Gresham College Lectures

How to Finance a Company

June 15, 2022 Gresham College
Gresham College Lectures
How to Finance a Company
Show Notes Transcript

How should companies raise money? 

This lecture will look at both debt (bank loans and bonds) and equity (shares given to other founders, or sold on the stock market). It will analyse how a company should choose between debt and equity and explain how many factors that companies – and even highly-paid investment banks – focus on are actually irrelevant. It will explain how financial decisions, stock valuations, and risk change in the presence of debt.


A lecture by Professor Alex Edmans

The transcript and downloadable versions of the lecture are available from the Gresham College website:
https://www.gresham.ac.uk/watch-now/finance-company

Gresham College has been giving free public lectures since 1597. This tradition continues today with all of our five or so public lectures a week being made available for free download from our website. There are currently over 2,000 lectures free to access or download from the website.

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- You have this genius idea for a new company, but how do you raise money to get the idea off the ground? Do you raise debt by borrow from a bank? Do you raise equity by selling it to other shareholders? Which is cheaper, which is riskier, and what are the tax implications? We're going to consider all of these questions in today's lecture, "How to Finance a Company." It's the final lecture in my series on the principles of finance on basic financial skills. So let me start by talking about the two main sources of finance that a company can raise. So if you want to raise money, you can get debt. So that's otherwise known as borrowing, and you typically get that from the bank or other bondholders. But the other source of finance is you can raise equity. And so what does that involve? That involves selling part of your company to other people who become co-owners? So let's give an example of a company that I know very well. It's called GRNDHOUSE, they're a fit tech startup. They're trying to be like the Peloton for strength. And so who owns that company? Well, there's the five co-founders, but they raised equity by selling part of the company to a venture capital company known as Passion Capital. But they also did some crowd funding. So they raised money from some of their clients. So I own a little bit of the business and so do other customers. And so we all have a small part of this startup, we are co-owners. So what do we get and what do you get if you are a debtholder? Well, if you are a debt holder, like a bank, then every month you get interest payments. And at the end of the loan, you get the loan paid back, right? So if you've borrowed 1000 pounds from a bank, you get interest every month and then you have to pay back the 1000 pounds at the end. But what do you get if you are a shareholder? what do I get as an investor in GRNDHOUSE? Well it's not clear because we get dividends, but dividends, unlike interest are not guaranteed, right? GRNDHOUSE can choose to pay whatever dividend it wants to. It could choose to pay zero, and it could choose to pay zero for many, many years. And it's entirely in its right to do that. And indeed, most startups won't pay any dividends for the first several years because they want to reinvest it in the business. So then why would you ever want to be a shareholder in a company if you're not guaranteed anything? Well, after a while the shareholders, the founders, will want to draw down dividends from the business. And because I'm a shareholder as well, the founders can never pay themselves a dividend without paying me a dividend also. So whenever dividends are paid, those dividends need to go equally to the founders as they do to the venture capitalists, as they do to any shareholders. We own a share of the business, so when the company chooses to distribute its profits, it has to distribute them evenly among all shareholders. And that's what we get. What other rights do we have other than getting dividends? Well, if we're an owner, part owner of a company like GRNDHOUSE, we have voting rights. Because we own part of the company, we can vote on who the directors of the company are. So if we're dissatisfied with how the company's run, we can express that by voting. And if sufficient people want to vote for a change, they can do so. But if you are a bank and you've lent to a company, what rights do you have? You have no rights at all to any say in the business. As long as it keeps paying its interest. Just like any of you with a house and a mortgage, right? You've borrowed from the bank but as long as you are paying your interest, the bank cannot say, renovate your kitchen. They can't say, keep the gardens tidy or so on. It's you who have control. The only thing that a bank might be able to do is impose covenants, restrictions associated with the loan. For example, you can't sublet it, but other than that, the bank has no rights. Whereas as a shareholder you do have rights. Two more differences, the priority. So what happens if a company fails? Well, if a company fails, then it's the bank that gets paid first. That's known as senior. And then only after the bank has been repaid, do shareholders get anything else? So they're known as junior, they are second in priority. And then the final difference that I'm going to talk about on this slide is, which is cheaper? I said that at the start of my talk, and typically debt is cheaper than equity. And this kind of makes sense, right? Because debt is senior because in a bankruptcy you get paid out first, then it is less risky. And because it's less risky, you typically demand a relatively low return because it's quite safe. So it might be that if you lend to a company, you ask for 10% interest payment every year. Whereas if you are a shareholder, you might demand a return in terms of dividends or capital gains of 15% per year. Why? Because you know that it's risky to invest in this company. It could go bankrupt and you get nothing back. And therefore you are demanding a 15% return. So equity is expensive, it costs 15%. Whereas with you borrow, you only need to pay 10%. But you might wonder why have I put cheap in quotation marks and expensive in quotation marks? Because if you think, well, debt is cheaper than equity, 10% is lower than 15%. Then you should always borrow from the bank, you should never raise external equity. But as I will show you across today's lecture, that is actually not the case. Even though one seems cheaper than the other, there is actually no free lunch. Under certain conditions, both debt and equity are just as good as each other. And to build this up, let me just riff on a point that I just alluded to about the different risk between debt and equity. When a company raises debt financing, it's subject to a different set of