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How to Find the Optimal Capital Structure - YouTube
Channel: Wall Street Mastermind - by Sam Shiah
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HOW DO YOU FIND THE OPTIMAL CAPITAL
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STRUCTURE FOR A COMPANY?
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ISN'T THAT...
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OKAY. I GUESS IN ORDER... THE
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OPTIMAL... ISN'T IT JUST HIGHLY DEPENDENT ON
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THE... I HAVE NO IDEA. I DON'T KNOW
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WHERE I'M SUPPOSED TO GO WITH THIS QUESTION.
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WHAT DO YOU THINK THE OPTIMAL CAPITAL
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STRUCTURE MEANS?
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SO THE PERCENTAGE OF DEBT AND
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THE PERCENTAGE OF EQUITY.
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RIGHT, BUT... SO THINK ABOUT THAT IN
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THE CONTEXT OF WACC.
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OH. OH, WHATEVER MINIMIZES THE WEIGHTED AVERAGE
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COST OF CAPITAL THEN.
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RIGHT OKAY.
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SO HOW DO YOU GET TO OPTIMAL CAPITAL
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STRUCTURE?
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WELL ISN'T IT...
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OKAY SO THEN, DON'T YOU JUST
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TAKE THE WEIGHTED AVERAGE COST OF CAPITAL
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AND MINIMIZE IT TO THE LOWEST POSSIBLE
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DEGREE. LIKE, WHAT CREATES THE LOWEST
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VALUE. SO YES, IN THEORY.
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SO IN PRACTICE HOW WOULD YOU DO
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THAT? I DON'T KNOW.
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I GUESS I CAN PROBABLY... WOULD YOU TAKE ON MORE
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DEBT? WOULD YOU REDUCE DEBT?
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OH YEAH I WOULD PROBABLY TAKE ON MORE
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DEBT BECAUSE THERE'S A HIGHER... THERE'S
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A TAX SHIELD ON THE DEBT IF THAT'S
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WHAT THE QUESTION IS ASKING.
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I'M NOT SURE WHAT THE QUESTION IS
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ASKING. THERE IS A TAX SHIELD ON THE DEBT,
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BUT IS THAT THE ONLY REASON WHY
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TAKING ON MORE DEBT IS BETTER FOR CAPITAL
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STRUCTURE?
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WELL I THINK PROBABLY NOT. NORMALLY
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THE COST OF DEBT IS A LITTLE BIT
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LOWER THAN THE COST OF EQUITY.
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AND ALSO NORMALLY IT'S A LITTLE BIT
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LESS RISKY. COST OF DEBT IS LOWER THAN
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THE COST OF EQUITY BECAUSE IT'S LESS
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RISKY. LESS RISKY FOR WHO?
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THE COMPANY. NOT THE LENDER.
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WAIT, I AM THOROUGHLY CONFUSED BY THE
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QUESTION,
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SORRY. SO IT'S BASICALLY ASKING,
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WHAT'S THE CHEAPEST WAY THAT YOU CAN
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FUND THE COMPANY WITH?
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SO BASICALLY,
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WHAT IS THE CHEAPEST SOURCE OF CAPITAL?
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IS IT GOING TO BE THE EQUITY? BASICALLY,
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IF YOU FUND THE ENTIRE COMPANY WITH
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EQUITY, YOU'RE ESSENTIALLY GOING TO
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BE GIVING UP THE PROFITS,
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WHICH POTENTIALLY CAN BE INFINITY.
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AND THEN LET'S SAY YOU'RE TAKING
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ON DEBT, THE MAXIMUM COST OF DEBT THAT
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IS GOING TO BE IS WHAT THE BANK IS
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CHARGING YOU.
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SO LET'S SAY IT'S 5%,
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THAT'S BASICALLY GOING TO BE THE CHEAPEST
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OPTION IN THIS CASE.
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SO COST OF DEBT IS LOWER THAN COST OF
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EQUITY. SO IN THEORY,
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IF YOU ARE CHOOSING BETWEEN THE TWO
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FORMS OF FUNDING...
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THE TWO WAYS TO FUND YOUR BUSINESS,
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IT WOULD BE CHEAPER TO FUND IT WITH DEBT.
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YEAH.
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THAT'S THE FIRST PART OF THE QUESTION.
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AND THE REASON WHY IT'S CHEAPER TO FUND
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WITH DEBT IS WHAT STANLEY JUST SAID, BECAUSE
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YOU'RE NOT SHARING ANY OF THE UPSIDE IN
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YOUR BUSINESS WHEN YOU FUND WITH DEBT.
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YOU'RE NOT GIVING A PERCENTAGE
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OF THE OWNERSHIP AWAY TO YOUR EQUITY INVESTORS.
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INSTEAD YOU JUST GO OUT AND BORROW
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THE MONEY AND YOU HAVE TO PAY THAT MONEY
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BACK EVENTUALLY AND YOU PAY A SMALL INTEREST
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EXPENSE ON IT.
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SO COST OF DEBT IS LOWER THAN
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COST OF EQUITY FIRST AND FOREMOST BECAUSE...
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BECAUSE YOU'RE...
