What I would encourage you to do is kind of look back at multiple ways in which I have tried to emphasize one of the most important aspects of valuation, which is to see where the financing matters and doesn't 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, in the process, you'll see me, [LAUGH] but I would 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 a little bit difficult, right, because of multiple reasons. One is their copyrighted 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'll encourage you to stay with me, I'll go slow. What I'm going 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 side 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're going to 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 for you and said that this firm, which is this stock that's been added to NASDAQ recently, NASDAQ is, by the way, the exchange where most technology firms kind of initiated their trading is an exchange that took off during the technology boom. You also know by looking at doing an analysis or looking casually at Google Finance or Yahoo Finance, the beta is 1.50. But in parentheses before the 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 and in many countries is a relationship between a bank and a company, okay, so 1.5. So quickly, what does that mean? Is this business risk higher than the average market risk? The answer's what? Yep. Why? Because 1.5 is greater than 1. And what is the beta of the whole market? 1, because you would move 1 to 1 with yourself and this is riskier than the whole market on average, and it makes sense right? Because video gaming is not something you absolutely need to do, though these days, I wonder whether [LAUGH] video gaming is more important than food. So anyway, second issue, 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 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, I0, 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 just as a reminder, I'm making this look a bit dramatic. Why? Because I'm going to keep the current business 25% and the new business how much? 75%. So why am I doing this? Just to make the problem interesting. Because if it was the other way around, though 25% of the new businesses is [INAUDIBLE] significant, here the new business would be 75%, so throwing some 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, and I hope you're writing, okay? There's a 50% chance that the project will generate an annual payoff of $7 million forever. What does the $7 million payoff mean? Does it mean revenue, does it mean costs? Or now that you know finance, does it mean cash flow? It means cash flows, profits, because you're interested in revenues and costs, in the end you are interested in the bottom line, $7 million. How many times? Forever. Is that true? No. But you have realized that forever basically is approximated by a perpetualty formula and makes calculations easier. In the real world, $7 million won't be constant, it'll change, and we'll need a spreadsheet. I'm going to stay away from a spreadsheet. In fact, most important problems, as I said earlier, can be cut off and actually executed, perhaps, without a spreadsheet. So 50% chance that it'll give $7 million for the foreseeable future. A 40% chance of an annual payoff of $5 million forever. So $7 million, $5 million, and a 10% 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. Online Inc is in the video gaming business, it's beta equity is 1.5 but that's also it's beta asset because it has no debt. But it's considering a major move into, what? A new business, which will become 75% of its total business, but only if they choose to do it. This investment will require this. Sorry, new idea or new business, will require $50 million investment and then you could make $7 million with a 50% chance, 40% chance of making $5 million and 10% chance of making nothing. There's one more piece of information, which I'll provide you and then I'll use this simple example. It's simple only because I've brought it into the essence of most cases are written over 20 pages, 30 pages because they're complicated. But I'm making it in 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 1.40. 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 0.25 on average and have riskless debt. So what am I telling you here? Debt to equity ratio 0.25 is important to know because that tells you the rate of debt. Right? What is the rate of equity on average? 0.75. 0.25 is debt, 0.75 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, whether it's exactly riskless or not. The key here is valuation. Online, Inc is forecasting that the average market risk premium is 5% and the risk-free rate on a long-term bond is 4.5%. Let's stare at this and try to understand the importance of these numbers. So let's see. Emphasize a few things. 1.4 is beta equity on which business? Soft. Right? Quick question. When will this be equal to beta asset? If there is no debt in this whole industry, because it's averaged, right? But its debt to equity ratio is 0.25. So what does that create? It creates a little bit of tension? Why? [LAUGH] Because you now have to worry about, how do you take account of this debt somehow, okay? The other news is that the beta d = 0. Where do I get that from? Riskless debt. One final question, what do these two numbers mean? Why am I giving you these two numbers? Which model will they go into? Well, you should know this by now, that the model they will go into is CAPM. What is 4.5% is Rf, the risk free rate. 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 that's what I mean, think through what information you have before you jump. So what is this 5% then at this rate? This is Rm- Rf on average. So here's the interesting thing, what does it mean to say that Online Inc is forecasting these two numbers? There's a little catch-22 here for you, a little bit of 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 phenomenon. 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 it's using 5% because it's kind of behaving a little bit like me. It's based on a lot of data. So if you look at lot of data, lot of stock markets for forever in the past, the number is probably closer to this 5% and just gives me a hint. But if you use US data, the numbers will be higher. It'll be closer to 7%. But then again, Online is not forecasting anything. It's using past data and some judgement to come up with the 5%. In other words, if most people had this point of view, they should have exactly the two same numbers. So 4.5 is a given and 5. 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 is 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 its business will suddenly be in south red? 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 be important and gaming will reach its 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 achieve two goals. One, recap what we have talked about for the past few weeks. Largely about cost of capital emphasis. Second, I want 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.