risks than if you had some outside shareholders. And this is best shown by giving you a numeric example. So I've tried to keep this as simple as possible just to illustrate the forces at hand. So let's consider a firm where you don't need to raise any outside financing because you have enough money as the founder to fund it yourself. And let's say you put up 500 pounds at the start of your own money, and that is all yours. Now, it could be that things go well, you're in the good state. And in the good state, that 500 goes up to 600. And then what have you made? Well, given that you own the entire company, your 500 also goes up to 600. There's no outside investors, you have gained 20%. But there might also be a bad state. Maybe it goes from 500 to 400. And if so, you suffer the entire brunt of that downturn. There's no outside investors to share that with. So this also goes down by 20%, 500 down to 400. Now, let's consider the situation in the bottom table where you haven't funded the company entirely yourself. Why? You need 500 to start it up, but you only have a hundred pounds. And this is realistic. Most of the time when you are a founder, you need to raise external financing. So let's say like, GRNDHOUSE, you choose to raise that financing entirely in the form of outside equity. You're selling shares to other people, venture capitalists, crowd funding, and so on. And let's say you sell 80% of that company to outside investors. So, out of the 500 that you need to start the business 400, 80% of that you achieve by selling 80% of the company to everybody else. You retain only 20%, which 100. So now what happens in the good state? The company goes up to 600 as before, but what do outside shareholders have? Right, they gave you 400 to begin with, but because they have a share of the business, they benefit from the upside. So they own 80% of the business that is 80% now of 600, not 500, so that's gone up to 480. And so how much do you benefit as the founder? You go up from 100 to 120. How do I get this 120? The company's worth 600, outside shareholders are 480, so you now have 120. And so you've also gone up by 20%. So why is this not surprising? Because you've sold a share of the business to outside people. If the company goes up by 20%, the founders benefit by 20%, outside investors also benefit by 20%. Everybody goes up and down to the same degree. We are all co-owners of the business. And on the flip side, if there's a bad state, the company goes down by 20%, everybody goes down by 20%. Everybody suffers together. Okay, so if you are raising outside equity, it's not that risky for you as a founder because you're still bearing the same risks and downturns as you would do if you funded it yourself. Why? Any downturn is shared with the outside investors who's stake falls from 400 down to 320. Now, let's say you chose not to do that. You still need to raise funding of 400, but now you raise 400 in the form of debt. Rather than selling part of your company to others, you instead borrow from the bank. And this is the situation here in the bottom table. So I'm borrowing 400 from the bank. Now, as before, let's say there's a good state. The company goes up from 500 to 600. What does the bank get now? The bank still only gets 400, right? Because the whole idea of debt is you only need to pay back what you borrowed, they get no share of the upside. It's just like going back to the mortgage and the house. If you borrow from the bank and your house goes up in value, that's great for you because the bank, you just pay back the mortgage. You don't need to give them any share of the upside. And so what this means now is that the good state is really good for you, right? Because had you sold part of the business, then the outside shareholders would be entitled to some of the share of the upside. Their stake of 400 went up to 480, but the bank, because you only need to pay back what you borrowed plus interest, that is stuck at 400. So now the upside, the good state is really good for you because you double your money from 100 to 200. But you don't get something for free. Because what it means is the downside, not only is the upside even better, but the downside is even worse. So previously, if you had raised outside equity financing, bad things happened, the company was worth 400. Then outside shareholder stake fell from 400 to 320 because they share in some of the downside. But with the bank, the bank's claim is always 400. You always have to pay the bank back what you borrowed. If the house has gone down in value, tough luck, you still owe the bank what you borrowed from it. If you don't pay up, then they're going to take over the house. And that's the same if a company borrows. The company's gone down to 400, but you still need to pay back the bank everything you borrowed at 400. What do shareholders have? They have zero, they're completely wiped out. So this is the most important difference in terms of debt versus equity financing, is one is riskier than the other, right? And the important thing here is to contrast the risk to the investor and the risk to you as the founder, as the entrepreneur. Why? Because in this case here, you've raised money through debt. So to the investor, it is safe for the investor to invest in your company because they know they are always going to get back 400, irrespective of whether the company does well or whether the company does badly. But because the bank is taking none of the risk, because they're having a completely safe claim, then you the founder are taking all of the risk, right? Any gain goes entirely to you and any loss is suffered by you. So all of the risk goes onto you as the entrepreneur. Whereas in the case of raising funds from other investors, other shareholders, then this is something where you are sharing up the upside and the downside, so there's not so much in terms of risk that you are bearing, okay? So this is the fundamental difference between debt and equity. And this is why it means that one is not clearly better than the other. I said earlier, that if you raised debt, it's cheaper, you might only have to pay 10% rather than 15%. But if you raise debt, it becomes riskier for you as the founder of the company. Why? Because there's a chance that the company can go bankrupted and you lose everything. Why? Because in return for paying a low interest rate to the bank, the bank bears no risk. And you bear all of the risk yourself as the company, as the founder. And therefore it's not actually true that you want to use debt. So let me hammer home this point in case it wasn't really clear, in terms of a real life example with some numbers. So let's say we're going to start a company which I've innovatively called GreshCo. So GreshCo is a company which will generate earnings of 1,500 pounds forever, right? That's what it's going to be getting as revenues. And let's say it pays out all of the earnings as dividends. And