 Well, hello everyone and welcome back to our Overviews of MBA 601 financial management. This is our overview of unit 5 managing capital If you haven't seen any other videos in this series obviously go back and check them out and of course this is all a part of Sailor Academy's course, so check the link down below and sign up If you have any questions as we're going along feel free to leave them in the chat And of course if you're watching this later because obviously everyone can't join us live put them in the Put a question you have down in the comment section and and we'll get to it But I will just hand it right now over to dr. Lou Pearson to get us going and I'll get out of the way Thanks Michael and welcome back to anybody that's listened to our previous presentations on financial management Before I get started, let me just note that I there have been a couple of comments Registered about having more examples of some of the financial concepts. We're talking about it. It's a good point However, remember that this is an overview We're trying to present a bunch of very complex topics in a short period of time Yes, there are lots more actual examples to work through in the course itself and if you're really interested in some of these topics There's lots of information that's available online to dig into them a bit more than we can do in the short amount of time We have for our presentation. So having said that Let me start out by just reminding everybody about our course objectives and for unit five we're specifically focusing on Explaining the steps of developing a capital budget Now remember that capital budget is something that companies typically do on an annual basis because it relates to Planning expenditures of large sums of money typically for plant and equipment. So it takes amount of time to think through to analyze And more importantly to ensure that the capital is available to implement those programs We want to recognize the importance of free cash flow as a measure of performance now this is a new topic and We're going to touch base on this today, but especially as a former CEO of a company I'll tell you it's a very critical measure of The decisions that are being made and we'll talk a little bit about exactly what free cash flow is not to be confused with cash flow and Finally the ability to actually calculate the cost of debt and equity we need to know those because If we are going to make an investment. We're looking for return that return has to at least cover the cost Of the investment which includes covering the cost of the debt and the cost of the equity This is unit five out of the seven units in this MBA course And we are going to talk specifically about managing capital One of my favorite topics and one of key importance to anybody responsible for managing and running a business some of the objectives in this unit will be to again review The cost of capital and what the implication of that cost is when you consider potential returns on making an investment Determining the cash flow of a project remember we are making investments Why because we're looking to generate additional revenue and so we want to know what kind of cash will that generate for the firm? We'll talk about the importance of free cash flow And we're gonna go a little bit more depth into the idea of calculating the firm's cost of capital So I'm gonna introduce a couple of new concepts So hang on and we'll dig into that in just a bit now Some of the topics that I will touch base on in today's presentation is again the capital structure We'll talk more about the cost of capital the weighted average cost of capital or whack What exactly is the optimal capital structure? I mean it's not really one of Lock we actually can control What are to some extent what our cost of capital is by how we set up the capital structure of the firm? we'll talk about cash flow and Specifically mentioned some of the implications of free cash flow now again before I go too much farther into this Let me just take a second and see it so far There are any questions on material we've covered before or before I get started I am I'm not seeing any questions in the chat right now But of course if anyone has any questions as we always say you can leave them in the chat Or if you're watching later feel free to leave them in the comment section below But I'll let you keep going and if anyone has any questions. I'll I'll jump in and I'll I'll let I'll I'll be your arbiter of questions. Thank you, sir So let's get started and again cash flow the cash flow that not terribly complicated But we are talking about cash, right? And so we want to know based on what we're doing Let's look at it this way in the day-to-day operations of the business We have cash that comes into the business and firms of revenue And payments for goods and services. We have cash that goes out As you're paying for materials or paying for payroll and rent and the like The difference between those two is cash flow, which can be either negative or positive Obviously, we're hoping for a positive cash flow But recognizing the dynamics of business at any given point in time There are times when that cash flow can be negative. We understand that Which is why one of the things management does is we prepare a cash budget And so we actually sit down and we Forecast we anticipate What the cash flow is going to be on a month a month and quarter to quarter basis And so if you have a Seasonal product it may be a point of time where for a couple months in the year You have a negative cash flow while you're waiting for a season to start That's not necessarily a bad thing if you know it You've budgeted for it and you prepare for it. And that's why Businesses may have lines of credit with their local lenders So that when I do have those periods of negative cash flow I have a method of having cash available to keep the business operating. Okay, so that's that's cash flow But I want to take a step further and discuss the idea of free cash flow Now free cash flow is a very important and I