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AND THIS COMES BACK TO THE THING THAT
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YOU WERE SAYING,
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IT'S LIKE,
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IT'S LESS RISKY AND I ASKED YOU FOR
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WHO? IT'S NOT LESS RISKY FOR THE COMPANY.
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I WOULD SAY DEBT IS MORE RISKY
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FROM THE COMPANY'S STANDPOINT BECAUSE
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WITH DEBT,
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YOU CAN ACTUALLY DEFAULT AND IF
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YOU DEFAULT THEN YOU GO BANKRUPT.
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WITH EQUITY,
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I CAN GIVE YOU A PERCENTAGE OF
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THE OWNERSHIP.
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THERE'S NO RISK OF ME,
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YOU KNOW,
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GOING BANKRUPT JUST BECAUSE I GAVE YOU
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A PERCENTAGE OF MY BUSINESS,
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I JUST HAVE A SMALLER PIECE OF THE PIE.
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IT'S LESS RISKY FOR THE DEBT...
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FOR THE LENDER. IT'S LESS RISKY FOR
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THE DEBT INVESTOR.
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BETWEEN THE DEBT... FROM THE INVESTOR'S POINT
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OF VIEW, WOULD YOU RATHER BE THE DEBT
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INVESTOR?
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WOULD YOU RATHER BE THE EQUITY INVESTOR?
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WELL, IF IT'S A...
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IF YOU'RE CONSERVATIVE AND FROM A
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RISK STANDPOINT,
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THE DEBT INVESTOR IS TAKING ON LESS RISK
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BECAUSE THE DEBT
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INVESTORS ALWAYS GET PAID BACK FIRST
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BEFORE THE EQUITY HOLDERS.
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IF THERE WAS A LIQUIDATION EVENT,
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IF THE COMPANY WAS GOING TO GO OUT OF
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BUSINESS,
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THEY WILL HAVE TO SELL THEIR
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ASSETS, GET AS MUCH MONEY AS THEY CAN,
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TAKE THAT, PAY THEIR DEBT HOLDERS FIRST.
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PAY THEM BACK FOR THE PRINCIPAL THAT'S
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OWED. AND IF THERE'S ANYTHING LEFT AFTER
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THAT, THEN IT WOULD GO TO THE EQUITY HOLDERS,
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BUT USUALLY THERE'S NOTHING LEFT AFTER
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THAT.
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SO THEY'RE SENIOR TO
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THE EQUITY HOLDERS ON THE PREFERENCE STACK.
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AND SO THEY'RE TAKING ON LESS RISK.
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AND SO THE LAW OF INVESTING IS
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THAT HIGH RISK,
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HIGH REWARD,
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LOW RISK,
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LOW REWARD.
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IF YOU'RE TAKING ON MORE RISK
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YOU NEED TO BE COMPENSATED FOR THAT RISK,
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THEREFORE YOU'RE GOING TO REQUIRE A
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HIGHER RETURN.
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YEAH, JUST REALLY QUICK THOUGH.
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HOW DOES THIS
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ANSWER THE QUESTION?
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LIKE HOW DO I FIGURE OUT THE EXACT BREAKDOWN
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OF THE COST OF CAP BETWEEN DEBT AND
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EQUITY?
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I KNOW...
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SO I WAS GONNA...
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SO I WAS GOING TO GET THERE,
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BUT
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THAT WAS GONNA BE THE FOLLOW UP QUESTION,
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BUT WE HAVEN'T GOTTEN THERE BECAUSE
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THE WAY YOU GET TO THE OPTIMAL CAPITAL
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STRUCTURE IS BY FINDING THE INFLECTION POINT
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WHEN YOUR WEIGHTED AVERAGE COST
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.OF CAPITAL IS AT ITS LOWEST POINT.
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SO THE QUESTION WOULD HAVE BEEN,
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WHEN IS THE WEIGHTED AVERAGE COST
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OF CAPITAL AT THE LOWEST POINT?
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BECAUSE IN THEORY,
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IF YOU REALLY THINK ABOUT WHAT WACC
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IS, IF YOU UNDERSTAND WHAT WACC IS,
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IF YOU HAVE NO DEBT WHATSOEVER ON YOUR
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BALANCE SHEET,
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THEN YOU SHOULD TAKE ON SOME DEBT BECAUSE
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YOU GO FROM BEING 100% IN EQUITY TO
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BEING PARTIALLY IN EQUITY AND PARTIALLY IN
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DEBT. AND THE COST OF DEBT IS GOING TO
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BE LOWER,
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SO YOU'RE WEIGHTED AVERAGE IS GONNA COME
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DOWN.
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THAT PART MAKES SENSE SO FAR RIGHT?
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AT SOME POINT THOUGH... SO TECHNICALLY
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YOU CAN JUST KEEP DOING THAT AND KEEP
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TAKING ON MORE DEBT.
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AND IT'S LIKE,
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AND 0% EQUITY THEN? THEN I'M GONNA
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HAVE THE LOWEST COST OF CAPITAL EVER.
