[SOUND] This is the calculation that

we've just done trying to figure out

what happens to the cost of capital for

Pepsico when leveraging is, right?

So it appears that the cost of capital is going down to 4.5%,

but what we already learned is that this calculation is wrong, okay?

One way to think about it is that this a mechanical effect, right?

It's a simple algebraic equation, right?

That couldn't possibly be right.

It's too mechanical to be described in the real world, right?

And in fact it is, right?

So you can think of this mechanical effect as also an illusion.

Just like the illusion, this mechanical effect of debt in the cost of capital is

also an illusion that you should avoid, okay?

In fact, this problem that we're talking about this is really cool,

because that is the motivation for research that won a Nobel Prize.

Back in the 60s, there were two people called Modigliani and

Miller who are the winners of

the first Nobel Prize that was given to researchers in corporate finance.

There has been others since then, but Modigliani and

Miller won the first Nobel Prize that is attributed to corporate finance resource.

So we really love these guys, okay?

And the motivation for

the research is that they got really mad with this mistake that people were making.

They got tired of hearing the argument that

because debt is cheaper than equity, right?

Then a company should issue that to reduce the cost of capital, okay?

What they showed in their research is why this mechanical effect is an illusion.

And the reason, right?

The reason is that the increasing leverage, if Pepsico issues more debt.

What will happen is that the cost of debt and the cost of equity are going to go up.

The company becomes risky.

So the right equation for

the WACC actually does not have a clear answer, okay?

The right equation is not what we had before.

The right equation is here, okay?

We know that leverage is going to 40% and 1 minus the leverage

ratio is going to 60%, the company can try to control that.

But what the company cannot control is what will happen to the required

return on debt and what will happen to the required return on equity, okay?

In fact, both will go up in the end, right?

Because the cost of debt and the cost of equity are going up,

you don't know what happens to the cost of capital, okay?

The reason why the risk is going up,

is an idea that we talked about in corporate finance one, right?

Is the idea of systematic risk, okay?

What happens is that the increasing debt is going to increase

the company's expose to systematic risk.

So a high debt company is also going to be a high data company, okay?

Debt increases beta.

In order for us to see why, what I want to do is to move away from Pepsico a bit.

It would be a bit difficult to do it using Pepsico,

it would probably involve too many numbers that you don't want to look at.

I'm going to use a simple example here, okay?

Where we have a boom and a downturn, right?

So here, the boom happens with probability 75%, 0.75.

The downturn happens with probability 0.25, okay?

And what we have here, is a cashflow to the company of 50 in the boom and

30 in the downturn, right?

So the company makes a profit of 50 in the boom and

a lower profit of 30 in the downturn, right?

If you figured out the expected value of equity today, would be 45, right?

It's just a weighted average,

we've done calculations like that in corporate finance as well, right?

To calculate the expected value,

what you do is you take the average between the boom and the downturn, right?

Another way to express this data is that

the current value of companies 45, right?

If times are good, right?

If you are in a boom, your value is going to go up by 11%, okay?

So 50 is 11% higher than 45.

If you are in a downturn, your value is 30 instead of 45.

You went down from 45 to 30 so that is a loss of -33%, okay?

So gains, losses, right?

You have the percentages there.

Now let's think about what happens if there is a debt payment?

So suppose we have the same company, but the company now promised to pay the debt

payment of $15 million let's say, the unit here doesn't matter, right?

What will happen to the cash flow?

So now, you have to make the debt payment so your cash flow is not 50.

It's 50 minus 15 goes down to 35.

Again, in the debt stage, right?

In the downturn, your cash flow goes from 30 to 15, right?

If you redo the math, what you'll see is that the debt payment is

increasing the percentage gain, right?

So if you are levered company and you hit a boom, right?

You're going to have a higher percentage gain in your value.

But if you hit the doubter the percentage loss is also going to increase.

It's now -50% instead of -33%, okay?

So just putting all this number together, right?

If you have no debt, 0 debt, right?

Those cash flows go to the equity holders, right?

They make a gain of 11% a loss of -33, right?

If you have leverage, what happens is that the percentage gain increases.

But the percentage loss will also increase, okay?

So debt is increasing the fluctuations in the value of the company, right?

And if these are aggregate states, right?

So if this is really a boom in the whole economy or a downturn in the whole

economy, what this means is that debt is going to increase daily, okay?