the equity's sold at a fair price. That's what we
showed in our numerical example. The market value of equity exactly compensates for the
increase in the number of shares outstanding. So the stock price remains constant, the stock
price does not go down, okay?

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So I like to really stress this point because it's something that I want all my students to
remember from this capital structure class, right? Which is the notion that dilution is an illusion,
okay? Dilution is an illusion, okay? Only in the proper English, okay? So dilution is an illusion.
Repeat that with me, repeat for you until you, remember that, okay? That's a very important
thing to remember because this argument is so common and it's so wrong, okay?

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The second argument is a little bit more complicated. This is going to take us a little bit more
effort to understand. The reason why dilution is wrong, I think it's pretty straight forward, but
this one is a bit more complex, okay? And it has to do with the cost of capital. Again, drawing
from Corporate Finance I, one thing we did in Corporate Finance I was to compute the weighted
average cost of capital for Pepsico. So the weighted average cost of capital is the weighted
average of the cost of debt, the required return on debt and the required return on equity. The
numbers are here. The required return on debt was estimated at 4%, right, 4.2%. And then you
multiply it by 1- the tax rate. And you multiply all of that by the 19%, is the existing leverage
ratio. So it's the amount of debt that Pepsico has divided by the value of the company. And
then the other component of the weighted average cost of capital is the required return on
equity. What is the required return that shareholders require when they invest in Pepsico's
equity, okay? And that turned out to be 5.5%. We estimated that using real data, so I'm not
making up these numbers, right? Again, as I said before, by the time you're watching this
lecture the numbers might have changed. But those were real numbers that we estimated
using real-world data. And the problem is that these numbers lead people to make the
following argument, okay? So the after-tax, right, when you look at this, right? The required
return on debt is 4.2%, but there is the tax benefit of debt. So you can think about the after-tax
required return on debt. Which is the 4%- 1- 25, that is 3%, 3.2%, right? So debt holders require
approximately 3% to invest in Pepsico while equity holders require 5.5%, right? So this might
seem to suggest that a clever CFO, a smart chief financial officer, should never issue equity,
right? Debt is cheaper, debt seems cheaper, okay? In fact, I want you to do the math on your
own for you to really understand what I'm talking about here.

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 This math is not going to give you the right answer, okay? But I think it will help you think
about this problem. Try to figure out what happens to Pepsico's weighted average cost of
capital if you increase the leverage ratio to 40%. So it was 19%, we're going to double the
leverage ratio to 40%, okay?

The answer is here, right? So we have the cost of debt, the required return on debt. It's now
multiplying a leverage ratio of 40%, right? And then we have the required return on equity,
which is 5.5. It's multiplying one line of the leverage ratio, it's 60%, right? So you move the
company from 20/80 to 40/60, right? If you do the math, which I hope you were able to do,
okay? Or if not, it's here, right? It seems that the weighted average cost of capital for Pepsico is
going down by 0.5%, right? Seems right, the problem is this calculation is wrong, okay? And I'm
not surprised that if you're confused at this point. As I said, this is a slightly more complicated
argument, okay? Here's the reason, the reason is that that is going to increase risk, okay?

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So notice that to do this calculation, right, you assume it. You made the implicit assumption
that the required return on debt and the required return on equity were going to stay the same,
4.2, 5.5%, okay? But think about the following, Pepsico is doubling it's leverage ratio, right? It's
issuing a lot more debt. Is the company really going to be able to borrow at the same rate?
Maybe not, right? Is the required return on the equity still 5.5%? Or are the shareholders going
to require a higher return because the company has more leverage? Maybe they do, okay? So
what we're going to learn next is why this calculation is wrong, okay? And we're going to look to
see what is actually the right calculation. How the cost of, Capital for Pepsico should change
when leverage increases.

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Lesson 1-5 Debt Increases Systematic Risk

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?

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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.

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 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?

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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.

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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?

38
 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?

39
 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?

40
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?

41
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

42
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.

43
Lesson 1-6 Evidence From the Field: Which Type of Capital Do
Firms Prefer?

We have to understand better, what is the difference between debt and equity? Why would
companies prefer debt to equity, or equity to debt, right? That's what we're talking about.
We've seen the M&M proposition. The first thing I want to do in this session now is to talk
about research, okay?

44
So that's the first time the mad researcher comes in our course. I told you he was going to show
up a lot, okay? That's the first time we're going to talk about research on capital structure.

45
That's actually going to be our starting point to try to differentiate that from equity, okay. And if
you think about this, right, the idea we have so far is that issuing debt or equity should give us
zero NPV, right? So if debt and equity are fairly priced then you should have a zero NPV, right?
But we learned in Corporate Finance One that NPV and stock price are equivalent concepts,
right? So what researchers have does is they have tried to follow up on this idea, right? Can we
try to measure how stock prices react, right? So we can observe data. We can data from the
real world, right? And measure how stock prices change when companies announce large
issuances of debt and equity, okay. And if M&M were right, if the M&M theorem of the M&M
result describes, is sufficient to describe the real world, what would happen is that we would
observe a zero reaction, right? Stock prices should not change when company has issued debt
or when company issue equity.

What happens? So, what people have done is conducted event studies. We called this an event
study, which is a type of research where we examine the market's reaction to new information.
In these event studies, the new information is about capital structure, right? So, the company is
issuing equity, the company is issuing debt. The research, there was a lot of research on this
topic earlier on in the 1980s when we first could get data on announcements and we had good
data on stock prices. So many researchers have studied this topic. And this paper by Eckbo and
Masulis that I'm sighting here, what it does, it summarizes the evidence on event studies of
capital structure, okay? And this is 95, it's not the current result, but the results continue to
hold. If you redo this study today, I think you would find exactly the same result. All right, what
are the results?

46
Companies that issue bonds, right, if you measure the stock price reaction to bond issuance,
what happens is that, in fact, you observe a small change, okay. There is no reaction to issuance
of bonds. So there's a zero change, right. However, when companies issue equity, their stock
prices tend to decline and it's a significant decline, it's 1.5% to 3% on average, okay. So issuing
equity seems to be negative NPV, all right. When companies issue equity, their stock price goes
down, okay.

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So, now we can also think about the other side, right? So we know that stock prices decline
when firms issue equity. We can also try to measure what kind of financing an average
company uses in the real world, right. Instead of doing examples, we can look at the data and
try to measure if companies use equity, outside equity or bonds or bank, some other type of
debt financing, to finance their investment, right? The event study I just showed you suggests
that issuing equity is negative NPV, right? So what would you predict, probably what I would
predict, is that companies trying to avoid issuing equity, right? Because issuing equity reduces
the stock price.

