0:00

Hopefully, you've given it some thought and, even more so, tried to do some

Â number-crunching. And, by the way, this number-crunching is

Â extremely important because it affects the cost of capital and the cost of capital is

Â very important because of? I haven't reminded you of this question.

Â Compounding, right? Okay, let's get started.

Â I know that beta's determined risk so I know this equation.

Â Beta asset is equal to beta equity, if what's true?

Â There is no debt. But then, it's weighted by equity over D

Â plus equity plus beta debt weighted by D over D plus E.

Â Okay? If you stare at this equation, it won't be

Â very surprising that you can rewrite it as beta equity, but, okay?

Â And what you can do is, do this on your own.

Â You can write beta equity as, you've seen this equation before.

Â Beta asset, business risk plus D over E beta asset minus beta debt.

Â Okay, so this is just a transformation. I've just transformed this to this.

Â These are essentially the same thing. Okay, quick question.

Â What is the cost of capital of the project?

Â The first thing you have to figure out is what the cost of capital of what project

Â are we talking about? Let me put S here.

Â 1:41

An S here. So, the risk of the assets of the software

Â business is what we are after. But then, I told you the numbers.

Â What numbers did I give you? I gave you numbers for beta equity.

Â So, what was the beta equity? Beta equity was 1.40 is equal to beta

Â asset, the unknown, plus, I told you on average the ratio of debt to equity was

Â how much? 0.25, remember?

Â All the data is with you. And which is, which is this industry?

Â S, software industry, beta asset. Again, the unknown, 'till now we are safe

Â [laugh]. We have how many unknowns?

Â One. How many questions?

Â One. Now, life is a little bit complicated if

Â I, if beta debt is also positive. What I made the problem pretty simple.

Â What did I say? The debt was largely riskless in this

Â industry, so I can put zero. Quick question, will this be true usually?

Â No, unless there's very low level of tech in the whole industry, right?

Â So typically, just as an example, beta debt is between 0.1 to 0.4.

Â I'm just giving you broad numbers just to give you a context in which to put it.

Â Why? Because there's always char, risk in debt

Â too. Remember this is corporate debt.

Â This is not, this is not straight forward government debt.

Â That too, without any coupons. Remember, if you have coupons there's

Â risk. Okay, can you solve this equation?

Â Heck, very easy. Beta asset security S will be equal to

Â 1.40 divided by 1.25. You see how that I get, how did I get it?

Â Because beta asset is beta asset plus 1.25 beta asset and 1.4.

Â So, beta asset in the software business is 1.4 divided by 1.25 which I believe is

Â 1.12. You see, I've done some homework before I

Â came. I think this is right and if this is not

Â just, just do a try, I think it's okay. So, 1.12 is the beta asset of which

Â business? The software business.

Â 4:14

Let me ask you, what was the beta asset of the video gaming business, was it higher

Â or lower? One estimate I had was 1.5.

Â I am calling it one estimate because I took the video gaming business existing of

Â my own. There could be other companies with video

Â gaming business, so you want to average these across different because these are

Â estimates. Okay, so beta asset software business is

Â 1.12. We have almost come.

Â 4:43

Almost come all the way to cost of capital, what have I done here?

Â Notice one simple thing, if I'd asked you, what is the beta asset directionally of

Â the software business if I gave you beta equity at 1.4?

Â You should say what? The maximum beta asset of the software

Â business can be 1.4 because the beta equity is 1.4.

Â But because it has debt, the beta asset has to be lowered, [laugh] you know, than

Â beta equity because equity has financial risk in it.

Â Okay? You estimate it to be 1.4.

Â So, let's just start off with a clean slate here and go to the next step.

Â So, what is the next step now? Cost of capital.

Â Turns out you know how to do that. Ra of the software business is equal to

Â what? Rf.

Â 5:44

What equation am I writing? Capm plus Rm minus Rf times beta asset of

Â software business. You see how cool this is?

Â I know this is 1.12, but I know this is 4.5, and how much is this?

Â Five%. Now, this is a little bit all our numbers

Â can't be well rounded and so on, so there's a little bit off.

Â So, this is 10.1%. Okay?

Â Why 10.1? Because 4.5 plus five multiplied by 1.2,

Â this become 5.6. So, five multiplied by 1.2, this

Â multiplication is 5.6. So, 5.6 plus 4.5 is 10.1.

Â We'll treat it almost ten, right? Just, just because we are family.

Â And I'm going to just worry about the 0.1 when we talk, okay?

Â So, quick question. Please think this through.

Â I've done a lot of calculations. But again, the thinking comes before the

Â pen starts punching numbers. And you didn't need Excel, right?

Â So let's take a break, come back.

Â