so if earnings are 1,500, then dividends will also be 1,500. Now, how do we find out the value of GreshCo? Well, if you cast your minds back to lecture three, then you say the value of a company is the future cash flows discounted by a discount rate, which reflects the risk of a company. And in lecture four, we said, well, how we find the risk of the company? We use the capital asset pricing model. And let's say, we've done that. We find that shareholders require a 15% return. So 15% is the return that shareholders require for investing in GreshCo, because of the level of risk of this company. So what do we do? Well, the value of GreshCo is the dividends of 1,500 discounted by the discount rate of 15%. And so this gives you a value of 10,000 pounds. If you are paying 1,500 every year, and investors require a 15% return, given your risk, you are worth 10,000 pounds. And so what does this mean? So let's say when you are starting this company and you want to raise money from 1000 different shareholders who own one share each, how much would you be able to sell those shares for? For 10 pounds. Right, you've got 10,000 pounds as your company, 1000 shares, so those shares are going to be worth 10 pounds each. And then what you want to look at is, well, does this make sense? Let's do a sanity check. So if I'm going to buy my company for 10 pounds, I'm going to buy one share for 10 pounds. What's my return on that? Well, what do I get? I get dividends. What are the dividends I get? The total dividends, remember of 1,500 they're split 1000 ways. Go back to what I said at the start of the talk. What you get as a shareholder of the company is your equal split of any dividends. So 1,500 of dividends, 1000 shares, that's one pound 50. So what is my return as a shareholder? I've put in 10 pounds, I'm getting a dividend of one pound 50 every year. That is a return of 15%. And that 15% is the return that I require as a shareholder given the risk of GreshCo. Okay, so that's a fair return. That's why it makes sense for these shares to be worth 10 pounds. If I'm investing 10 pounds in GreshCo, I'm getting a 15% return. That is the fair return for investing in the shares of a risky company. Now what I want to look at is a different situation. Let's say, rather than raising your money for GreshCo entirely with shareholders, instead, you choose to raise some money from the bank. And the bank says to you, if you raise 5,000 pounds from me, I'm going to lend to you at 10%. Right, why borrow from these shareholders? Why sell your shares to these shareholders who demand 15%? Why not instead borrow from me? And I'm going to give you this cheaper rate of 10%. That sounds great, right? Don't we want the cheapest source of financing? But as alluded to in that previous segment, that cheaper financing is going to come at a cost and that cost is greater risk. So let's work through this in terms of the numbers. So, the bank lends 5,000 pounds. Remember what your company was worth to begin with. It was worth 10,000. So the bank is lending 5,000, then shareholders, their claim in the firm is only 5,000, it's just the difference. So, if I'm selling my shares for 10 pounds each, given that shareholder's stake in the company is only 5,000. Then I can only sell 500 shares at 10 pounds. And let's step back from the numbers. Let's think about common sense. Does it make sense that I can only sell 500 shares now? Well, yes it does. Because as a shareholder of GreshCo, you know that part of the earnings are going to go to the bank in terms of interest, right? So that company's going to be less valuable because you need to pay part of your income in terms of interest. So you are only going to be willing to own that company if it's shared by fewer people with fewer other shareholders to offset the fact that the bank is taking a big chunk of your profits. Let me repeat this, because the bank is taking a big chunk of your profits, it has to be that there's fewer other shareholders who take a chunk of your dividends. Otherwise you're not going to be willing to invest in the company anymore. So it makes sense for the fact that if you are indeed borrowing from the bank, there have to be fewer other shareholders there for you still to be willing to pay 10 pounds for that company. So now what I want to look at is how the earnings per share changes for the company. It used to be, you got one pound 50 per share, but now two things are happening. On the one hand the earnings are changing because you're having to pay out interest. But the number of shares is also changing, that's gone down to 500. So the question is which outweighs each other? Does it balance out or is one stronger? So let's look at this in terms of a simple calculation, what do the earnings per share become? Before, you were getting 1,500 pounds. Now you then have to pay interest to the bank. What is the interest? You've borrowed 5,000 pounds from the bank, and you've borrowed this at a 10% interest rate. So that is 500 pounds. So how much do you get after interest? 1,500 minus 500, so that's 1000 pounds. How do you split that? Well, you are now splitting it 500 ways because there's 500 different shareholders out there. So you get 1000 pounds is the dividends after interest, you are splitting that 500 ways, and now you get two pounds per share. So again, let's just step back from the numbers. This seems to be magic, right? You've increased your earnings per share from one pound 50 to two. And know how profound this is, you haven't changed anything about the business, right? When we think about how do we make a great company, Let's make innovative products, let's have great marketing, let's have great customer service. Let's have great employee engagement. You've done nothing of that, right? You haven't changed anything about the company, all you've changed is the source of financing. You've moved from equity to debt, and that has alone increased your earnings per share from one pound 50 to two. So if this was right, then this means that as a manager of a company, don't worry about marketing. Don't focus on employee engagement. Don't even think about product quality. All you want to do is raise as much debt as possible. And that is a sure fire away of increasing your earnings per share. So for me now, as a shareholder, I'm better off because I'm going to get two pounds for every share that I have earned, that I own, rather than one pound 50. And how has this magic happened? Well, this magic happened entirely because debt is cheaper than equity because I'm paying this cheap rate of 10%. And just to highlight this, let's look at what's in the red box. Right, two things happen when you raise debt from a company. On the one hand, you pay out interest, that's bad for earnings per share. But on the other hand, you have fewer other shareholders, right? Because I'm raising money from the bank, I don't need to sell my company to as many other