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What I would encourage you to do is, kind of, look back at multiple ways in which I

have tried to emphasize one the most important aspects of valuation.

Which is to see where the financing matters and does not matter.

And we saw that in a world with natural, tendencies of low cost of doing business

and so on in a competitive market. What happens is financing doesn't add

value. Real assets add value.

Real ideas add value. Okay, so this is a very profound result

and I've done it in two or three very intense ways.

Before I do the example, I would encourage you to revisit and think about, play the

video a couple of times. Of course I am in the process you'll see

me. But I will encourage you to kind of read a

book, do whatever resources before you jump into example.

Okay. The example that I'll give you here is, I

would call, almost like a case. And doing cases online is little bit

difficult. Right?

Because of multiple reasons. One is their copyright material and stuff

like that. And you need to have those.

So, I've constructed an example. The other problem is, that it requires you

to really think through carefully. Now some of you may jump to conclusions

quickly, and try to do the whole problem. I'd encourage you, stay with me, I'll go

slow. What I want to do for the next five to ten

minutes before we jump into answering various questions, is to try to read

through the problem. And I have this problem for you as an

online tool available on the site as a resource.

But you shouldn't need it, you should read with me and go slowly.

So here, let's start. Online Inc.

Is a video gaming company with no debt. Right?

What does that tell you? Right away you have to think.

Imagine. You know, do deep breathing, and try to

visualize the balance sheet of this company.

What do you see? You see real assets and then you see only

equity. So what does strike you?

That the return and risk of the real assets is based on the marketplace.

However, the return and risk of equity have to be the same.

Because there's no, debt. I've also done some work with for you and

said that this firm, which is this stock that has been added to Nasdaq recently.

Nasdaq is by the way, the exchange where most technology firms were.

Kind of initiated their trading. Is there, is an exchange that took off

during the technology boom? You also know by looking at doing an

analysis and looking casually at Google Finance or Yahoo!

Finance, the beta is 1.50 but in parenthesis before the big beta I say

equity beta I shouldn't have to do this. You should know that if you see beta

anywhere it should be beta of equity because debt doesn't trade as often in

many countries as a relationship between a bank and the company.

Okay? So, 1.5.

So quickly what does that mean? Is this business risk higher than the

average market risk? And says what?

Yeah. Why?

Because 1.5 is greater than one and what is the beta of the whole market?

One. Because you would move one to one with

yourself and this is riskier than the whole market on average and make sense

right because video gaming is not something you absolutely need to do tough

these days I wonder but you know, video gaming is more important than food, you

know, so anyway. Second issue which is, which is where

things start becoming interesting is now, online is considering investing in the

software business. So if you may notice, it's going the

opposite direction of one of the most famous companies we know which went from

software to gaming. Anyway, the business project will require

an initial investment of 50 million, right?

So by the way, as usual, if I make some error that's okay.

You have, you are there to fix it. So let's keep going.

The number $50 million. Now in the real world this could be far

more. But let's keep it at 50 million..

What reminds you? What is the symbol that comes to mind when

you think 50? Million, finite, the investment.

If undertaken. That means if they choose to do this

project, or start this business in addition to the existing business.

The video gaming, business will represent 25 % of Online Inc.'s assets so, so just

as a, as a reminder, I'm making this a little bit dramatic.

Why? Because I'm going to keep the current

business 25 percent and the new business, how much?

75%. So why am I doing this?

Just to make the problem interesting. So, just because if it was the other way

round, though 25 percent of the new business is trim significant, here the new

business would be 75%. So throwing some, you knoq drama into the

whole thing. So, this is just for you to think.

There is a next bullet point. This is all in front of you.

You, an I hope you're writing. Okay.

There's a 50 percent chance, that the project will generate an annual payoff.

Of $seven million, forever. What does the $seven million payoff mean?

Does it mean revenue? Does it mean costs?

But now that you know finance doesn't mean cash flow.

Means cash folds, profits because you're interested in revenues and cars, in the

end you're interested in bottom-line $seven million.

How many times? Forever.

Is that true? No!

But you have realized that forever basically is approximated by perpetuity

formula and makes calculation easier. In the real world seven million won't be

constant, it will change and we will, need a spreed sheet.

I am going to stay away from a spreed sheet.