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That is exactly what we see in the data. Let me explain you what this is. So this is data I got from
the Federal Reserve System for US companies, okay. And this is very recent, so I got this in 2016.
Like I said, the evidence that equity going was full or describing really hasn't changes, okay. So
what these bars measure is the source of financing for companies expenditures. Okay, the blue
bar measures internal funds. So those are cases where, that's the average for companies that
finance their investments using their own cash flows, okay. So you can see that the blue bar is
by far the largest, okay. And then, the red bar measures the fraction of investments that is
financed with debt issuance. And what you can see here is that this red bar is also significant.
I'm not sure you can see the numbers there, but the average red bar is about 20%. So meaning
that companies finance, on average, 20% of their investment using nil debt financing. And
finally, this green bar is equity. And the striking feature here is that these green bars are
actually negative, right? What does that mean? It means that companies are, on average, not
issuing new equity to financing the estimates, right? In fact, what the average company does is
to repurchase shares. So instead of issuing new equity, companies are buying back shares and
reducing the amount of external equity that they have. At least that's what the average
company does, okay. So this is consistent with the idea that issuing equity reduces stock prices.

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All right, we actually call this in corporate finance the pecking order of financing. What that
graph seems to suggest is that companies first use internal funds to finance their investments,
then they use that, and then they use equity. All right, and the aggregate net equity issuance
has in fact been negative, in almost every year, if you look at that graph, or if you look at the
Federal Reserve data yourself, is publicly available, if you want to check my work, okay.

50
So, the messages that companies are in fact reluctant to issue equity in practice, okay. There
are some exceptions and one of them is in mergers and acquisitions. That's in the final module
of this class, corporate finance two, we're going to talk about the financing of M&A and one of
the key points is going to be that when companies finance large M&A deals, they are in fact
issuing a significant amount of new equity. That's one case when companies are going to issue a
lot of new equity. There are other cases as well, for example Venture Capital Industry, right, is
based on equity. So when a Venture capitalist provides financing to a new venture, it's typically
not going to be that financing it's closer to equity, right. And of course, the other exception is
when companies go to the equity market, to the public equity market for the first time, we call
that an IPO, okay. So in that case companies are definitely issuing new equity. But what that
graph shows is that these three exceptions here, they are important, but they are not enough
to overturn the general pattern that companies prefer to be issued debt rather than equity.

Okay, the bottom line is that debt seems to be the most important source of external funds for
most companies, okay, which is a very important message to take away from the data. What
we're doing the next lecture is, we are going to try to dig deeper and try to understand debt
financing in detail. First, we're going to try to understand why is it, that companies prefer debt
to equity, right? We're going to try to see how debt affects profits and value, okay. And then, in
the next module, we're going to go very deeply into the details about debt finance. We're going
to talk about different aspects of debt finance in the real world such as the pricing, collateral,
ratings, and etc. So we're going to try to really dig deep and understand how that financing
works in the real world.

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Lesson 1-7 The Effect of Leverage On Taxes and Profits

So, the first thing we are going to do is to try to understand the relationship between debts,
profits and value. That's going to take quite a bit of work for us to go through all the arguments
that we need to understand. Let's go back. Our starting point is going to be the Pepsico
example. Again, we're going to go back to that example we were talking about, right, where
Pepsico was trying to decide whether to issue debt or equity. What we just learned is that most
likely Pepsico will issue debt instead of equity. That's what average companies do in the real
world, right? Let's try to understand how this debt issuance will impact the company's
profitability. To do that, we're going to go back to financial statements.

52
Remember that we have the before and after, right? That's before, meaning before the debt
issues, after, meaning after the debt issues, right? The difference here is that your interest
payment is going up by $200 million, okay? And, right? If you look at the earnings, we talked
about this already, but here I want to make it very clear, right? The interest payment is going to
reduce the company's earnings, right? Very simple here, accounting, mechanical, there is
nothing very deep going on. Interest goes up, earnings go down.

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So, here is a question for you, and I want you to work, to think about this right now at the
beginning of this session, okay. Is Pepsico more or less profitable after the debt issuance?

To answer that, we're going to go back to Corporate Finance I again. Okay, remember that our
definition of profits, the definition of profits that I like to use is what I call OPAT, Operating

54
Profit After Taxes, okay? Operating profit after taxes, okay, operating profit after taxes is
defined as our EBIT, your operating income minus the taxes that you pay to the government.
And what is very easy to show is that OPAT is going to go up with leverage. So, Pepsico is
actually going to become more profitable after the debt issuance. So, if you got that answer
right, if you remember the definition of OPAT, I'm really happy.

I, or if you haven't taken Corporate Finance I, maybe it would be difficult for you to figured that
out. But in any case, let me show you what is going here, okay? So, here at the bottom what
I've done is I calculated the OPAT for Pepsico. So for example, in December 2015, right? You
had operating income of $9.7 billion, right? You are paying $2.1 billion in taxes, so your OPAT is
7.515, right? It's going to be a small change, so we have to talk about all the numbers, right?
Your interest payment went up after the debt issues. The effect of that is that the taxes went
down, right? But your operating income is still the same. Your business hasn't changed, right?
So, if you do the calculation at the bottom, what you'll see is that your OPAT is going to increase,
okay? The operating profits after taxes is going up, right? What that means is that Pepsico is, in
fact, becoming more profitable after the debt issue, right?

55
And this picture kind of shows what's going on. What is happening here is that by issuing debt,
companies take money away from the government, right? The main effect is that debt is
lowering the company's taxable income. So, you're taking money away from the government,
who gets the money, the shareholders, right? So debt, it's a positive effect of debt, the fact that
profits go up. And you might think, why are we going to stop at $5 billion then, right?

56
If we issue $20 billion of new debt, now it's going to become, it's going to be easier to see the
effect, right? Your interest payment's going to go up to almost $2 billion a year, right? Meaning
that you're going to get a big tax deduction. Your OPAT is going to go up even higher, right? In
fact, it's very easy to show that if a company

57
is profitable, your operating profit after taxes is going to increase with leverage, okay? So, this
picture, I'm going to start using these pictures in this lecture. So, essentially, what I have here is
leverage on the x-axis, and on the y-axis, we're going to have measures of profit and value. So
far, what we figured out is that OPAT is going to increase with leverage. So, the higher the
leverage, the more profitable companies are going to become, okay?

So, let's bring back the researcher, right, let's talk about the real word, right, and the evidence
from the field, right?

