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What I would encourage you to do is, kind of, look back at multiple ways in which I

Â have tried to emphasize one the most important aspects of valuation.

Â Which is to see where the financing matters and does not matter.

Â And we saw that in a world with natural, tendencies of low cost of doing business

Â and so on in a competitive market. What happens is financing doesn't add

Â value. Real assets add value.

Â Real ideas add value. Okay, so this is a very profound result

Â and I've done it in two or three very intense ways.

Â Before I do the example, I would encourage you to revisit and think about, play the

Â video a couple of times. Of course I am in the process you'll see

Â me. But I will encourage you to kind of read a

Â book, do whatever resources before you jump into example.

Â Okay. The example that I'll give you here is, I

Â would call, almost like a case. And doing cases online is little bit

Â difficult. Right?

Â Because of multiple reasons. One is their copyright material and stuff

Â like that. And you need to have those.

Â So, I've constructed an example. The other problem is, that it requires you

Â to really think through carefully. Now some of you may jump to conclusions

Â quickly, and try to do the whole problem. I'd encourage you, stay with me, I'll go

Â slow. What I want to do for the next five to ten

Â minutes before we jump into answering various questions, is to try to read

Â through the problem. And I have this problem for you as an

Â online tool available on the site as a resource.

Â But you shouldn't need it, you should read with me and go slowly.

Â So here, let's start. Online Inc.

Â Is a video gaming company with no debt. Right?

Â What does that tell you? Right away you have to think.

Â Imagine. You know, do deep breathing, and try to

Â visualize the balance sheet of this company.

Â What do you see? You see real assets and then you see only

Â equity. So what does strike you?

Â That the return and risk of the real assets is based on the marketplace.

Â However, the return and risk of equity have to be the same.

Â Because there's no, debt. I've also done some work with for you and

Â said that this firm, which is this stock that has been added to Nasdaq recently.

Â Nasdaq is by the way, the exchange where most technology firms were.

Â Kind of initiated their trading. Is there, is an exchange that took off

Â during the technology boom? You also know by looking at doing an

Â analysis and looking casually at Google Finance or Yahoo!

Â Finance, the beta is 1.50 but in parenthesis before the big beta I say

Â equity beta I shouldn't have to do this. You should know that if you see beta

Â anywhere it should be beta of equity because debt doesn't trade as often in

Â many countries as a relationship between a bank and the company.

Â Okay? So, 1.5.

Â So quickly what does that mean? Is this business risk higher than the

Â average market risk? And says what?

Â Yeah. Why?

Â Because 1.5 is greater than one and what is the beta of the whole market?

Â One. Because you would move one to one with

Â yourself and this is riskier than the whole market on average and make sense

Â right because video gaming is not something you absolutely need to do tough

Â these days I wonder but you know, video gaming is more important than food, you

Â know, so anyway. Second issue which is, which is where

Â things start becoming interesting is now, online is considering investing in the

Â software business. So if you may notice, it's going the

Â opposite direction of one of the most famous companies we know which went from

Â software to gaming. Anyway, the business project will require

Â an initial investment of 50 million, right?

Â So by the way, as usual, if I make some error that's okay.

Â You have, you are there to fix it. So let's keep going.

Â The number $50 million. Now in the real world this could be far

Â more. But let's keep it at 50 million..

Â What reminds you? What is the symbol that comes to mind when

Â you think 50? Million, finite, the investment.

Â If undertaken. That means if they choose to do this

Â project, or start this business in addition to the existing business.

Â The video gaming, business will represent 25 % of Online Inc.'s assets so, so just

Â as a, as a reminder, I'm making this a little bit dramatic.

Â Why? Because I'm going to keep the current

Â business 25 percent and the new business, how much?

Â 75%. So why am I doing this?

Â Just to make the problem interesting. So, just because if it was the other way

Â round, though 25 percent of the new business is trim significant, here the new

Â business would be 75%. So throwing some, you knoq drama into the

Â whole thing. So, this is just for you to think.

Â There is a next bullet point. This is all in front of you.

Â You, an I hope you're writing. Okay.

Â There's a 50 percent chance, that the project will generate an annual payoff.

Â Of $seven million, forever. What does the $seven million payoff mean?

Â Does it mean revenue? Does it mean costs?

Â But now that you know finance doesn't mean cash flow.

Â Means cash folds, profits because you're interested in revenues and cars, in the

Â end you're interested in bottom-line $seven million.

Â How many times? Forever.

Â Is that true? No!

Â But you have realized that forever basically is approximated by perpetuity

Â formula and makes calculation easier. In the real world seven million won't be

Â constant, it will change and we will, need a spreed sheet.

Â I am going to stay away from a spreed sheet.