believe a very critical measure For a business. So first, what is free cash flow? Well, if you were to take the cash that a comes into a business And for example from revenue and you account for all the operating expenses Now note here. I'm saying operating expenses. So not necessarily all the expenses in the business But those specifically related to day-to-day operations I mean a company may have some expenses because they're doing some outside Investments and something not related to the company. We're not going to count those We want the operating expenses tied to this business The taxes have been paid And if there were any outstanding positive net present value projects And remember what those are a positive net present value project is one that if the firm invests in it It will have a return that is great enough to cover the cost of the investment And have a positive impact on wealth to what to shareholders So All operating expenses have been paid You've paid taxes and you've made any investments in positive NPV projects that are on the table If there is cash left That is free cash flow Now, why is it free? It's free because it's not required to operate the business you've covered all of that in the expenses and the taxes and the investments you've made So what is free cash for free cash is for you could be the company may make a determination to pay dividends Sometimes firms if they have an exceptionally good return on free cash flow can make a one time dividend payment Give back to investors Some of the money they've paid in You could use it to pay down debt early to reduce the cost of debt maintenance and interest payments But here's the key in in my mind and in my experience the free cash flow Is a report card on the decisions that i've made in running the business If what i've been doing has resulted in generating revenue of a sufficient amount that we've covered all the operating expenses paid all of our taxes invested in available Projects for us in terms of plant equipment for expansion and growth And there's money left over then those decisions have been pretty good And the more free cash flow that's generated In my mind and in the mind of your investors the better job we're doing um, and so it it is a great reflection Of exactly what the firm is doing and more importantly the kind of impact they're having On creating real value in the eyes of their investors Okay, so that's a key now when you think about all that Maximizing free cash flow by making appropriate management decisions It obviously turns our attention to the idea of yes capital management Capital management is just that it's managing all the capital at the firm hands I think about this process Um, if you're a sole proprietor you started a company you've invested your money to start a business You're making decisions on that money to invest in plant equipment or to support the services that you're going to offer to the market Or you're a public company and you're receiving money from shareholders as as stock is being purchased There's cash coming in and you have to manage that cash To manage it to do what to increase the value of the firm Do it profitably Create an improvement in profit year over year and yes generate free cash flow Now the whole process can be complicated It is and the larger the firm the more time it takes The more analysis is required I I can tell you that as a former president and ceo of a company Uh a good amount of my time was spent in issues dealing with capital management It's a critical part of the business But in my world the definition of capital management is simply this it's the processing of process of managing my firm's money Manage the money. Um, that's one of your key responsibilities in the business Now as you run that business remember that they're on a day to day month of months quarter to quarter basis There are a lot of demands cash We have short term demands. There's payroll costs and materials rent and like all those things necessary to keep the business going day to day week to week Um, so we have to manage that. What does that mean? Well Take a basic one payroll Based on the number of of people that you have in the organization There is an implication for the amount of the payroll and the expenses associated with Payroll and the benefits for employees the training that might be required That is a manageable cost meaning you make decisions on how larger how small the payroll can be Now it's not as simple as saying well keep keep payroll small to minimize cash What if it has a negative impact on quality production customer service? So you're constantly weighing alternatives as you manage those short term expense items the cost of materials At one point in my career. I was responsible for global purchasing for a international corporation We spent a substantial amount of time continually evaluating the cost Of the materials and parts that we were buying in support of our production facilities Which were located around the world our our purchasing budget was in the tens of millions of dollars a year A half percent savings and cost could have a huge impact on the overall success of the business So that's managing cash. Okay on a day-to-day basis Cash coming in One of the things that I did early on in my career. I was keenly interested on a monthly basis on getting report of accounts receivables You've sold your products and your services and invoices have been sent to customers and you're waiting to receive your money And so we would look at a at a receivable report to see what what what amount of money was due and current How much of that was past due? 10 days past due the due date 30 days past due the and so that we could take actions For example, if in fact you notice That the past due on accounts receivable was increasing What are you going to do? I mean there's certainly opportunities to increase your collection but One thing to consider is avoiding those potential hazards and should we be reviewing our credit policy Is the credit policy perhaps too loose? Do we need to tighten it