Okay, so we've established the mechanics of listing your shares on the stock exchange via an IPO. And we've also discussed the issue of leaving money on the table when subscription prices are deliberately set below market values in the phenomena known as IPO under pricing. Before we can get into the factors that might drive us to use debt as an alternative to equity financing. We first need to work out exactly what impact the introduction of debt has on a firm. So, to set the scene, let's head back to your coffee delivery business, which, you'll be glad to know, is doing fine since it listed on the stock exchange. You decide that you need to invest in a new coffee roaster, and estimate that the return that could be generated on the investment is approximately 17.5% per annum. You talk to your friendly banker and they offer you an interest rate of 10% per annum. It's a no brainer, right? Borrow at 10% to invest at 17.5% percent, well let's see. So let's demonstrate the impact of leverage on returns. Firstly, let's consider your whole coffee business completely funded by equity. There are 10,000 shares, each trading a $40 per share. So the market capitalization, the market value of your equity is $400,000. Let's also assume that there are three possible states of the world that you face. Let's first take our normal or our expected state of the world. We expect to generate $100,000 of operating profit. So our net income before tax is $100,000. We pay tax at a corporate rate of 30%, leaving net income of $70,000. So our return on equity in our expected state of the world is 17.5% Simply, $70,000 divided by $400,000, being the market value of equity. In the poor state of the world, we generate only $10,000 of operating profit, implying a return on equity of only 1.75%. And in the great state of the world, we generate $200,000 of profit, generating a return on equity of 35%. Now let's consider the down state of the world, where operating profit is only $10,000. Interest expense needs to be paid irrespective of the underlying business conditions. So this implies a Net Income before Tax of -$10,000. So Net Income, to be distributed, the loss to be distributed amongst shareholders of -$10,000. That implies a Return on Equity of -5%. So note that shareholders are actually worse off than they were before and the downstate of the world. Why? Well, interest needs to be paid irrespective of the underlying cash flows from the firm's operations. So this diagram demonstrates the impact of leverage on returns and there are two very important effects that we need to document. Firstly, returns to Investors can be enhanced by introducing debt into the firm's capital structure. That is the expected return of shareholders may increase by introducing debt and that'll occur where the return on assets exceeds the explicit interest cost of debt. The second effect is that returns become much more volatile, that is, returns are more uncertain. In the up state, our returns are enhanced to shareholders, but in the down state, our returns take a hit. So, how would a shareholder respond to increased debt? As we said, on the one hand expected returns are higher. On the second hand though, the cost of debt has two components, the explicit cost of debt is obviously interest expense but there's an implicit cost of debt. That implicit cost of debt or indirect cost of debt, so it's known as increased risk, we refer to that concept as financial risk. That is, returns to shareholders become more volatile as we firstly introduced it into the firm's capital structure and then as we start to increase the level of debt as well. So why do shareholders care about this? Well go back to your first calculation of the value of any asset using present value formula. And you'll find that the discount rate of cost reflects risk. One component of that risk is financial risk. So as you increase the risk of shareholder returns, shareholders will use a higher discount rate to discount the expected cash flows from the shares. And that, all other things remaining equal, will be expected to have a negative effect on the company share price. So in summary, introducing debt into a firm can increase the expected returns to shareholders provided the rate of return on assets exceeds the interest rate on debt. It will also increase the variability of returns to shareholders,. And this increasing variability is known as financial risk. Shareholders will demand compensation for exposure to financial risk, and they'll use a higher discount rate when valuing the share. Now, next session, we will start to consider cross-sectional variation in debt levels and try to explain why different firms choose to have different levels of debt.