Â In fact most important problem as I said earlier, can be thought off and actually

Â executed perhaps without the spreadsheet. So 50%t chance that it'll give 7,000,000

Â for the foreseeable future. A 40 percent chance of an annual pay off

Â of 5,000,000 forever so 7,000,000 5,000,000 and a ten percent chance of

Â getting nothing. So what is this world showing that there

Â is uncertainty because if there's no uncertainty, the world is uninteresting.

Â So let me back up for a second. Our line is in the video gaming business.

Â Its beta equity is 1.5 but that's also its beta asset, because it has no debt.

Â But it's considering a major move into, what?

Â A new business which will become 75 percent of its total business.

Â But only if they choose to do it right. This investment will require, this sorry

Â new idea or new business will require $50 million investment.

Â And then you could make seven million with a 50 percent chance.

Â 40 percent Chance of making five million And ten percent chance of making nothing.

Â There's one more piece of information which I'll provide you, and then as I,

Â I'll use this simple example. It's simple only because I've brought it

Â into the essence of it. You know?

Â Most cases I've written over twenty pages, 30 pages because I complicate it.

Â But I'm making it that sense, simple, one more piece of information.

Â Companies solely in the software business. Remember what business is online in?

Â Video gaming. But companies solely in the software

Â business have an equity beta of 1.4. Quick question.

Â Why am I saying solely in the software business?

Â Because the new idea is what? New project is what?

Â Software business. In the real world, it may be difficult to

Â find firms solely in the software business.

Â But that's where the real world makes things a little bit complicated.

Â So big firms that are out there doing software business solely have an equity

Â beta of 1.4. How do you get this?

Â You look up all the firms that are in the software business, average their equity

Â betas and it turns out to be 1.4. These firms have a debt to equity ratio of

Â 25 on average and have riskless debt. So what am I telling you here?

Â Debt to equity ratio of.25 is important to know because that, that tells you the

Â weight of debt, right? What is the rate of equity on average?

Â .75, right?.25 is debt, .75 is equity. And good news or bad news, but important

Â news, the debt tends to be riskless. In other words, the chances of default in

Â the software business is low. You may disagree or not.

Â That's not that important an issue. But that's exactly riskless or not, the

Â key here is valuation. On-lining is for casting, that the average

Â market risk premium is five%, and the risk free rate on a long term bond is 4.5%.

Â So let me just, lets stare at this and try to understand the importance of these

Â numbers. So lets see.

Â Emphasize a few things. 1.4.

Â 11:33

What does four point, 4.5 percent is RF, the risk create.

Â Right? And the long-term bond, if you were to

Â think about, can it be a corporate bond? Chances are very low.

Â It has to be a government bond, right? So, so that's what I mean.

Â Think through what information you have before you jump.

Â So what is this five percent then, interest rate.

Â This is RM, minus RF on average. So here's, here's the interesting thing.

Â What does it mean to say that Online Inc. Is forecasting these two numbers?

Â There's a, there's a little catch 22 here for you.

Â A little bit of a, you know, a puzzle. Can Online Inc come up with its own

Â forecast of these two numbers, or should it?

Â Answer is no. Why?

Â Because these two numbers are based on market phenomena.

Â So if Online Inc. Is doing it right, these two numbers

Â should be based on a long term treasury bond.

Â Ten year is 4.5. This nobody should disagree about.

Â There's some disagreement about this number.

Â Very important. So I, its using five percent because its

Â kind of behaving a little bit like me. Is, it's based on a lot of data.

Â So, if you look at a lot of data on a lot of stuff markets for-, forever in the

Â past, the numbers probably closer to this five%.

Â And it's just, just giving you hint, that if you use US data, the numbers will be

Â higher. It'll be closer to 70%.

Â But there again. Online is not forecasting anything, it's

Â using past data and some judgement to come up with the five%.

Â In other words if most people had this point of view, they should have exactly

Â two same numbers, right? So 4.5 is given and five.

Â I would, I would encourage you to do this, take a break and I will take a lot of

Â breaks this time. Just think about the data, think about the

Â following. You have been given a lot of data but the

Â decision to be made very simple. Online is doing video gaming.

Â Should Online go into software? Question number one.

Â Question number two, is this a trivial or important decision?

Â It's an extremely important decision. Why?

Â Because if online chooses to do this, what fraction of it's business will suddenly be

Â in software. 75%.

Â As I said earlier, the fun part is it's going against the trend.

Â But I don't think there's any such thing in life.

Â Software will become important, and gaming will important.

Â And gaming will reach it's limited ability, and software becomes important

Â and so on. So let's take a break, come back and what

Â we'll do now, is do one question at a time.

Â And the reason I'm doing this example, is to do...

Â Achieve two goals. One, Recap what we have talked about for

Â the past few weeks. Largely about cost of capital, emphasis.

Â Second, I want to you to be able to put together everything and if you do this

Â problem and think through issues clearly, you'll be able to do a lot of valuation.

Â Okay? So let's take a break.

Â Come back soon.

Â