up make it a tad stricter? So that's what I mean by actually getting involved in managing capital And on the long term we're talking about Larger sums of money for capital investments and plant and equipment launching new product lines expansion of facilities So you've got all of these things that you're working at In fact, as you sit there in that chair, there are a lot of competing interests for the dollars that you have There can be lots of good things to spend money at The question is No business at least no business that I've ever been involved in in the last number of decades Has ever had more money than we could possibly invest I will tell you that there have been times in my career when I wished that I had substantially more money to invest But most times you don't have that luxury And so it's necessary for you to make decisions on where you will spend the capital that you have You have 10 projects before you all are positive all can have a positive impact on the business But you can afford to invest in four Which four of those projects will you and make your investment? And obviously as we talked in in prior presentations One of the driving points here is you'll make the investment where you get the opportunity for the greatest return Let's put our money where we'll get the most money back for the firm and for our shareholders Now having said that Where do we start how does this process get started? And we've touched briefly on the fact that one of the one of the major things that management has to do is to determine the capital that's needed to support the business And to be able to make some investments and key projects and initiatives um And to make a determination and where that capital will come from Now generally speaking there's two buckets of funds that that make up the capital available to the firm One comes from debt money that we get from a lender We borrow x number of dollars to have cash available to To invest and the second is equity and money that's generated by the business and by the investors acquiring stock in the firm So we have this debt and equity The the decision-facing management and it is an important decision Is exactly how much of each you plan on using to develop the firm's capital plan? Assuming you had no restrictions And you had access to All the debt that you required and you had access to a pool of equity How much of each are you going to use to build the capital plan? Now before I go further let let me back up one second and remind everybody that the capital plan Is actually a plan. We've thought about this. We've done considerable analysis. We've evaluated investment opportunities There is a ton of data sitting on the table in front of us And as a result of that we have estimated when we put together this year's strategic plan and the budgets Exactly what how much capital we wanted in the capital plan? All right, so it's not by accident. We have a number Now the decision before the board is how much debt and how much equity will we use to meet the requirements at a capital plan Now we said debt is it's using other people's money We go to our local lender and we borrow short term or long term loan Um debt is called leverage. Why because we're leveraging other people's money To make an investment and generate a return now Note that debt financing usually costs less than equity financing And we'll talk more about why that is uh in a bit Now from an investor's point of view from your shareholders Um using debt is a good thing. It actually increases the return on equity Very simple reason You are earning money for shareholders using somebody else's money. You're not using theirs So their return on equity is very good The the lower amount of equity the greater the return uh on equity for for your investors Now debt financing can come from something as simple as going to a bank and taking out a loan firms can also issue bonds Which is a debt instrument a bond is Selling an iou to the public You buy a bond and just like a loan that bond has a payback date And it has interest payments that are made on some predetermined schedule So people can invest in bonds just like they can in stock Equity is ownership and that's a key issue with equity If I have shares of stock in a company then I am part owner in that company We talked last week about the fact that common shares common stock gives me a voting interest in the firm I can vote on decisions the company is making I can vote on the board of directors A shareholder by stock takes an ownership position And that investor now also bears all the risk of that investment If the investment doesn't work out the shareholder has no recourse the the pay return of that money Is not guaranteed So you can invest a hundred thousand dollars in stock. You can lose a hundred thousand dollars in stock Right. So the investor bears all the risk But with that ownership stake comes an ownership stake in all of the firm's future profits So we look to invest in companies that have a positive track record that are doing positive things and moving forward Now before we go much further, let me just summarize quickly This difference between debt and equity and as all things in business There's a advantage and a disadvantage to all things And your task is to sit there evaluate The advantages and the disadvantages And make a determination on exactly how much risk you're willing to assume in your decision Now when we talk about debt the advantage is the lenders don't get any ownership right So the bank doesn't become an owner in your firm When the debt is paid the relationship is over There's nothing more to talk about And typically the interest that you're paying is a tax deduction. We mentioned that uh earlier on in In our presentations that that's called the tax shield So I know that um, although I'm going to pay a certain amount of interest I will get some relief on the tax side because tax is deductible The disadvantage to debt is that there's a payment schedule We call that debt maintenance and a firm has a responsibility to ensure that they