## Debt Policy in 15 minutes: Finance Capital Structure Theory & Return on Investment Ratio ROI / ROE

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.

So for this video, share if you like it, find us on Facebook and Twitter. Please like our

fan page and please retweet us or just send our YouTube links on email. Have a great day

and good bye. debbierojonan Page 1

@tootuffy Thanks too tuffy! I always feel great when I save someone from "death"! =p

@nadradt Thanks nadradt! Remember to click "Thumbs-Up Like" and share with your friends. Cheers!

Really helped. Thanks ðŸ™‚

@Orra247 Thanks too Orra!

thank you very clear and extremely helpful !!! XD

@houdapurple Glad to know that!

Hey,

I watched your videos on WACC and CAPM. I have to write 2000 words for tomorrow on the M+M theorem … your videos are really helpful to understand and thats why I decided to buy the "Plan A+plus Super Exam Blaster" to see you videos on Modigliani and Miller! I hope it helps, 23 hours until the deadline lol…

Glad you upgraded to premium; but dunno if M+M Theorem will add up to 2,000 words though. It's actually a super simple concept (usually explained in a difficult way, LOL). In fact I'm writing an e-book right now and MM theorem is only around 1,000, including examples. (sorry, not yet available)

I managed to get it done 15min before the deadline. The question was why companies do not gear up to a maximum as suggested by M+M, the tax shield video and M+M video 1 helped a lot there… at least to clearly explain the theorem.

Wow, so happy for you! Congratulations!

Et voila thanx a lot find your video really helpful its just make it bullshit lol nothing to worry merci beaucoup xx

merci to you too!!

Wow! Great to have a viewer all the way in Germany!

good luck to you in texas!

Little update, essay made me get a first ðŸ™‚

Thanks!

WOWWWW!!!

Man, your videos cover almost my whole finance course, your videos are really really appreciated man! Keep it up! Love em!

glad you "really really" appreciate it!

this is the best video ever,

Thanks Mostafa!

Thanks you …:)

Welcome….:)

It's really nice thank you. Btw where can I find the M&M proposition video?

Thanks too Ken. The M & M is on my website. Cheers.

I can't find the other video about M-M, please could you share the link, I realy need it. thanks in advance.

Hi Hussein, unfortunately Youtube doesn't allow links in comments. Go to my website (not Youtube channel) and you'll find it there. Cheers

this video intro is very funny, i enjoy every bit of it, now it makes sense, cheers mate!

I was wondering what is the difference between ROE and the COC/ Required Rate of Return?

make sense, ty

simple explanation of a complicated concept !!!!!!.

Very Good Explanation of the RO

Very Good explanation of ROE..