investors. Why? Because I don't need as much money from them. I'm raising part of the funding from the bank. And because that 10% is cheap, because that 10% is low, the reduction in the numerator is less than the reduction in the denominator. And so that's why the second force outweighs the first. And that's why earnings share goes up. Because if you were to look at what would happen, if instead the interest rate was 15%. So debt was no cheaper than equity. Well, if that was the case, the interest would be 15% on 5,000, that's 750. And if that's the case, then earnings fall from 1,500 to 750, 750 divided by 500 is one pound 50. So there would be no change in earnings per share. So it's entirely because debt is cheaper than equity that the earnings per share goes up from one pound 50 to two, because it means that the numerator falls less than the denominator and therefore earnings per share goes up. So I've posted this as a magic, right? Just by changing your financing, without changing anything about the company you've magically increased your earnings per share. So then why doesn't any company go out and do that right? Is GRNDHOUSE crazy for choosing to raise its funding from other investors like me, rather than just borrowing from the bank? And the answer is no, they're not crazy. Why? Because the earnings per share is not the only thing that you care about as a shareholder. Why? Well, a running theme throughout every single lecture that I've taught, is that as an investor or as anything in finance, you care not only about return, you also care about risk. And that's why risk has already cropped up many times in this lecture before. Because yes, you are now getting two pounds per share rather than one pound 50, but there's a cost to that. As I've stressed, when you are raising debt, it becomes riskier for you to be a shareholder in the company. Why? There's the possibility that the company goes bankrupt. And just to remind you, right? What did we look at in lecture four as being the two types of risk that a company faces? One of these risks is business risk, right? That is the risk because of whatever business you are in. If your business is Rolex watches, that is really risky because in a downturn, people don't need Rolex watches. They just won't buy them. But in an upswing, when bankers get their bonuses, then they will spend that on Rolex watches. But for a food company that doesn't face much business risk because we need to eat in good times or bad times. So, often we think that the main driver of the risk of a company is the business. Are you cyclical or are you stable? But what I've stressed in this lecture is there's a separate type of risk, which is financial risk. The more debt you take on the riskier it is for you to be a shareholder. Why? Because the bank takes none of the risk. You're taking all the risk yourself and you can go bankrupt. And just remind you, that's something we saw in the early example. If you took on debt rather than outside equity, when raising funds, yes, you have the possibility of really good things happening. But on the flip side, you have a possibility of very bad things happening. See, what this says is that before you demanded a 15% return to be a shareholder in GreshCo, but now that the company's raised debt it's riskier, you are going to demand more than 15% to compensate for that risk. But the question is, well, how much more? Should it be 16%, 17%, 35%? How do we know, can we be scientific about this or is this just finger in the air? But fortunately there is an easy way to calculate how much higher return you require when the company becomes riskier due to there being more debt there. And this is given by this equation here. So let me try to explain this step by step. RL that's the rate of return that you require for a levered firm. A levered firm is a firm with debt. So when the firm has some debt, what is the return that shareholders require to compensate for the fact that debt makes the company risky? Well, that has two components. The first component is the return to the unlevered firm. If the company had no debt, what return would it require? So that was the 15% we had previously. When there was no debt, shareholders required a 15% return. Why? Because of the cyclicality of GreshCo, right? Even if there's no debt, a company faces risks, because it goes up and down with the state of the economy. That is the business risk that I referred to earlier of Rolex watches versus food. But then you have an additional whammy. The risk that you bear as a shareholder is not only the business risk from the fact that you are in a risky and cyclical industry. You have this additional risk which arises from the fact that you have debt there. And how much is that additional risk? Well, what you do is you take the debt that you have over the equity and multiply it by the difference between the shareholder's return and the debtholder's return. And that might seem hopelessly abstract so let me make this concrete with an example with the exact numbers that we've used throughout this particular case, let's put this in. So the big question is, when GreshCo chooses to raise 5,000 pounds of debt, how much does the required return go up? Well, before you required 15%, then you've raised 5,000 pounds of debt. And there's 5,000 pounds of equity. The difference between shareholder's and debtholder's return is that 15 minus 10. And so overall the return required by shareholders goes up from 15%, if there was no debt to 20% with debt. So the big punchline, the riskier your company is because you're taking on more debt, the greater return shareholders now require. And that greater return is now 20%. And so why is that so powerful? Because we can now re-calculate the value of GreshCo shares with debt. Remember what the value of a share is, it's the earnings per share divided by the discount rate. The earning per share has gone up to two pounds, but the discount rate has gone up from 15 to 20. And so these two things exactly cancel each other. So the value of a GreshCo share is 10 pounds, exactly as we were before. So again, let's step back from all of the numbers. What does all this all mean in terms of common sense? And more importantly, what does it mean to entrepreneurs when you run a company? This means it does not matter how you finance yourself. Yes debt is cheaper than equity, but debt makes your company riskier and that additional risk fully and perfectly offsets the fact that debt is cheaper. Yes, the cheapness of debt means your earning per share goes up. But the risk of debt means that the discount rate goes up. These two things completely counterbalance and therefore nothing changes. And so this implies completely the opposite of what I said earlier. How do you make a great company? You focus on great products. You focus on great marketing, great customer loyalty, great employee engagement. You don't need to worry about