58
What would this model predict so far, right, so if leverage increases profit, what will be your
prediction? Your prediction is that leverage ratios should be very high, right? If companies are
profitable, then they should be almost entirely financed with that. Leverage ratios should go up.
But the problem is when you look at the data, this is not true, okay? The average leverage ratio
for companies in the US, it's similar for other countries as well, is approximately thirty percent,
okay? And an interesting fact is that this average leverage ratio is even lower for profitable
firms. So, what this means is that Is that maybe we're missing something, right? There is
something else going on, and it's not just this increasing profitability, right? The other
prediction is that companies should always finance investments with debt, and we saw the
evidence that's not true, right? They do prefer debts than outside equity, but the first thing that
companies do is to use their own internal funds. That's the pecking order, first internal funds,
then that and then outside equity. So, there's something missing here from this model. The
conclusion is that there must be a hidden cost of issuing debt.

59
What we'll try to do next is to understand where this hidden cost is. In essence, we're going to
try to understand other consequences of issuing debt for the company's financial statement,
and ultimately for profits and value.

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Lesson 1-8 Leverage and Personal Taxes

The first effect we're going to talk about is personal taxes, okay? We talked about the positive
effects of debt on profits. That comes from corporate taxes, right? But issuing that is also going
to change taxes that the investors paid at the investor level, right? So to get a full picture of
how that affects profits, we have to think both about corporate taxes, but also personal taxes,
let me show you this. We have to do some calculations here but they are quite straightforward.

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All right, so, what we're going to do is we're going to follow what happens to OPAT, right?
Before issuing debt, PepsiCo had an OPAT of $7.5 billion in 2015. And by examining the financial
statements, we can also figure out where this money went, right?

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So $1.156 billion were used to pay interest. PepsiCo paid $3.617 billion in dividends, and then
the rest of the cash went to retained earnings, okay? All right? So now what we need to think
about is personal taxes. The payments that debts are making to investors are going to generate
taxes at the investor level. The interest payment that goes to debt holder is going to be taxable.
The dividend payment to equity holders is also going to be taxable, okay.

So debt investors receive that 1,156 in interest payment, and the specific tax that they pay is
going to depend on many factors. One important factor is what is the marginal income tax rate,
right? Interest payments are typically taxed at the personal income tax rate, it's just treated as
regular income. In the US, the marginal income tax rate can be as high as 39.6%. Using the
current tax code, the tax code might change, so by the time you're watching this, we might
have a different tax rate. There is an election coming on in the US actually, when I'm recording
this, so who knows? But right now it's 39.6%. What this means is that, that investors, if they pay
39.6 We're going to talk about that. If they paid that high tax rate, what they would receive is
$698 million. The rest of the money goes to the government, right? So remember, the reason
why there are increased profits because we're taking money away from the government. But
when the company pays interest to investors then the government gets some money back. We
have to take that into account. What about equity investors? They received $3.617 billion in
dividends. Again talking about the US the highest dividend tax rating in the US is 20% for people
at high income level.

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If we assume that dividends are taxed att hat rate then equity investors would receive a lower
amount, right instead of 3.167 equity investors would receive $2.894 billion. What about
retained earnings, with retained earnings there is no immediate tax, right?

PepsiCo retains the earnings, the earnings aren't going to be taxed when they're distributed to
equity investors, either through future dividends or maybe through future share repurchases.

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So, for now let's just say that PepsiCo gets 0% tax, right? So you retain your earnings, you don't
pay any tax for now, so what happens?

This payoffs after personal taxes are then different, right? So if we take personal taxes into
account, debt investors are getting 698, equity investors are getting 2.894. We have the
retained earnings So we can sum everything, right. So out of the OPAT of $7.5 billion we
generated a master tax income to investors of $6.334 billion, okay. So that is the situation
before Texaco issues any new debt. That was the before situation. Now what I want us to do is
to consider what happens to the after tax payoff after the debt issuance, and let me use a
bigger amount here just for the sake of the example.

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Let's use $20 billion the debt issuance instead of a $5 billion debt issuance that we started with
just for us to see the numbers more easily. What's going to happen to the after tax pay off? Try
to do the calculation yourself, I started here for you with the interest payments then the new
interest payment. And then the new retained earnings that perhaps we could make after the
new debt issuance. So try to figure what happens to the after tax payoff.

66
Here is the answer using the same tax rates, right? The government will get a chunk of it, right?
If you did the math correctly you would get that your OPAT out of the OPAT, right? Which now
is higher, right? Because of corporate taxes. Investors would end up getting $6.218 billion, right?
So let's put the numbers together on one slide for us to see. Before the $20 billion debt
insurance perhaps because OPAT was 7.5, investors are getting 6.3, the government was
getting 1.2, right?

67
Just rounding the numbers here to make it easier for me to talk after the $20 billion debt
issuance the OPAT went up to 7.7 but the after tax income that goes to investors actually went
down to 6.2, right? All your OPAT increase, but the after-tax payoff decrease with the debt
issuance in this case. The government, they are the player here, is the government. The
government and OPAT getting more taxes.

68
So you took away, you thought you were taking away money from the government. But in the
end of the day, the government bites back, right?

69
Because that increases personal taxes. I exaggerated this example for a little bit. It is, of course,
not a generic example, right?

There were many problems with the assumptions One of them is that, their investors are
probably not taxed at at the highest marginal rate. Many investors hold bonds in tax deferred
funds, right? So for example if you have retirement money that you're taking for your
retirement This money is invested in a fund that will not actually pay tax until you withdraw the
money after your retirement all right. The effective tax rate on retained earnings on the other
hand is not really zero as assumed right. Shareholders will eventually have to sell for
shareholders to get cash back Either the company has to do a share repurchase, right? Or
shareholders have to eventually sell the equity, or the company has to pay dividends. So at
some point shareholders are going to pay tax, so the zero tax rate is also an exaggeration.

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Figuring this out in the data is actually very complex. okay, fortunately you know you dont have
to do it there is research, here comes the mad researcher again. There is research we can drop
on.

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 In fact in this area of corporate taxation there is one particular researcher which is considered
the world's Expert on, I wish you was me but it isn't, okay? His name is John Graham, he's at
Duke University and he's done a lot of research trying to estimate what happens to company's
profit, what happens to company's value taking to account both the cooperative tax benefit and
the personal tax, these advantage of debt. I'm just going to give you the bottom line, remember
our picture, right? We have leverage on the x axis, profits on the y axis, we have our OPAT, right?

The OPAT is going up, that's the cooperative tax effect, what's going to happen is, after you
incorporate personal taxes, this benefit becomes lower. So profits do not increase as much with
leverage as we would have thought. But if you look at the this picture what it shows is that
there still is a positive slope. Okay what John Graham shows is, is even after taking personal
taxes in a reasonable way trying to estimate what actual tax rates investors are paying. What
we find is that profits still increase with leverage. So by increasing leverage, companies are on-
net taking money away from the government and giving more money to debt holders and share
holders.