are able to To meet the interest payments on the debt they have Let me go back to the whole issue of uh of capital management. This is one of the tasks if a firm misses interest payments What's likely to happen? the Lender could call for the debt to be paid in full Or most likely that we call it'll result in penalties and even in an increase in the interest rate So we have to manage that we have to ensure that capital will be available when those interest payments are due The more debt that the firm uses the greater the risk of default The fault means that at some point if a firm is carrying too much debt And they can't serve the debt and it's not uh turning the business around the business could file for bankruptcy In which case certainly your shareholders lose everything and lenders are liable to get pennies on the dollar And there's also a potential issue with collateral When you're going out and securing a debt The lender may very well be looking for collateral Anybody who is purchased a home If you've got a home mortgage, you know that while you're paying the bank your mortgage, which could be for 20 years or more The bank owns the house It's it's collateral for that loan to ensure that the loan is paid off Well in the world of business there's collateral too Depending on the size of the loan a lender may request that we pledge Our equipment or property or even inventory as collateral or assurance that the loan will be repaid Now on the equity side The advantage is that one equity doesn't have to be repaid On the other hand if you'd like to continue to grow the business in some more stock You certainly want to be able to generate a return for your shareholders The advantage is that investors are looking for future returns So if you're using money and and making wise decisions and increasing the value of the firm Then you're meeting the expectations of your investors The disadvantage of course is that you're giving up ownership rights So the individual who starts a business it becomes very successful. It starts to grow There's an opportunity to expand even further You open up to investors you go on the stock market and sell stock You are now giving up ownership rights in that business to new investors And it obviously means that now you have participation from folks outside of your business in business decisions right so a lot of things going on there and If this is demonstrating that the concept of capital management can be A difficult task Then I think I'm making my point It is it's not impossible. It's difficult requires a great deal of attention and real management Now the capital structure we've been talking about is going back to the simple Determination that we've decided that we have to have a capital plan of next number of dollars Because we know that we have investments that we have to make in new plant and equipment The firm decides the Owner of the firm the president the ceo and the financial executive decide How they will structure that capital plan How much debt will they use and how much equity? So for example, the firm decides to borrow Six million dollars from lenders We're going to take out a six million dollar long term loan from our local bank We're going to raise four million dollars by selling shares of stock To raise the ten million dollars we need for our capital plan Now, what does that mean? That means that we have a debt to equity ratio of 60 to 40 percent Or our capital plan has 60 debt And 40 equity Now having said that with all of that deponder I'll stop here for a quick break and see if that's generated any questions Michael I can't hear you Good call. I accidentally double muted myself I was just going to say that's good because what I was going to say was I'm going to give everyone a chance here to uh To catch up in case they're behind, you know, obviously Dense material, so we'll give everyone a minute and then we'll come back and see if we have any questions Okay, well, I'm not seeing any questions right now But again, if you have questions at any time feel free to leave them in the chat Or if you're watching later, leave them in the comment section below But let's just hand it back over to dr. Pierce. I'll just uh keep on moving Okay, and you know, uh when it comes to questions There's uh, I recognize that there's a lot of material that we're covering in a relatively short period of time Remember that this is an overview of a master's course Which will take many many hours of Of review and reading and studying to get through so As there are questions and uh, it wouldn't be surprising if they occurred to you later again Feel free to post those questions But let me continue in and dig more into this idea of the cost of capital Because money is not free There is a cost to it and one of the things that the firm needs to know is At any given point in time what their cost of capital is today And I'll tell you that we also spend a considerable amount of time looking at forecasts and trying to Predict what the cost of capital will be going forward Um anybody who who pays any attention at all to the economy based on How far your check is going if you're working and the taxes that you pay or the interest that you're earning on a savings account This is a very fluid topic and so Imagine sitting there with a multi Million dollar multinational business and trying to determine what you think the interest rates will be on debt 12 months from now With all of the analysis and the research that we do It's still only our best guess giving what we know today So the cost of capital Again is an important criteria. We talked a little bit of why we use the cost of capital in our Analysis of projects that we're going to invest in Remember that when we looked at investing money today for money to be received in the future We took those future earnings and we discounted that back We discounted it back to what is the present value? And what did we use as a discount rate? We use the cost of capital Uh, true to trap typically what a what a company will use their weighted average cost