financing, right? Just chill out and don't worry about using debt or equity. And why was this so powerful? Because at the time that this result was derived you had slick investment bankers and dapper management consultants coming around to companies and saying, "Oh, pay me loads of money. I will advise you on the best way to raise financing, debt, or equity, or mezzanine, or all of these different hybrid securities." Don't bother paying them anything, right? It's not going to make any difference to your company. Just focus on what the company does, its products, its customers, financing is a completely washing itself out. And so this is one of the most powerful results of finance. And it's known as the Modigliani and Miller Capital Structure Irrelevance Theorem. Now that doesn't roll off the tip of the tongue, so let me explain what it means. What is capital structure? Capital structure is how a company finances itself. It's mixed between debt and equity. And there's other more complicated instruments like mezzanine, which I'm not considering today. Now, what does it mean for capital structure to be irrelevant? It doesn't matter how much debt or equity you use the company is going to be worth exactly the same. So the big punchline is companies should focus on what they do, not how they finance it. And a way of thinking about it is that what drives the value of the company is its real activities. What it actually does, its products, its employees, its customers, not its financial structure. But then you might think, well, that's sort of a sad way to end my Gresham series with how to finance a company. It doesn't matter. That would be quite sad for my final lecture. And indeed, this also seems to be at odds in reality because in reality it does seem that capital structure does matter. If you look in the real world, what happens when a company raises equity? The stock price typically falls. People don't like a company raising new shares. And then if in contrast, a company raises debt, stock prices typically go up. And then when private equity takes over a company, they typically do raise the debt of the company. So all of these three observations seem to suggest that in the real world, debt is preferred to equity, at least up to a point. So all of the arguments that I've just given that debt is irrelevant, seem to be at odds with the real world observation that companies and investors typically like debt. And the reason for this is that Modigliani and Miller made a very important assumption. And what they assumed is that capital markets are perfect. So what they meant by this is that, well, the value of a company, it only goes to shareholders and debtholders and nobody else. But if there's imperfections in the capital market, there's other people who take value from the company and those other people taking value from the company might actually mean that capital structure matters. Why? Because it affects the slice taken by those other people. So the question is what other people take value from a company and how can the choice of debt versus equity affect that? And that's going to be the final section of this talk. Now, the most important party which takes from a business is the government, through taxes, right? So in order to raise money, the government does tax your profits. And here's the really important thing is that when a company calculates its profits at the end of the year and calculates how much tax it needs to pay, any interest that it pays to debtholders is tax deductible. It reduces the amount of profits it makes. And therefore it reduces the amount of tax that it has to pay. But in contrast, when a company pays out dividends, that is not tax deductible, that does not reduce your tax burden. And as a result of that, it is better to raise money through debt rather than equity, because it allows you to save taxes. And let's go through this in terms of a numerical example, where I'm going to use the same thing as before. I don't want to throw you more numbers, same example as before, but just with taxes. Remember what does GreshCo earn? 1,500 a year. Now let's have a tax rate of 20%. So not all of that 1,500 goes to shareholders, 300 that's 20% goes to the government. So this means that shareholders now only have 1,200 as before, I'm trying to keep as many of the numbers, as the same as before. You've got 1000 shares that gives you 12 pounds per share add a discount rate of 15%, the shares are now worth eight. They're not worth 10 anymore, they're worth eight. Why? Because there's a tax man there and he takes part of the money. Now what happens if the firm has debt? Well, same numbers as before we've got 500 of interest. And therefore the income after interest goes from 1,500 down to 1000. But here's the important point, because the company now only makes profit of 1,000, not 1,500, how much tax does it have to pay when it's 20% of only 1,000? So the tax now goes down to 200 and therefore the profit is 800. The profit is not so affected by taxes as it was before. And if you work through all of the maths, what it turns out is that the earnings per share now goes up from one pound 20 to one pound 80. Why? There's two effects going on. Number one, there was the fact there's fewer shares outstanding. That was the case previously when the earnings per share went up from 1.50 to two in the old example. But now you have the extra benefit of not only are there fewer shares out there, but you are paying less tax. And that gives you a second boost to your earnings per share. And that second boost is enough to offset the fact that risk has gone up from 15% to 20%. Let's recap, without taxes two forces exactly offset each other. Earnings per share goes up because shares outstanding are lower. Risk goes up. Those two things completely offset each other in the last example. But now that earnings per share has this additional boost from the fact that you're paying less tax, that now outweighs the fact that risk has gone up and therefore the share price goes up from eight pounds to nine pounds. So the big punchline is in a world of taxes, which is unfortunately the real world, right? You want to issue more debt because the more debt that you have, the lower profits that you make after interest, and that saves you taxes that boosts earnings per share, it boosts the stock price. Now shareholders are better off, whereas before they were just completely indifferent, because the tax shield is there, you're paying less taxes. Now there's a second effect, right? I talked about, other parties take from the pie. It's not just shareholders and debtholders. We've talked about the taxpayer, they take part of the company. Who else takes part of the company? It might be the manager. How might he take from the company? Through laziness through incompetence, right? So you have a manager managing company. The manager should be acting in shareholder's interest, but maybe