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Lesson 1-9 Leverage and the Risk of Financial Distress

This picture is the summary of what we have so far. We have profits, leverage, what we've
shown is that profits increase with leverage for profitable firms, right? So as long as a firm is
profitable, as long as a firm can take the tax benefit from the government, right? Then what
happens is that profits will go up even after taking personal taxes into account. So your OPAT
goes up, your after-tax payoff goes up less, right? But it tends to also go up with leverage. So
tax benefits is a big reason why companies might prefer leverage.

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So let's think about the following. If that's the case, why not increase profits, increasing debt
even further? For example, we might think of a slightly crazy situation where PepsiCo issues so
much debt that you have $9.6 billion interest expense, right? In that case, you're going to pay
zero taxes. Right? Your taxable income goes to zero, you pay zero taxes, your OPAT is going to
be the same as operating income. All Right? Clearly not, your intuition is telling you that
something's wrong, right? Of course it is, we're going to talk about it.

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What happens is that there is a cash shortage, right? If a company's in a situation like that, yes,
you're not paying taxes, but you're not going to have any profits to pay dividends, for example.
There is no cash to pay dividends. There's no cash to make investments, R&D, any other
expenses, right? A company in this situation, where your interest payment is as high as your
operating income, is a company that we call financially distressed. What we say in corporate
finance is that if a company is in that situation, the company is financially distressed. Okay?

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In practice, financial distress is not going to arise from voluntary increases in debt, in our
example, the example is a little bit crazy because of debt, right? PepsiCo would probably never
be able to issue that much debt anyway. What tends to happen in practice is that companies
become financially distressed because of poor performance, right? Maybe they expected to be
able to pay interest at the time that they issued debt. But then there was the big crisis, either
with their products in the marketplace, or maybe an economic crisis. Profits turned out to be
lower than expected. Companies become financially distressed. This is an example of this
situation.

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So, suppose that PepsiCo is distressed because the operating income went down to about $2
billion, right? So now, PepsiCo has a EBIT of $1.9 billion, and interest expense that is higher than
your EBIT, right? So yes, you're going to pay zero taxes. But that might create problems. I want
to give you some time to think about this. How should PepsiCo respond to this situation? What
is the company's likely to do if it encounters a situation like that?

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The answer is that something's going to have to happen, right? If PepsiCo has cash, maybe the
company has saved enough cash in the balance sheet, that they can use that cash now to keep
financing investments, for example. If they have it, maybe they don't, right? Or, PepsiCo could
try to refinance its debt, right? If the problem is that interest payments are very high, PepsiCo
can try to go to the bank, or to go to bond markets, and try to refinance there. As we talked
about in Corporate Finance One, refinancing a liability means that you have to issue a new
liability to buy back the old one. Right? Or, PepsiCo could try to issue new equity. Right? If you
can't raise new funds than what PepsiCo is going to have to do is to cut dividends or cut
investments, right? So either way, you're going to have to manage this shortage of cash.

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The important notion is that most of these options, with perhaps the exception of standing cash,
most of these options are likely to generate significant value losses for the company, right? If
PepsiCo goes to the debt markets to refinance debt, what will probably happen is that you're
going to have to refinance at very high interest rates. If you're financially distressed, a bank is
not going to give you new financing unless you pay a very high interest rate. Right? We learned
already that if PepsiCo issues equity, right, the stock price is likely to go down, right? In fact,
what people have shown is that this stock price effect is even larger for firms that are financially
distressed. Right? If a firm is close to bankruptcy, financially distressed, you issue new equity,
you know, you're going to have to pay to do that. What happens is that the stock price goes
down a lot. Right? Cutting dividends is also going to reduce the stock price. That's something
we're going to learn in module two, that dividend cuts have a similar effect as equity issuance in
the other way. Okay? And finally, we learned in Corporate Finance One that cutting
investments, if they are positive NPV, cutting positive NPV investments are also going to reduce
the stock price, right? The bottom line is that any of these options, right? Any of these reactions
that PepsiCo might have, are going to cause value losses.

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Or most of them, like I said, if the company has enough cash, it might be able to use the cash to
mitigate the cost of financial distress. But, in the other cases, it's very likely that they're going to
be value losses, right? These value losses that are caused by high debt is what we call a cost of
financial distress. Okay? In corporate finance, we refer to these value loss as a cost of financial
distress, if they are caused by debt. So it's very important that this has to be driven by a
situation of high leverage, okay? Bankruptcy is an extreme version, right? A company that is
bankrupt is a company that cannot find a way of repaying its liabilities. And the company has to
go to court and either liquidate or reorganize, right? That's like an extreme outcome. But
financial distress is even more likely to happen than bankruptcy, right, because bankruptcy is
the extreme version. Financial distress happens much more often than outright bankruptcy.
Okay?

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So, one question you might be wondering is, how large are these costs in the real world? Right?
How large are these costs of financial distress when we actually go out and try to measure them?

There is, in fact, a very nice paper that was written in 1995 that estimates cost of financial
distress for companies that became distressed due to high leverage. Okay? And this is the paper

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by Andrade and Kaplan that was published in '95. What they've shown is that financial distress
can cause a loss in value of 10 to 25% using the benchmark of value one year prior to financial
distress. So when a company enters financial distress, its value tends to go down by 10 to 25%,
okay? So it's a significant value loss, and now we can think about it, right? The question for our
module here is capital structure. We have the cost of financial distress. How will this cost of
financial distress affect the capital structure decision that we are thinking about, right? And the
intuition is pretty clear, right?

What will happen is that higher leverage is going to increase the probability of financial distress.
So when a company starts increasing leverage, on one hand you might have tax benefits of that.
But on the other hand the higher is your interest payment, the greater is the chance that your
profits are going to become lower than your interest payment at some point. Right? Like I said,
this is usually driven by poor performance, but poor performance is a reality right? It might
happen, okay? And what will happen is that, if your company has high leverage, the poor
performance is more likely to cause cost of financial distress.

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Lesson 1-10 The Trade-off Theory of Capital Structure

Let's go back to our picture. We have profits, value, and leverage. Again, leverage in the x-axis,
value and profits in the y-axis. If you think about tax benefits, what we've shown with the
PepsiCo example is that your after-tax profits are going to increase with leverage. So PepsiCo
becomes, or any company that is profitable, will likely become more profitable as leverage
increases, right? This increase in profitability will also increase the company's value. So I plotted
the value here as well, instead of just profit as we were doing before.

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However, we also learned about cost of financial distress. As your leverage increases, what will
happen is that the risk of bankruptcy, the risk of financial distress, is going to go up, right? If
financial distress happens, then all of those bad things happen. The bad things we talked about,
the company has to refinance, it has to issue equity, cut investments, right? These actions will
tend to reduce the company's value. What this means is that as you increase leverage, value
goes down through this financial distress channel, right? If you put the two pictures together,
what we get is what we call the trade-off model of capital structure.