of capital Now a couple things to note about that cost one um, the amount of debt increases Uh, the cost of debt Now this this makes a good deal of sense when you think about it the more money you borrow The greater the risk of default now who is bearing that risk? The lender So if I go to the bank and I want to borrow a million dollars There's a certain risk that the bank assumes that I'm going to pay that million dollars back Which is why they do credit checks and review financials and the like Um, and they assign an interest rate Now that interest rate and the risk are going to be greater if that is 10 million dollars Or a hundred million dollars So the more debt that the firm uses Uh, the greater the risk to the lender and that typically means that the cost of debt will increase Um, the cost of equity also increases as you use more debt Now we're going to talk about this in a bit But I want you just to think about that for a minute as the company uses more debt In less equity the equity they use the cost of that increases Why for the same reason that the bank has a problem with risk As debt increases And the risk to the firm of default increases That means that investors their equity the risk on that has increased And if you go back a few of our presentations, you remember one of of pierce all's rules The greater the risk the greater the expected return So as risk increases The expectation of return increases Um, so we've talked about default And there's there's a couple of things when we talk about capital management think about this with default If a firm is facing a problem and they recognize that there's a potential issue with covering their debt Sales are down costs are increasing The business might be under some financial pressures Part of the other risk to the firm prior to actually default is Think about the amount of management time that is now being consumed with dealing with these day to day issues Trying to ensure that there's money there to meet the payroll To pay the suppliers To make interest payments on the debt The more challenging the financial situation for the business The more challenging it is for the executive management team that's running that business And so that's an issue that is also part of capital management Now the cost of equity There ahead there it represents a cost to the firm because the cost of equity is what is the investor expecting it back All right, so depending on what the investors are looking for the expected rate of return Which we refer to a number of times in in our presentations That is a cost of equity It's what you expect or what you require when you invest your money Most of us when making an investment You have some expectation of what we think we're going to get back or at least I hope you do We don't invest money and hope that something comes back someday We have some expectation of when And how much money will be returned to us based on that investment Because as you know and we've referred talked to about it before you can invest in a risk-free instrument You could put your money in a savings account and earn 2% annual interest compounded on your money You could invest in a treasury bill or a treasury bond And get a guaranteed interest rate and your money back in a certain period of time a risk-free investment So if you're going to take an investment with risk, then you're going to be looking for more money Now we talked about the concept of weighted average cost of capital matter of fact, this is the slide from unit three When we put down a simple capital plan here Where we were going to use 2.5 million in debt and 3 million dollars in equity To generate the 5.5 million we needed in our capital plan Now the cost of debt We said would be 6.2 percent That was the interest rate that the bank is going to charge us for the loan and We put down a cost of nine percent for equity again based on the expectations of our our shareholders the debt to equity ratio in this case is 45 55 We are using 45 percent debt and 55 equity so more equity than debt The weighted cost was simply the Amount of debt times the cost of debt which was 45 percent times 6.2 the cost of debt giving us a weighted cost of 2.8 And for equity it was 4.9 Giving us a weighted average cost of capital for this capital plan Of 7.7 percent That's the cost of capital Now For those of you so interested i've included at the bottom of this what the formula is for the weighted average cost of capital Again, not terribly complex Knowing the amount of debt and the cost of debt is relatively easy in the program because you know how much you're borrowing And you know what the interest rate is one of the one of the challenges here is is really determining What is the cost of equity? So we had talked briefly about understanding the difference that investors are looking for more than the risk free rate All right, because they're going to assume some risks. So they're entitled to more of a return How much return well now i'm going to show you the good news The good news is that we can actually do a reasonable job of calculating what the cost of equity is And and to do that we're going to use what's called the capital asset pricing model Sit back take a deep breath and think about this for a minute. This is really not as complicated as it may seem The cap M model is used to help us project the cost of equity So if you look at this formula our A sub S is what is the rate of shareholder's equity? What's the rate of equity? What are they looking for the return on equity to determine that we're going to look at a couple things The first thing we're going to look at is The risk free rate Remember that every investor including the company if you're sitting there with money available Has the opportunity to simply invest that in a risk free rate. You can invest your money in treasury bonds You'll get so much interest a quarter and you get your money back at the end of the period Maybe it's a five-year bond in five years. You get that money back. That's a risk We know what that rate is we can look it up on