the manager just doesn't bother, just goes to play on the golf course. Maybe the manager's writing some books on the side and doing all these other things. But what is so powerful about debt is remember, debt increases the risk of the company. And because debt increases the risk of the company, this gives strong incentives for the manager to make sure that the company does well, right? Remember the good state and the bad state. If the firm had no debt financing, then you are worth plus 20 or minus 20. But when you are raising 400 of debt, remember now what happens is that shareholders get the entire benefits and they bear all of the consequences of a downturn. So because any manager of a company knows that if there's debt there and the company does badly, they lose their job. They're completely wiped out. Whereas if they do well, then they're doubling the money. This gives huge incentives for the manager to make sure that he or she brings about the good state through restructuring, through great products, through all of the things I've alluded to before. So now we have a second benefit of debt, right? The first benefit is it reduces your taxes. The second benefit is when there is debt, this gives you a lot of upside as the manager. If you do well, you don't need to share any of the benefits of this with the bank. Just like as a homeowner, right? Why do you have such incentives to renovate your house, to make sure there's great upkeep. You don't share any of that with the bank because you are the person who gains entirely, if you renovate the house. It's the same for a company. But on the flip side, if you make a mistake, you mess up. Then you bear all of the risk and that's why the incentive is strong. So you now have two reasons why debt is good. So you might think, well, why does anybody use anything other than debt? And this is going to be the final thing I present, which is the idea of bankruptcy costs. The more debt that you raise, the greater the chance that the company goes bankrupt, and bankruptcy is costly. Well, the question is, well, why is bankruptcy costly? And you might think, well, that's a bizarre question, right? Ever since we learned to play monopoly, we learned that bankruptcy is a bad thing. But actually when I ask, why is bankruptcy costly? It is actually not that obvious an answer. So let me show you this. So let me start with the first table here. That is a firm with no debt. So it can never go bankrupt, but bad things can still happen to it. Like if there's the bad state, it goes down from 500 to 400. It's not bankrupt, but it's still bad, right? You've lost 20% of its value. So when I ask, why is bankruptcy costly? I'm asking you, why is it worse for you to go down by 20% and go bankrupt than just to go down by 20%? And so in the bottom table here, I have a situation in which we have a firm which has loads of debt, not 400. It has now debt of 450. So, if the firm starts out like this, 500, it's worth, 450 is the banks, 50 is yours as the entrepreneur. Now, if bad things happen, the firm goes down from 500 to 400. Now what is the bank's claim worth? The bank's claim is only worth 400, right? This is striking, but why? The bank is owed 450, but your company's not worth 450. Your company's only worth 400. Yes, the bank can scream and shout and say, "Oh, give me that extra 50." But equity has this thing called limited liability. You as the shareholder, you don't have to stump up 50 from your back pocket and boost them to 450. You can just walk away and get nothing, right? You've lost everything, you've lost the company, but you haven't lost more than that, you can get zero. You don't have additional liability. So if this is the case, you might think that actually bankruptcy is not so costly, right? In the first case in which the company did badly, but didn't go bankrupt, you lost 100. But in the second case you only lost 50 because of this idea of limited liability, right? The company's failed but the bank is suffering part of that failure because they're only getting 400 not 450. You just walk away from the company. And that's realistic, that what sometimes happens when houses go negative equity. The homeowner walks away and then the bank makes losses. And that was something which manifested in the financial crisis of about 15 years ago. So then the question is, why is it worse for you as a shareholder to be in this situation, than this one, when you can walk away? Well, the answer is that in a bankruptcy it's not the case, typically, that the bank walks away with 400, the value of the firm. Instead there are costs associated with the bankruptcy process. So what are those costs? Let me talk about the fee. The first is that let's say the company goes bankrupt. Then debt holders take control of the company. There's typically not just one debtholder, right? There's loads of people squabbling over who's owed money. You might have the bank, you might have bond holders, you might have employees who have not been paid their salaries. You might have former employees who demand their pensions. And all of these people will squabble. And they will all ask for lawyers to try to argue that they are the ones who should get paid back. And so these lawyers are expensive. And so those lawyers will eat into the value of the company. So it's going to go down from 400 to let's say 350. What's another reason why bankruptcy is costly? Well, 400, that's the value of a company as a going concern. If the company continued to operate. But what happens in a bankruptcy? You liquidate the company, but many of the assets of a company, you cannot liquidate. What about the employees, right? The employees of a company are one of their biggest assets, but they just walk out of the door. They're not worth anything in a bankruptcy. So these are known as intangible assets, you lose them. And finally, even for the tangible assets, the ones that you can liquidate, you don't get as much from them. If you are a bookstore and you close down, you have to sell the books at half price. So there's an additional amount of value destruction from the fact that you have to sell those assets very quickly. That is known as a fire sale. So then step back again from the numbers. What does this mean in the big picture? Now, if a company has lots of debt and it's at risk of bankruptcy, the bank knows that if the company goes bankrupt, they're not recovering 400, they're recovering only 200, right? Because the bankruptcy process is costly, they're not going to get back anything close to what they lent. And then what does this mean in practical terms? Well, the interest rate they're going to charge is no longer going to be 10%, it's going to be something huge. Okay, and so this is now an interesting trade off. On the one hand, companies want to raise more debt. Why? It gives them greater tax shields. It gives greater incentives to the manager to do a good job, but if raise too much