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It's the trade-off between the tax benefits of debt and the cost of financial distress. So the way
that company should choose their optimal leverage, the optimal amount of leverage to have, is
by trading off the positive effect of taxes on profits with the negative effect of leverage on
financial distress costs, okay? What you get is a picture that is going to give you, presumably, if
we wanted to give you an optimal leverage ratio, that we call L* here. In this case, that would
be the optimal amount of leverage that a company would have, okay? So this is all very nice
theoretically, right? And here, we bring back our researcher again. How does this figure look
like in the real world?

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Right, that's what we are interested in. A very nice theory but let's see if we can figure out how
this picture looks like for real world company. This is done in a very nice paper by a researcher
called Arthur Korteweg.

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What he does is he estimates exactly that picture, the effect of leverage on value for firms of
different characteristics, okay?

And this is what Korteweg finds. Korteweg finds that there is a picture like that in the real world.
There is an optimal capital structure, which as we talked about already, the average firm has a
leverage of about 30%. Korteweg finds that the average firm tends to have an optimal capital
structure, and here's the important number. The average firm in the US, the average company
in the US, tends to gain 5% in value by moving from a leverage of 0, by having no debt, to a
situation where you have 30% of debt, okay? So you would gain 5% in value by moving from 0
debt to 30% leverage. That's how this picture would look like in the real world, according to
Korteweg, okay? And then of course, this is just an average picture. Not all firms are going to
have the same optional leverage.

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 If you think about the model we just described, there are many variables that are going to be
important, right? For example, the volatility of cash flow. Financial distress is going to happen if
the company's performance becomes poor, right? So riskier companies, companies that have
higher cash flow volatility, are going to have a higher chance of becoming financially distressed.
The tangibility of assets matters as well. If a company becomes financially distressed, and you
have very tangible assets like land, right? It's going to be easier for a company to raise financing
by selling the land, or by borrowing against the land. So tangibility should also reduce the cost
of financial distress. Profitability, right, profitability also matters because, as we discussed, only
profitable firms should really have tax benefits of leverage, right? If you don't have any profits
to shield, there's no tax benefits to take advantage of. Size also matters, right? Think about
financial distress. If a large company becomes financially distressed, it's probably going to be
much easier for a large company to access financial markets and refinance debt, issue new
equity, than for a small company, right? So size should also affect this trade-off. And finally, the
company's valuation, this is something we talked about in Corporate Finance I as well. Is the
market-to-book ratio, right? The market-to-book ratio essentially what it measures is, it
measures whether the company's values lies in the future, right? Where the future profits
matter a lot for this firm, right? So if you think about the market-to-book ratio, what should be
the case is that companies with high market to book ratio have a lot more to lose if they
become financially useful, okay? So one way to think about these characteristics, for example,
thinking about volatility, right?

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We have that picture that we showed you for the medium firm for Korteweg's paper.

The medium firm will have an optimal leverage ratio of 30% and will be getting 5% of value by
moving to the optimal leverage of ratio. If a firm has high volatility, then this picture will be
shifted lower, right? The high risk firm will not have as much benefits of having high leverage
because of the increased risk of financial distress. Okay, so the picture shifts down, meaning
that optimal leverage is going to be lower for a firm with high cash flow volatility, okay? The
problem is that now we reach the limitation of what we know from the research.

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 We have this very nice model that describes capital structure, and it seems to be consistent
with real-world capital structures. But what we don't know is how much, going back to that
picture, what we don't know is how much lower should the leverage be, right? If you look at
that picture again, you'll see that we had a question mark. We really don't know how much
lower should the leverage be for the firm with high cash flow volatility. One way to think about
this is that the trade-off model is not good enough to give us a precise quantitative structure.
But you can still use the trade-off model as a qualitative model. So, as we discussed, right, we
have the medium firm has an optimal leverage ratio of 30%. But firms with high cash flow
volatility, low tangibility, small size, etc., should have less debt.

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So you can use this model as qualitative guidance for how much leverage a company should
have in the real world. And what the research has shown is that, by and large, these
characteristics do seem to predict variation in leverage ratios in the right direction.

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Interview: Analog Outfitters

I want to talk a bit about the Analog Outfitters Interview that you are about to watch. This is a
very small business, and as the owner himself says, the financial management aspect of the
business is under developed, they are learning by . And what you’ll see also is that many of the
key questions that we ask in this course and also in Corporate Finance I, are going to appear in
our conversation because of the questions I asked him, and the topics that they want, actually
there is more than one interview, the topics that they chose to talk about. So here's the big
question I have for you, you're taking an MBA level finance course and that might allow you to
actually think about, how would you have done it differently? Which financial management
decisions would you have changed? What would you have changed about the financial
management of this business? Let me highlight a few topics that you can pay attention to. First
of all, the financing strategy which is one of the big topics we're going to talk about in corporate
finance too. What are some of the methods that Analog Outfitters has used to finance its
business?

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Traditionally, the owner definitely talks about that and he also talks about the problems with
these traditional methods, if I wanted to identify those and think about it. And in addition, it's
going to be clear, I think, in our conversation that the company is trying to change the way it
does things. And the question I have for you is, is the company moving in the right direction,
right?

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In terms of risk management, which is one topic we're going to talk about in Module Three of
Corporate Finance 2, is I wanted to think about why is it that this company faces currency risk?
It's a very small company so you might think that they don't have currency risk, but in fact they
have. And more specifically, think about how changes in the value of the dollar relative to the
other currencies can affect the profits of this company. This is one of the topics we're going to
talk about in Module 3, and you can start thinking about it as you watch this interview. The
owner also talks about R&D. This is the technology company right?

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 So, they do invest in R&D, right? And I wanted to watch that and think about whether this is a
significant investment for the company or not? I think there are some numbers in the video
that allow you to compare the investment in R and D with some of the other investments that
this company makes. All right, so going back to Corporate Finance 1, I want you to think about
this question and also consider whether the company is using the type of R&D financial model
that we discussed in Module 3 of Corporate Finance 1. Payout, we talked about payout as well.
One point that is coming up in the interview is that the role of payout has changed over time
for this company. I want you to think about why this is the case? Why has payout become more
important? And what is the company doing to design a payout policy going forward?

