Debt Policy in 15 minutes: Finance Capital
Structure Theory & Return on Investment Ratio ROI / ROE Okay. Welcome back again to MBAbullshit.com.
Our topic for this video is Capital Structure and Debt Policy. So let’s get down to it.
Now I’d like to start with a story. Okay. Let’s remember when we were kids. Most parents
or our parents always taught that it’s best to spend your own money. That you should not
borrow money, in corporate finance or financial management we know that it’s debt. Okay?
Don’t borrow money because you might go broke, because you might not be able to pay
back your debt. And later on in life, especially after in the 2008 recession, we further learn
that again you should not borrow. Like for example, you shouldn’t collect credit card
debt because it will become so big and in the end you will end up poor. Okay? So the
moral lesson is: to get rich, you should not borrow money which is debt and you should
spend your own money, and your own money is your equity. In corporate finance, is this
lesson really true? Let’s see. Actually, from the point of view of traditional
capital structure, if you want to get rich you have to borrow more. That’s right. You
should borrow more. And mathematically, this is actually correct. Why? Because the more
you borrow, the more you will earn or the more you can earn compared to your investment.
And this money that you’re earning compared to your investment is measured by return on
equity also known as ROE. But note this is just the traditional view. Your professor
or the exam might expect a different answer because as you’ll see on my other video
on MBAbullshit.com, I show how financial gurus, Miller and Modigliani, M and M, mathematically
supposedly proved or theorized that actually it doesn’t matter whether a company has
more debt or more equity, and you will see why. But don’t worry. It sounds simple.
It’s actually very simple. I know that the name Miller and Modigliani sounds scary but
don’t worry about it. It’s actually very simple. On the other you’ll even see a better
positive effect of debt when we consider taxes. So you’ll see this in my other super easy
video on Tax Shield also at MBAbullshit.com. So now back to the traditional view. So from
the point of a traditionalist, if you want to get rich you should borrow more and the
more you borrow, you’ll earn more compared to your investment. You will have a higher
ROE. What is return in investment or return in
equity rather? Well, it measures how much percent that you will get back after you invest
your own money into a business. Let’s look at this first example. Example 1, you invest
one hundred dollars of your own money for a lemonade stand, you earn back only twenty
dollars. So your ROE is twenty divided by one hundred, and that will equal twenty percent.
Now let’s look at example 2. You invest one hundred dollars of your own money for
a barbecue stand this time and you earn back fifty dollars. Your ROE is fifty divided by
one hundred, and that equals fifty percent. So you earn more with a barbecue stand therefore
it has a higher ROE. As you can see here, you earn fifty dollars; it translates to a
higher ROE of fifty percent. Here you earn only twenty dollars and it translates to a
lower ROE of only twenty percent. That’s how ROE or Return in Equity can be used as
a measurement of how much you earn. Now what if the barbecue stand will still
earn fifty dollars profit return as you can see here? Okay. It will still earn the fifty
dollars profit return and the cost is still one hundred dollars as you saw here, the cost
of your investment. The barbecue stand cost you one hundred dollars to buy. You had to
buy the equipment for one hundred dollars for example. But you only invest sixty dollars
of your own money and that is called equity, and you instead borrow the remaining forty
dollars in debt to get the total of one hundred dollars. Why do you need one hundred dollars?
Because that’s how much the barbecue stand costs. So here, you still need one hundred
dollars but this time, you did not use your own money and instead you use only sixty dollars
of your own money and you borrowed the remaining forty dollars. What will happen to your ROE?
It will become fifty dollars divided by sixty dollars, not anymore divided by one hundred
dollars because ROE talks only about your own money. It does not take into consideration
the total cost of your equipment which is one hundred dollars. So now, what is your
ROE? Fifty divided by sixty equals eighty-three percent which is much higher than the original
fifty percent that we saw here. See? So what does this mean? That borrowing or [0:07:00]
debt increased you ROE or increased how much profit you get back compared to your own investment
which is equity. Go ahead and watch this slide again if you want.