the On the market where you can track what a treasury bill or a treasury bond is selling for so we know what the risk free rate is Now what about the additional risk? The additional risk says we're going to do this we're going to look at Our m which is what is the market in general? Returning this is a consider a portfolio of all the stocks that are available on the market So this is a fully diversified portfolio of stocks The overall market which has winners and losers in it Stacks that are up and down is generating a certain return. So let's see what the market is returning Now from that rate and obviously that rate is going to be higher than the risk free rate, right? Because there's a lot of risk in the market. So there's a higher expectation of return Let's subtract the risk free rate from that That's going to give us what we call the risk premium So now what you're looking at is the risk free rate Plus the additional rate or the risk premium because you're assuming risk We're going to do one more thing We're going to look at that firm that company or that project and we're going to look at the beta of that firm Now before we get into the greek alphabet beta here simply means What is the risk of that particular company? Beta is a measure of how a firm is doing compared to the overall market All right, so if you look at the marketplace the beta for the market is one. It's 1.0 Individual firms can have a beta that is greater than or less than that 1.0 And what does beta mean? If the marketplace has a beta of 1.0 And my company has a beta of 1.5 It means that my firm is riskier than what the overall market is doing Now if i'm successful that also means my return is better than the overall market But it doesn't indicate that there's risk It's not as safe as the overall market if the beta is negative It means that the risk is less than the overall market Now that probably also means that the expected return is less because there's less risk I'm going to leave beta with this you can one there are a lot of ways to calculate beta if you're into charts and graphs and regression analysis and calculating means and variances You can calculate the beta matter of fact you can calculate beta for a stock With some excel formulas You can look on a stock page most brokers when they're giving information on a on a company will will list the beta of the firm So let let me assume that one you can get beta What is it doing here? It's taking that market risk premium remember the risk free rate minus the market risk We're taking that we're now going to multiply it by the beta which Assuming the beta is greater than one increases that risk premium, right? The greater the risk the greater the expectation of return And by doing this simple And it's simple once you have all the numbers calculation We can estimate what the expected rate of return is or what the cost of capital is Now before anybody panics, let me give you a quick example Let's assume that the rate of return on the market is 13 percent The overall market is is is enjoying a 13 percent return on investments The risk-free rate from a treasury bond is 7 percent. That's a risk-free rate And the beta for my firm is 1.2 So slightly riskier than the overall market So given that information can I estimate the cost of equity? Yes Risk-free rate is 7 percent We're going to look at the 13 percent return on the market minus that 7 percent Which is 6 percent we're going to multiply that 6 percent by beta 1.2 That's the additional risk that we're going to assume And that gives us a 7.2 percent market risk premium. So what's the cost of equity? It's the sum of the risk-free rate Plus the market risk premium are 14.2 percent So in this case my cost of equity is 14.2 percent and what that says is it's Logical when you step back and think about it for a minute You're this is for the the benefit of shareholders, right? They're investing money What do they want to get back? Well, if the shareholder invested in the risk-free bond They get a return of 7 percent. That's a given By investing in your firm they're looking for more than that Well, how much more? The risk-free rate plus A premium based on you're standing in the market with what the market is doing and any additional risk So the average shareholder is looking for a minimum return of 14.2 percent That's what you're going to use as the cost of equity So it's not it's not quite Yes work as we sit there and work on Making a determination of our capital plan and determining what the cost of equity is now one thing I said was that Given this and knowing that the overall Cost of capital the weighted average costs of capital will vary By the amount of debt and the amount of equity you use What is the right percentage? Again, we we're not going to guess at this. What we're going to do is we're going to sit down And we're going to determine what the optimum capital structure is All right, and the optimum capital structure simply says At what debt to equity ratio? Do I have the lowest weighted average cost of capital? Now this chart Is fairly simple, but I want you to think about a few things What I've done here is we've got a basic spreadsheet that lists down Um amounts of debt from 10 to 70 percent all right, uh, and And alternately the amount of equity. So if I'm using 10 debt I'm going to use 90 equity in my capital plan If I use 70 debt, I'm going to use 30 equity the cost of debt Now we can determine the cost of debt Because that represents the interest that the lender is going to charge us based on the amount of money We're going to borrow now note what I said was that as the Cost as the amount of debt increases What happens to the cost of that it also increases Why because the more debt you borrow the greater the risk to the lender Their expectation of return is greater interest rates are higher We're also going to allow for the fact that Uh, the cost of debt or the interest rate Has that tax shield? So depending on what the firm's tax rate is We're going to take the benefit of that tax rate to reduce the cost of debt