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 Payout is going to be a topic that we're going to discuss in Module 2 of Corporate Finance 2.
Thanks for talking to us, can you tell us a little bit about the company, the products, a little bit
of history maybe? >> The history, well probably a lot like a lot of small businesses, started in a
basement. And Benji Day was the original owner, and basically we went from doing everything
from repairing pro sound equipment, and a little bit of everything, all the way to wanting to
build our own amplifiers. So we went from kind of a live sound rental company, repair company
to manufacturing. And, which is a great direction, I'm a musician and I'm a builder. >> >> And,
so now we fully just manufacture our own amplifiers out of recycled materials and some of the
old vintage materials that we find. >> How long have you been manufacturing? >> We've been
manufacturing around five, six years. >> Five, six, yeah. >> I think, probably not. >> >> But we've
been in business for longer than that. >> Yeah, they look great . >> Yeah, and so it's a pleasure
to kind of give some of these materials a rebirth and make an original tone, an original sound.
>> Yeah. >> And that gets back down to the basics of just old finish tube amps. >> Yeah, the
sound was beautiful here as well. I was playing- >> Yes, you were the first person to play an
amplifier in here. >> Yeah, I heard that. It was incredible, yeah. >> So you christened this place.
>> I have to get one for me. They sounded great. >> It was absolutely beautiful. >> So Dan? >>
Yes. >> Thanks for talking to us. >> My pleasure. >> Yeah. Can you tell us about what were the
big investments your company has made in the last few years? >> Yeah, as our business has
grown, for the last seven or eight years, we've been in a building in downtown Champaign. And,
we own the building, but we started off with one little 2,000 square foot section and rented out
the rest of the building. And it was sort of comical our section didn't have a bathroom >> >>
And we couldn't afford to pay the rent, so I had to find other renters. And so we would had to
walk down the street and use the- >> To go to the- >> Sneak in the back of a restaurant to use

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their bathroom for about a year and a half. Anyways we finally had enough money where we
took over more of the building and more the building until the last few years we had the whole
building except for the apartment. But we realized very quickly during our growth that we were
in the absolute wrong place for a manufacturing business. We've really transitioned from a
service business doing repairs primarily to a manufacturing company and went from a company
that was open to the public to accompany that essentially a factory. So we don't need to be
open to the public yet here we were in downtown Champaig with no parking and we couldn't
have semi trucks to delivery, it was just very difficult. >> Yeah. >> And so, we had to rent
properties around town. So, getting back to your question, what was the investment? Well, this
place was certainly one of them. We have four acres here of land, a 9,000 square foot building,
and then two 1,500 square foot out buildings. And plenty of room to build a new building if it
ever comes to that. >> Yeah. >> So this was one that we've been working on for about a year.
Another big investment we did was at our last building. We made a professional production
woodshop. For all of our cabinet work. When we first started making speaker cabinets, we were
literally doing in the parking lot with portable hand tools, like literally, in the gravel parking lot,
setup saw horses and stuff. >> Even in the winter? >> Yeah. >> >> Yeah, we didn't have a choice,
because we couldn't get saw dust in the rest of the facility because of all the electronics. We
really paid our dues. So, that wood shop cost us probably about with the tools probably about
let say $50,000. We had a contractor build it out properly and so that was a big investment. >>
What happened to that when you move here? >> That part, we're still renting that part of the
building for another like month as we finish this building. And we have a lot of our stuff is
stored in another storage place in town. So that really made possible for us to get our quality
and our efficiency much higher to where we could do you really precise work. Recently, I'd say
one of our bigger investments was to hire a full time marketing person which, you know is
difficult when the cart of the horse is like when you have to have the sales to afford the
marketing person. But if you don't have the marketing person, how you going to get the sales?
We've been very fortunate that word of mouth has done. We've never done any advertising
ever of our manufactured products since we started in 2011 with this part of the business. And
luckily our dealers and our word of mouth took us to a certain level, but we realized there's
only so much you can do with goodwill and you know referrals from other people. So we made
the leap to hire a person to do that and it's worked out excellent. >> Yeah. >> And it was worth
all of the hard work it took to make that happen. >> So let's talk about the initial investments.
We talked about the manufacturing that you have to build. How did you finance that? >> Well,
that's a great question. There was a couple of ways we did it. >> One of the mistakes we made
in our business over the years was that we took on an investor named Visa. Ever hear of him,
Visa? No, American Express? >> Visa, the credit, I see. So you borrowed on your credit card. >>
Yeah, and that was a mistake. And the problem with that is that if you don't really plan out
financially a project or a plan. You think, yes, I can get it done right now. We've never been very
good financial modelers. I should going to get an MBA and I need to sign up for your course. >>
You will be welcome. >> So, we did a lot of short term fixes without enough long term planning.
Now, we have paid off all of our credit card debt, but you know, we wasted a lot of money at 10%
interest. >> Interest rate is very high, right? >> Yes, this is ridiculous. So, we did borrow about

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$25,000 from my father. I come from a family business background. We have a 100 year old
family business that my great grandfather started in 1916, called Ideal Industries. We make
electrician's tools and wire connectors and stuff. So I grew up around business and I grew up
understanding a lot about how you build and grow a business, I have not been a successful as
my great grandfather was, but I do my best anyways. Anyways getting to the investment part,
my dad worked as an executive there for many years. So he had some free, some extra money
and so he has lent me money at various times when we could go get a bank loan, but his terms
are better. >> So when you move to this space here, did you take a bank loan to buy the space
or is this a >> This is a very interesting situation, where we are here, this is a beautiful building
but it is one that has been neglected And the story here is we're on an old airforce base that
was close in 1994. And as you might imagine a small town, it would be like UofI leaving
Champagne. >> Yeah. >> They lost half of their population over like 16 months. And this
Airforce base, it was given to the village. And they've been trying to, ever since get businesses
out here. And sadly, some of the buildings fell into some disrepair, as can happen. And so
basically, we approached the village of Rantoul and said, this is a perfect place for us. And we
worked out a pretty good deal with them. We are closing on it, they let us move in before
closing. >> Mm-hm. >> Because I had to sell my other building in downtown Champagne. So we
should be closing in another month, and I will take out a loan, but I can tell you that moving to
an old Airforce base 15 miles from Champagne, financially, is the best thing I've done, because
we're getting a great facility for 10% of the cost. It would be 15 miles that way. And we're not
open to the public we can be in the middle of the corn field. So this is perfect for us, and
there's all these industrial buildings around here that we're renting a few of them. And there's
just wonderful opportunities here. There's a 200,000 square foot airplane hangar over there for
sale, if you need some space. >> >> So you said you're going to take a loan to help finance this.
A mortgage? >> Yeah, I'll take a mortgage. I'm going to put probably about $20,000 down and
take a mortgage for the rest. And so our mortgage payment will be probably half of the rent
that I was paying to myself for our other building. We had a real estate company and then
Analogue Outfitters, two separate business entities, and the real estate company just owned
that one building, and so I paid rent to that. >> But you own the other space, right? >> I did, I
bought it in 2005 when Downtown Champagne really was starting to come up a little bit, but
still kind of on the downturn, still recovering from the 70s and 80s. And now it's really an
entertainment district it's really doing great. >> Probably made a good profit on that. >> We did
very well that's part of what helped us get rid of all of our debt, it was doing well on that
building. >> So that's what I was going to ask you actually, so you have this windfall, right, from
selling the building. How did you use that in the company, or did you use that some other way?
>> Well, we used a little bit of it. It's funny, it was actually in my wife's name. >> Yeah. >> And
so we teased that it was her company. >> >> And it was her building. Even though she never
went over there. Every two months she'd pop in and say hi. >> >> But basically what we
decided, we were going to split the profits. She gets half to do what she wants and I get half to
do what I want. And course, she used her half to like, fix up our house and do some stuff. And
then I used part of my half, to pay off some debt and then basically, you know, buy this and
then just saving some for For the future. >> Saving for the company, right? >> You know, I don't