debt, now bankruptcy becomes so likely that banks get scared and they say, "Well, we're only going to lend to you if you give us a massive interest rate to offset for the fact that you might go bankrupt, and we will have to suffer these bankruptcy costs." And so overall what you have is something known as the trade off theory. You trade off the tax benefits of debt and the incentive benefits of debt with the bankruptcy con. And the beauty of this trade off is that this is going to be different for different companies. So this means there is no one size fits all capital structure. And let me end with this. What we have is this table which shows you the different capital structures across different industries. So in the top you see biotechnology, they tend to have very little debt. So this is the amount of debt as a percentage of firm value. Why do they have little debt? Well, they have very few profits to begin with because they're startups. So the idea of taxes saving you, right? That doesn't really work for a company, which is not paying taxes to begin with because there's no profits. And on the flip side, bankruptcy in these cases is really costly. If a company goes bankrupt and you are a biotech company, there is nothing to be liquidated because the main assets are people. But on the flip side, if you are in shipbuilding and Marine, you are an extremely profitable company. You're very mature, you're making a lot of profits, so you do want to have debt because the interest reduces your tax burden. So the benefits of debt are high and the costs of debt are quite low because bankruptcy is less costly in these industries. Why? Because there's hard assets, there is collateral there. If indeed the company goes bankrupt, the bank has control of the ships and those ships are worth something. Unlike the people in a biotech firm that walk away. And this is why finance is really interesting, right? Because if there was one size fits all, if every company should have 32% debt and 68% equity, then all companies would look the same. There would be no need for financial advice or for studying these things. But because these costs and benefits differ from across different companies, then we have a huge range of capital structure. Startups like GRNDHOUSE lots of equity, mature companies like shipbuilding, they'll use a lot of debt. And that's why there's so much diversity and heterogeneity in capital structures across industries. Okay, so that's the end of my final lecture. I just want to say a big thank you to everybody who supported all of my lectures. So we started with how business can better serve society. Then we looked at business skills for the 21st century. Then we looked at the psychology of finance, and now the principles of finance. Trying to teach the core skills of an MBA, but make that accessible for free. And if you want to catch up on any of these lectures, they're available on the Gresham college website, not only the actual lectures themselves, but all of the notes. I know that particularly these topics, there's a lot of numbers there. So I've tried to break this down in very simple language in the transcripts. And I'm delighted to announce that my successor, who going to be taking over from me later this autumn, this is professor Raghavendra Rau. He was a professor at the university of Cambridge and a leading authority in finance. I actually used some of his work in my last lecture series on the psychology of finance. You might remember the studies, which if you are a .com company and you added .com to your name in the internet bubble, the stock price rose up. Even if you didn't change anything about what the company did. Just by adding .com to your name, you just capitalized on the internet bubble. But he is not going to be speaking about that. He's going to have three series in really interesting topics. The first series is going to be FinTech. Things like cryptocurrency, and blockchain, and Bitcoin. How is that going to transform finance? His second series will be on the biggest ideas in finance, making that accessible for a wider audience. And finally, it's the social aspect of finance. So how maybe your neighbor's decisions on what stocks he or she chooses will affect yours? The idea that finance is not an individual thing in a vacuum, but something that we do as a society. So, I hope that you will support his lectures as much as you saw with mine. Again, thank you so much to all the support that you've had. And let me just bring Claire forward for the Q&A. (audience claps) - Professor Edmonds, thank you so much. We've got a couple of questions from the online audience, then I'll open it up to the in person. - Absolutely. - We'll start with one from the online audience. What debt ratios in your opinion would be best to look at when analyzing leverage? - Yes, I think the question here is, well, what goes into a debt ratio? So a debt ratio is the amount of debt divided by the value of the company. So what you want to have in terms of the amount of debt is net debt. So this is debt minus the amount of cash. Why? Because you could use cash at almost any time to pay back some debt, so you want to net out cash. And then the value of the company in the denominator. What you typically want to look at is market value, which is the number of shares multiplied by the shares outstanding. That is quite separate from book value, which is the value of the company in a company's accounts. Why? Because some of the value of the company is not reflected in the accounts. These are things like your human capital, your employees, your brand, your customer loyalty. So market value takes that into account. Even though those are things that you cannot see on a balance sheet statement. - And there's a question about this chart here. - Sure. - Sorry, which is the table's dated January, 2020 have events of the last two and a half years changed anything here? - They absolutely have in terms of the numbers, right? These numbers may well be different. In particular, if market values have gone down because of the downturn, then the amount of leverage will go up. Why? Because it's debt compared to value, and if value goes down, leverage goes up. However, the relative ranking of these things won't change. So it still remains the case that if you are a startup company, you have very little debt to start out. Whereas if you are a capital intensive company like airlines or shipbuilding, you typically have more debt. And what I want you to take away from this is not so much the actual numbers in absolute terms, but the numbers in relative terms. How it will be that the ones with more collateral and more profits are the ones that are going to be using more debt, because the benefits are higher and the costs are lower. - When you have invested in companies, do you prefer to see them lower or high debt, or does it simply depend on what the businesses do? - Well, my answer is