So if I assume that the firm is paying a tax rate there, it's about 30% is what they pay in taxes But that means that the after tax rate for interest Is the interest rate times one minus a tax rate In this case it's that means that it's going to be 0.7 percent So the actual cost will be 0.7 percent. So the after tax cost of debt Goes from 3.6 percent at 10 percent debt The 4.8 percent 70 percent of debt For those of you who are wondering if they're why we don't have more numbers. I'm hoping you have more than enough numbers now Now equity as the percent of equity The higher the percent of equity the lower the cost of equity Again, why? Because as I am using less equity, what am I doing? I'm using more debt As I use more debt risk increases and shareholders are looking for a greater return on the investment So even though I'm using less equity The cost of equity is increasing I'm gonna let that sink in for a minute And simple concept if the money is riskier the investment is riskier Then the investor is expecting a greater return on investment Now looking at that now I've calculated the weighted average cost of capital Just what we did a page or two ago for each of these 10 to 90 20 to 80 debt to equity ratios and notice what happens At one point At a 40 60 debt to equity ratio, I have the lowest weighted average cost of capital So what will my capital plan be? Assuming I have access to 40 percent debt and 60 equity. That's going to be my ratio 40 60 now to make this even more complex Uh, thank goodness for excel spreadsheets. You can take this from 10 percent 10.5 percent to 11 percent 11 point you can make it as finite as you want Lay out all of the different costs Put together This analysis and what you typically will find no guarantee But generally speaking is in this range in the 40 to 60 percent debt to equity ratio You generally will have the lowest weighted average cost of capital So now when we think about What is that go back to that formula for the weighted average cost of capital? What's the cost of equity? We can determine that right here So we've used the cap M To determine the cost what the shareholders are looking for is an expected return Given their opportunity to have both a risk-free investment and recognizing the premium for investing in the market And based on the debt to equity ratio We've been able to calculate our weighted average cost of capital Which if you recall is the number that we use to discount future cash flows We use it to solve for net present value and the like Now next week we're going to um talk about valuation Excuse me. I want to get into some more detail on We a lot of our discussions have been on what management is doing the management decisions and the idea being that You should be focused on improving the value of the firm for the benefit of ownership and shareholders Well, let's talk about some ways that we can actually determine How effective that strategy is and what the value of the firm is So that's what we'll talk about next week. And so at this point, I guess we'll stop and see if there's any more questions out there, Michael Absolutely, and if you guys have any questions, feel free to leave them in the chat or Put them in the comment section below if you're watching later But I'll vamp for a minute and I'll ask you a layman's question as a guy who used to be okay at math in college Uh So when we're looking at um The rate of return from the market like that's like a a calculable thing that you probably like can look up Right like what the average market rate's doing, right? And then um, so what we're what we would decide I guess like If you're talking constants and variables like you could say maybe that like The market rate would be a constant because like whatever the market rate is at the time you're doing it That would be quote unquote a kind so are you just so we're just deciding as a firm that we want to go Have our return be 1.2 and then that's what allows our beta is what allows us to make our full calculation Because the other stuff is kind of decidable based on market factors. Or am I thinking about it wrong? I think it simply put it's the right idea. I remember that these numbers are dynamic, of course I mean, what is the market worth? What time is it? So as people who invest in the market you you'll look up on the exchange and you see what is my stack doing today Is it up or down? But we know that stacks go up and down all the time So what we generally look for is is there a basic trend in the market now? It may be up a little bit It'll be down a little bit as it is every day But generally the market is returning a certain amount If I know that the market is returning 10 percent And I look at the performance of my stack against that and I'm only return and I'm returning 11 percent I'm doing better than the market So my beta is higher Why? Because it's riskier The greater the expected returns the higher the risk If I'm doing less than the market The beta is lower the risk is lower So the now the key of course is picking those numbers What market number do you want to use? And we spend a lot of time thinking analyzing and trying to come up with a reasonable What are the most what are the investors see when they look at the market today? Awesome. Well, thank you for my edification here. Um, it looks like no one else Had questions like I did they must be all be smarter than me. Uh, not hard to do honestly, but again If there's no more questions, uh You know again, if there's any questions, well, I'll vamp for a little bit You can put them in the chat But if you're watching later, feel free to leave them in the comment section below again. Thank you everyone for For watching of course Thanks, dr. Pierce all for taking us through this and as you said, we will be back here next week for unit six and Uh, well, I mean, thank you everyone for joining us. I I don't have much else to say it looks like everyone's Feeling pretty good. So again, just thank everyone for joining us. Thank you dr. Pierce all for taking us through it Thank you, michael