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know. It's in our real estate company, I left it there, so I don't know what I'm going to do with it
for sure. I mean it's not a ton of money, but I want to, you know, leave some, maybe do
something fun, buy some new fishing poles. >> >> I'm really into fishing. So are you the owner
of the company? Is it a partnership with Ben and- >> I am currently the sole owner. >> You're
the sole owner? >> Yeah, and I started it in 2002, as Benny said in the basement and then I
upgraded to a garage after that. So a big upgrade. >> >> But I am going to be taking on a
partner, Brian, who you might be interviewing today. >> That's what I was going to ask you,
actually, if you ever considered bringing capital by having more partners. >> Yes. >> So
apparently, the answer is- >> Yes, and the reason, really, for him, it's really not I chose him not
so much for a capital infusion but- >> I see. >> A management and- >> It's more on the
management side? >> Yeah, because he has a long history, as an entrepreneur, he had his own
heating and cooling company and build it up to have. >> Over 30 employees you know built it
up from scratch and has a lot of history, you know, he decided to make a change and wanted to
get into something he was more passionate about. So he saw that and, but, he's worked for me
for about four years as a fabricator. >> And because of his skills. And bending sheet metal. You
know, making duct work, he's the one that has figured out how to make these. You know, take
the old road signs and bend them up. because he has that skill. And as a fabricator, he does all
the woodwork too. And over the years he would give me little advice and say hey, we should
really consider this. Why don't we do that? And then one day I'm like wait a minute you've got
all of this business knowledge. You've got all this fabrication knowledge and your hobby is to
work more. >> >> He's one of those guys. >> Yeah. >> I mean you need to be part of the
ownership structures. It's ridiculous. And so, we started that about a year ago. And we're just
getting all the details worked out about how he's going to buy in. And part of the way he's
buying in is with, basically, sweat equity. >> He's taking a diminished salary in exchange for- >>
Having some ownership rather than contributing capital. >> Right,and which is great, it works
out great. He's brought some new energy to the company even though he's been here for four
years, now that he is on ownership track. You know, his efforts are even greater. I mean he's
here at seven in the morning and a lot of times I get a call from him at eight o'clock and he's still
here. He's just an extremely hard, passionate worker. So, he's the perfect guy for a partner. You
know, and I've, there are other times I considered having a partner, but I never really had quite
the. >> The right fit. My dad always told me, he said, a good business partner is one of the best
things you could ever have. >> Yeah. >> And a bad partner is like you might as well not even be
in business because it's going to take every bit of joy and probably success out. So I was always
very careful in how I thought about that. And I think I've found the right person. >> Yeah, that's
great. Let's talk a little bit about risks that you see going forward. What are the major risks that
you see for your company and your future? >> Tthat's such a great question. When I read that, I
had so many different ideas. One is that the music business. As all businesses change, it's just
that's a guarantee. Musical tastes change, and that's one thing we've seen is that a lot of young
people are instead of listening to bands like Led Zeppelin and Pink Floyd, really guitar centric
bands. They're gravitating more towards this electronic dance music which is, you know,
sometimes it will have a drum set and some other instruments, but a lot of it is electronic. >>
Yeah. >> And so the sales of electric guitars over the last couple of years have >> Have been

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going down. Acoustic guitars are still growing and so as electric guitars go down, well of course
amp sales go down. It's probably a temporary blip, that's what I think. I mean I can't imagine
the electric guitar's really going to go anywhere but there's trends, just like disco in the 70's,
that It's just there's some volatility in that. So that's one of them. And I think that one of the
other risks I see is that we have a tremendous international presence that's where we sell over
half of our product. All this stuff is going to Paris. >> Really? >> Yeah. >> Wow >> And we have
dealers in Costa Rica, Hong Kong, Sweden, Germany, Spain, Netherlands. I mean, you know,
Japan. And I'm a little concerned about our new President. You know he's he's scaring off a lot
of, with all of his sort of potential trade wars. You know, and that can really have an impact on
us, I think, If suddenly it's much harder to import or there's new tariffs imposed. So that
concerns me. >> Do you spend any money on research or? Yes. Do you do any R and D kind of
things? >> Yeah, I don't even want to know how much. You know hundreds of thousands of
dollars over the years to develop new products and that is. We had one product which we don't
have here right now. One of our better sellers. It took a year to develop it. And that's expensive,
I did it myself and I used some interns from the University of Illinois. And another friend of mine,
we did it, it was expensive. >> Yeah. >> So, but to make something great, you have to put in the
time. So it's just part of it and then try to figure out how to price the product to recover that
investment, how many do I have to sell to get this money back? So and we've been successful
at that in most products but not all of them. So. >> Do you think about that ahead of time?
When you start doing research, do you think about the >> Not enough. >> Not enough, right?
>> Not enough. That's something that would be a weakness of mine as I'm not a great financial
modeller or long distance planner for things like that. What is our structure going to be? How
much is it going to really take to develop this product? And part of that comes from just being
sort of artistic guy and when I get something in my head I just want to make it. >> >> And worry
about the rest later. >> >> And that's really been a mistake. And so, part of having the team I'm
trying to create here is to have a little more discipline with things like that and do better.
Financial modeling to really decide, is this a good thing? Artistically it might be great, but this is
a business. And we gotta pay our bills and pay our employees, so we can't just be a bunch of
artists. >> >> We need some right-brained people around here too. >> Yeah. >> So >> Great. >>
Yeah. Let me ask you a final question. >> Sure. >> Especially now that you have another partner,
have you given some thought about how are you going to pay cash to the owners or how are
you going to distribute, right, the profits? >> Right. >> This is like the dividend, how do you get
the money in your pocket? >> Right >> In part, versus keep eating in business. >> We're
working on that right now with I've paid myself in the past as an employee and occasionally
taking some dividends, but you know as an owner of a small company you're always the last
one to get paid. >> >> If you want to stay in business you have to do to it that way through the
rough times you know. >> And so that's just how it is. So, but yeah, we're working on our
operating agreement with our Lawyer to figure all that out and to, you know, he's going to be
purchasing a chunk of the company too, so. >> The Lawyer? >> No, not really. >> Yeah,I thought
you said the lawyer. >> He can pay cash. >> My partner Brian >> Your partner Brian >> Yeah, he
will be buying a large chunk of the company and so we have that payment to work out,so there
is a lot of details to work out with the lawyer but, >> And certainly the how we're going to deal