Now, what does this mean for us? This means that more debt is good for a company and its
owners. Why? Because it increases the company’s profitability. How? Because more debt increases
the amount of profit a company’s owners can make compared to the owners investment.
Now let’s see this happen in a bigger corporation. Case 1, the company has one thousand dollars
in barbecue equipment which is the assets and to buy to the equipments, one hundred
friends or investors invested ten dollars each by buying one share of stock each worth
ten dollars. So the company has exactly one hundred shares of stock. One hundred time
ten dollars equals one thousand. And let’s say that this company earns five hundred dollars
in one year. How much is the earnings per share? The earnings per share will be five
hundred dollars which is the earnings divided by the one hundred shares and that gives us
five dollars per share and the ROE of one friend or one investor will be five dollars
divided by ten dollars of share equals fifty percent. Note that in theory, by the way,
the owners and investors get back their money when the company pays them their share of
the profits called dividends which is exactly equal to the earnings per share. However,
in real life, it is not so simple because these dividends may or may not be equal to
the earnings per share. More of that in my other video about dividend policy and dividend
payout on MBAbullshit.com and that is very important part of capital structure and corporate
financial management. Anyway, back at the simple example, you have
to remember this because you might get confused so sorry about that. Back at the simple example,
the earning per share, the ROE of one friend investor is fifty percent. Now in another
case, a similar company maybe has the same one thousand dollars of barbecue equipment
and to buy the equipment, only sixty friends or investors invested six hundred dollars
equity by each buying one share of stock worth ten dollars each. In this case, the company
only has sixty shares of stock because you only have sixty friends and they invested
one share of stock each of ten dollars, and the company also borrowed four hundred dollars
debt from the bank. After they borrowed the four hundred dollars debt from the bank, they
were able to get the one thousand dollars needed. Six hundred dollars of equity, the
friends invested their own money, plus four hundred dollars borrowing debt. But in this
case, the company must pay ten percent interest on the four hundred dollar loan. How much
will the same company earn in one year? Well we have the five hundred dollar profit (There’s
nothing new here. From the first case, from the first example, the company also had five
hundred dollars profit) minus the interest. Remember we have to pay ten percent interest
on the four hundred dollar loan so the interest is four hundred dollars times ten percent,
forty dollars. How much do we earn? Five hundred dollars less forty dollars: only four hundred
sixty dollars. It’s not good right? It’s less than the five hundred dollar profit in
the last case, in the first example. Well let’s see. Let’s compute how much each
investor really earns. Remember the earnings per share is four hundred sixty dollars divided
by sixty shares and the earnings per share is seven dollars and sixty-seven cents. Now
you’re wondering why is it one sixty shares? Well because we borrowed money. Since we borrowed
money, we needed to invest less of our own money. So now there are only sixty shares
instead of one hundred. But in the first example, we didn’t borrow any money and so we needed
more friends to invest money so there are one hundred shares. So now the earnings per
share is seven dollars and sixty-seven cents and the ROE is seven dollars and sixty seven
cents divided by the ten dollars per share that each friend paid for his share of stock,
and the ROE will be around seventy-seven percent. Is this seventy-seven percent big or low,
big or small? It’s bigger than fifty percent. You got an ROE of fifty percent when the company
had one hundred shares of stock and no debt, no borrowing. So we had fifty percent ROE,
return on equity. But in the second case, when we did have debt, when we did have borrowing,
the ROE jumped from fifty percent to the new seventy-seven percent which is better. So
even with the interest expense, we got a much bigger profit per investor or for each friend
and we got a much larger return on equity. What’s the conclusion here? The conclusion
is that more debt is good for a company and its owner because it increases the company’s
profitability. How? Because more debt increases the amount of profit a company’s owners
make compared to the owners’ investment. Again, always remember this is just the traditional
view and in my other video in Miller and Modigliani, you’ll see that it actually doesn’t matter
as long as there are no taxes but if there are taxes, it really is better to have debt
which you will see in my other video about Tax Shield.
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