actually, I try not to invest in individual companies. And the reason for this is, my third series on the psychology of finance is that, yes, I do understand finance that's my day job. But I also recognize that if I'm going to invest in individual companies, I'm going to be investing against people whose job it is to stay that company in huge detail, right? So they might meet with management. They might be analyzing the customer base and the employee satisfaction, whereas my day job is teaching and research. So when I invest, I typically invest in mutual funds. So with funds, let's say Royal London Asset Management Sustainable Fund. So what they have is they have a fund manager and his job it is to go around and analyze all of these companies backed up by his team. And so I would typically invest in mutual funds. And that was one of the main messages of the third series, the psychology of finance recognizing, yes, we can get overexcited about individual stocks, but actually, let's not look at that because we want to make sure that we are investing with expertise. And that's what a fund manager's job is to do. But let me then, that might seem a little bit dodging the question. So what would a fund manager look for? They will typically try to look at the level of debt, but not that low is always better or higher is always better. They'll look at the level of debt relative to the actual company. So if you had say a biotech company with lots of debt, that would be actually too much high is bad because you don't want a lot of debt when you've got a company with not much collateral. And on the flip side, if you had an air transport company with low debt, that would be too little because you might say, well, why are you not benefiting from the tax benefits of debt? So it depends on the industry rather than more, always better or less, always better. - And your examples seem to be more applicable to established company, but for startup with no predictable cash flow with no assets/collateral, they have no as access to bank loan, nor they have no money to issue bond. So they have to resort to angel investor like friends and family, or even issue crypto token or NFT. So what would your advice be to them to raise finance rather than debt, because they have no assets? They are pretty much unbankable. So what would your advice to them to take advantage of this non-dilutive debt situation? Thank you. - Thanks very much for the question. And if you didn't hear it fully. So the question is, if you have a startup company, they don't have collateral. It's very difficult for them to raise debt. A bank's not going to be lending to them because if the company goes bankrupt, they don't have really much to claim on. So as was suggested in the question, they do have to raise equity financing. And so this might be through a venture capitalist, and that's Passion Capital in the example of GRNDHOUSE. You might have heard of other famous venture capital firms and so on. So they are financing startup companies. You also have angel investors, and that might be individuals who put quite a lot of their own money in the company. So I'm actually an angel investor in GRNDHOUSE. There's a very famous pop singer who I'm not allowed to mention, who's also an angel investor. And then you'll have just crowdfunding. So they raised money through SEDAs, which is an online platform. And so there you'll have individual customers who will be chipping in small amounts of money into that company. And so why is that a benefit? Well, not only do they have a stake in the company and you can raise money, but they now become ambassadors of the company. They feel I have a stake in this, let me try to tell other people about this. So actually, while you do think, if I'm raising outside financing, this is dilutive, which is part of your question, right? You're sharing part of the gains with outsiders. Well, if the outsiders do have part of the gains, then they now have an incentive to be ambassadors of the company and not just customers. And so that is some benefit which does offset the cost of dilution. - Well, this is, I'm afraid to say, professor Edmonds' final lecture as the Mercer's School Memorial professor of business. And I just wanted to say a few words of thanks for his tenure. Well, as well as being a professor at Gresham college, Alex is professor of finance at London Business School, where he also serves as the academic director of the LBS center for corporate governance. He's currently managing editor of the review of finance, the leading academic finance journal in Europe.

His book, "Grow The Pie:

How Great Companies Deliver Both Purpose and Profit," was based on his inaugural Gresham lecture series. And it was named one of the FT's books of the year for 2020. It's also, you'll be interested to know, being translated into Arabic, Chinese, French, Korean, Russian, and Turkish. Well, Alex's tenure as Gresham professor began in 2018. And in that time he's delivered four series of lectures. His first was called, "How Business can Better Serve Society." A series examining whether businesses exist to make profits or serve a purpose. And presenting rigorous evidence that there doesn't need to be a trade off. This was followed by his series on business skills for the 21st century, which took us through the key skills needed to succeed in business with lectures on time management, public speaking, mental and physical wellness, and critical thinking. In 2020, his series was called, "The Psychology of Finance." And this showed how psychological biases can distort financial decisions made by investors, CEOs, and citizens. And explained how we can be on the lookout for these biases and harness this awareness to improve our own decision making. And this was followed by his final series on the principles of finance, which has demystified financial jargon to teach us some of the most essential financial skills such as saving and investing. And throughout your whole time at Gresham professor Edmonds, you have delivered your lectures with passion and energy, striding up and down the stage of the Museum of London. And we have all appreciated enormously the way you have opened up a new understanding of the world's financial systems and business systems over the last four years. And we'd like to thank you very much for all you've done for the college and hope that we can invite you back again to lecture for us in the future. Thank you. (audience claps) Thank you so much, Simon. Thank you to Clair. Thank you everyone in Gresham, but thank you in particular for the audience, both in person and online. Just supporting by watching yourself. And I see that people have shared it on Twitter and LinkedIn and just spread the word. So what this allows is just the message of finance and purposeful business to reach a wider audience. So thank you for all the parts that everybody's played in that. Thank you. (audience claps)