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with that cash is part of it. And we want to have a good solid operating agreement, everything
laid out in advance, so everybody knows, you know. If he wants to sell out to me in the future
or I want to sell out to him, and you know, all that's spelled out, the formulation, evaluation,
everything, so fight about it. There's nothing to fight about you know. Because it's all laid out.
So, the dividend policy will be part of that discussion. >> Interesting. Thank you, thanks for
talking to us. That was very interesting. Hi Brian, thanks for talking to us. >> Thank you. >> So,
we were talking a little bit beforehand. You have a business background? >> I sure do. I used to
own a heating and cooling business in St. Louis that I grew basically started out with me and
one other technician and grew up to 35 techs and at 35 trucks on the road. And did that for
five or six years and sold my half of the business and about it really, did really well. It's exciting.
>> Why did you get out of that deal? >> I don't like heating and cooling. >> >> I'm a musician,
and more of an artist kind of a person. I'm a craftsman, basically. That wasn't much fun. It was
really hard work. So, you know, and awful hard work. >> Did you start that company? >> No, I
kind of did the same thing I'm doing here. I went to work for a guy, and basically just kind of
turned the business around with hard work basically. I just got busy, had some pretty good
ideas as far as how to market the business just did things differently, and kind of got it rolling,
so, and it worked. And then I burned myself out, it was too much. So it was time to get out. >>
You have some famous musicians playing your amps. >> We do. We do have some, you know,
Pearl Jam has one of our amps >> John Scofield, we got a, we have a piece of gear that's going
to Dave Gilmore I think today >> Wow >> Maybe? Which is pretty cool, you know, we've got all
kinds of people and it's great, it's fun. >> That's fantastic. You just joined as a partner, right? >>
Yes. I've been with the company for I think 5 years now, 4 or 5 years And I just did art at night.
I'd work from 10 o'clock in the night till 6 o'clock in the morning and didn't see anybody. >> >>
And then basically, I saw potential in the business side of things. And said, we should really go
for this. And it was the time for Ben. He's been doing it for 13 or 14 years and he's like, I need
the next push. >> Yeah. >> And so that's just one of my strength as a partner. I know how to
drive the team, get things done, get it going. Put the work in. I'm not afraid to sweat it out. I do
want to sweat, I couldn't stay . >> Yeah, that's what we've from. >> Yes, I just work, work, work.
>> >> Get the job done and then it pays off at the end in which >> So far we've done pretty well
with it, we have new changes. >> But that's part of the partnership, you're also going to buy
into the company, right. >> Yes, yes. >> Not just red equity. >> Yes, yes. I'm buying into the
company with all my-. >> Any concerns. Financial concerns or what worries you about. >> Well,
it's an investment for sure. >> I don't really have any worries. I don't know, I tend to keep things
positive no matter what. I don't do very good at losing so if I'm going to join the battle, I'm not
going to quit. I will win one way or the other and just takes hard work, basically. And being
innovative and think of new ideas and just approaching things differently from everyone else. I
think, at least in the world of musical instruments, is, see what everybody else is doing, and do
the complete opposite because you want to stand out. And that's how we approach things. >>
So do you, Business students from all over the world watching. Do you have any advise that
you'll give to the people starting? >> Well you know I do have a little advise and, I hate this I'm
not doubting the younger folks in the world, but I think younger people these days are afraid to
get dirty and get down to business and get to work. And I think if you really want to make

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something succeed and you really lead it and sweat it and love it, the work is not really work,
it's a labor of love, and you need to If you're going to become a business owner, you need to
love what you are doing or it is not a true passion I guess. You have to have passion for what
you are doing or it is never going to work, you know.

You either are going to make a lot of money and be miserable or you can make a lot of money
and do what you love, you know, >> Yeah. >> So I choose the latter. >>

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Module 1 Review

In this model, we talked about debt and equity financing, right? So, we started with a simple
examples of how debt and equity financing affect income and cash flow statements, the
mechanical affect. Then we talked about the net present value of both debt and equity issuance,
the cost and benefits and we talked about this idea that if debt and equity are fairly priced and
the NPV should be close to zero or maybe exactly zero. Then we talked about two
misconceptions that you should avoid when thinking about real world capital structure. The
first one is this notion of delusion. Delusion is an illusion. Delusion does not really matter, and
it's not the right way to think about leverage, or equity issuance or any capital structure The
second one is that that issuance does not mechanically reduce the cost of capital. The fact that
the required return on that is lower than the required return on equity, does not mean that a
company is going to reduce the cost of capital by issuing debt. That in fact was the motivation
for the Modigliani and Miller result. Which is one of the key results in cooperative finance, okay?
The logic there is that, that is going to increase systematic risk.

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Higher leverage is going to increase the required return on equity and the required return on
that, meaning that after a company issues leverage, issues debt, right? Because the company
becomes riskier, the cost of capturing the end doesn't change at all. Right? That's what
Modigliani and Miller showed us and we discussed it. The logic behind them, in them on how to
use it in practice to avoid making these mistakes that we talked about. Then we moved onto
the real world and we talked about the evidence that equity insuancecauses a decrease in stock
prices, right? And that is consistent with the other finding that companies are usually reluctant
to issue equity to finance projects.

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So the most important source of marginal financing to companies is death. Right? So given this,
we moved on to really dip into what happens to a company when a company issues debt. If a
company issues new debt what's going to happen to profits, risk and etc. Right? We figured out
the effect of leverage on taxes and OPAT, right? Because of the tax advantage of debt, a
company that increases leverage is going to reduce taxes and increase profitability. Personal
taxes mitigate this effect but don't completely eliminate it. Right? So, the real trade office
between this tax-advantage and the cost of financial distress, right?

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 We discuss how cost, what cost of financial distress are, and how leverage increases the risk of
financial distress and then we learn how to put these two things together, tax and the stress
cost, in a trade-off model that allows us to analyze how firms make capital structure choices in
the real world.

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