In fact most important problem as I said earlier, can be thought off and actually

executed perhaps without the spreadsheet. So 50%t chance that it'll give 7,000,000

for the foreseeable future. A 40 percent chance of an annual pay off

of 5,000,000 forever so 7,000,000 5,000,000 and a ten percent chance of

getting nothing. So what is this world showing that there

is uncertainty because if there's no uncertainty, the world is uninteresting.

So let me back up for a second. Our line is in the video gaming business.

Its beta equity is 1.5 but that's also its beta asset, because it has no debt.

But it's considering a major move into, what?

A new business which will become 75 percent of its total business.

But only if they choose to do it right. This investment will require, this sorry

new idea or new business will require $50 million investment.

And then you could make seven million with a 50 percent chance.

40 percent Chance of making five million And ten percent chance of making nothing.

There's one more piece of information which I'll provide you, and then as I,

I'll use this simple example. It's simple only because I've brought it

into the essence of it. You know?

Most cases I've written over twenty pages, 30 pages because I complicate it.

But I'm making it that sense, simple, one more piece of information.

Companies solely in the software business. Remember what business is online in?

Video gaming. But companies solely in the software

business have an equity beta of 1.4. Quick question.

Why am I saying solely in the software business?

Because the new idea is what? New project is what?

Software business. In the real world, it may be difficult to

find firms solely in the software business.

But that's where the real world makes things a little bit complicated.

So big firms that are out there doing software business solely have an equity

beta of 1.4. How do you get this?

You look up all the firms that are in the software business, average their equity

betas and it turns out to be 1.4. These firms have a debt to equity ratio of

25 on average and have riskless debt. So what am I telling you here?

Debt to equity ratio of.25 is important to know because that, that tells you the

weight of debt, right? What is the rate of equity on average?

.75, right?.25 is debt, .75 is equity. And good news or bad news, but important

news, the debt tends to be riskless. In other words, the chances of default in

the software business is low. You may disagree or not.

That's not that important an issue. But that's exactly riskless or not, the

key here is valuation. On-lining is for casting, that the average

market risk premium is five%, and the risk free rate on a long term bond is 4.5%.

So let me just, lets stare at this and try to understand the importance of these

numbers. So lets see.

Emphasize a few things. 1.4.

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What does four point, 4.5 percent is RF, the risk create.

Right? And the long-term bond, if you were to

think about, can it be a corporate bond? Chances are very low.

It has to be a government bond, right? So, so that's what I mean.

Think through what information you have before you jump.

So what is this five percent then, interest rate.

This is RM, minus RF on average. So here's, here's the interesting thing.

What does it mean to say that Online Inc. Is forecasting these two numbers?

There's a, there's a little catch 22 here for you.

A little bit of a, you know, a puzzle. Can Online Inc come up with its own

forecast of these two numbers, or should it?

Answer is no. Why?

Because these two numbers are based on market phenomena.

So if Online Inc. Is doing it right, these two numbers

should be based on a long term treasury bond.

Ten year is 4.5. This nobody should disagree about.

There's some disagreement about this number.

Very important. So I, its using five percent because its

kind of behaving a little bit like me. Is, it's based on a lot of data.

So, if you look at a lot of data on a lot of stuff markets for-, forever in the

past, the numbers probably closer to this five%.

And it's just, just giving you hint, that if you use US data, the numbers will be

higher. It'll be closer to 70%.

But there again. Online is not forecasting anything, it's

using past data and some judgement to come up with the five%.

In other words if most people had this point of view, they should have exactly

two same numbers, right? So 4.5 is given and five.

I would, I would encourage you to do this, take a break and I will take a lot of

breaks this time. Just think about the data, think about the

following. You have been given a lot of data but the

decision to be made very simple. Online is doing video gaming.

Should Online go into software? Question number one.

Question number two, is this a trivial or important decision?

It's an extremely important decision. Why?

Because if online chooses to do this, what fraction of it's business will suddenly be

in software. 75%.

As I said earlier, the fun part is it's going against the trend.

But I don't think there's any such thing in life.

Software will become important, and gaming will important.

And gaming will reach it's limited ability, and software becomes important

and so on. So let's take a break, come back and what

we'll do now, is do one question at a time.

And the reason I'm doing this example, is to do...

Achieve two goals. One, Recap what we have talked about for

the past few weeks. Largely about cost of capital, emphasis.

Second, I want to you to be able to put together everything and if you do this

problem and think through issues clearly, you'll be able to do a lot of valuation.

Okay? So let's take a break.

Come back soon.