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BUT IN REALITY YOU CAN'T REALLY DO
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THAT BECAUSE BEYOND A CERTAIN POINT YOU
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START HAVING TOO MUCH DEBT. WHEN YOU
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HAVE TOO MUCH DEBT,
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THAT MEANS YOU'RE NOT GOING TO BE
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ABLE TO SERVICE YOUR DEBT OBLIGATIONS,
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YOU'RE NOT GONNA BE ABLE TO PAY THE
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INTEREST PAYMENTS ON TIME.
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YOU'RE NOT GONNA BE ABLE TO MAKE
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THE MANDATORY DEBT REPAYMENTS WHEN THEY'RE
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DUE. AND AGAIN, THAT'S WHEN YOU
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GO BANKRUPT.
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SO EVEN WHEN YOU TAKE ON DEBT
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THERE'S DIFFERENT DEBT INVESTORS THAT
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LOAN YOU MONEY WITH DIFFERENT TERMS.
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THEY COME IN AT DIFFERENT TIMES,
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SOME CAME IN EARLIER,
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SOME CAME IN LATER AND THEN THE
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PEOPLE THAT COME IN LATER USUALLY SIT
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LOWER ON THE PREFERENCE STACK WHICH MEANS
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THEY GET PAID BACK LATER.
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AND SO THEY'RE GETTING PAID BACK
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LATER, THEY'RE TAKING ON MORE RISK WHICH
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MEANS THEY'RE GOING TO CHARGE YOU A
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HIGHER INTEREST.
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SO ACTUALLY AS YOU TAKE
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ON MORE DEBT,
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YOUR COST OF DEBT IS ALSO GOING UP
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BECAUSE THE LATER DEBT THAT'S COMING IN
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IS GOING TO CHARGE YOU A HIGHER COST
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OF DEBT.
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DOES THAT MAKE SENSE?
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AND THEN ALSO ONCE YOU GET TO
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A CERTAIN POINT, IF YOU HAVE... IF YOU'RE STARTING
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TO HAVE TOO MUCH DEBT, YOUR COMPANY BECOMES
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DISTRESSED.
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PEOPLE START WORRYING LIKE,
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OH THIS COMPANY HAS A LOT OF DEBT,
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THEY ONLY HAVE THIS MUCH IN CAPITAL.
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ARE THEY GONNA BE ABLE TO PAY THIS
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BACK? THEN
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YOUR COST OF EQUITY ALSO STARTS TO
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GO UP BECAUSE NOW YOUR EQUITY HOLDERS ARE
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WORRIED BECAUSE THEY'RE LIKE, WELL WE
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DON'T GET PAID BACK UNTIL ALL THE DEBT
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HOLDERS GET PAID BACK.
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SO IF SHIT HITS THE FAN AND THE
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DEBT HOLDERS CAN'T GET MADE WHOLE THEN
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WE GET NOTHING.
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THEN OUR INVESTMENT IS WIPED OUT.
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BASICALLY
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IT'S A CURVE.
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IT'S LIKE IF YOU GRAPH ALONG THE XY
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AXIS, THE X-AXIS IS AMOUNT OF
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DEBT, PERCENTAGE OF DEBT AND THE CAPITAL
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STRUCTURE AND THE Y-AXIS
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IS YOUR WEIGHTED AVERAGE COST
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OF CAPITAL. THEN IT LOOKS LIKE A
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U-SHAPE AND THE OPTIMAL CAPITAL
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STRUCTURE IS AT THE VERY TROUGH OF
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THAT U-SHAPE.
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DOES THAT MAKE SENSE?
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MHM. THAT'S PRETTY MUCH IT.
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OKAY SO IT'S JUST... OKAY I GOT IT.
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YEAH. DO YOU GET IT?
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YEAH I WAS GONNA SAY, THAT IS JUST
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THE DERIVATIVE OF THE EQUATION BUT I
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DON'T KNOW IF... I'M PRETTY SURE
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THAT'S WHAT YOU MEAN BY THE TROUGH OF
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THE... YEAH IT'S JUST THE DERIVATIVE THE
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EQUATION.
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BUT I DIDN'T KNOW THAT'S WHAT YOU'RE
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SUPPOSED TO SAY BECAUSE I DID NOT SEE
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ANYONE EVER MENTION THE
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DERIVATIVE IN ANYTHING.
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YEAH IT'S JUST... I MEAN I JUST, I WOULDN'T
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EXPLAIN IT THAT WAY.
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THAT IS THE MATHEMATICAL WAY OF
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EXPLAINING THAT.
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AND CHRISTIAN SAYS YES IT IS AND
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YOU KNOW, CHRISTIAN MAJORS IN ASTRONOMICAL ENGINEERING.
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SO IT'S JUST, YOU KNOW, FOR
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THE VERY MATHY PEOPLE THAT'S GONNA
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MAKE SENSE.
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BUT FOR JUST A BUSINESS OR FINANCE
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MAJOR LIKE A BANKER WHO YOU KNOW,
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DIDN'T MAJOR IN MATH,
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IF YOU JUST SAY OH IT'S A DERIVATIVE
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OF THE WHATEVER IT WAS, THAT MIGHT
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NOT REALLY REGISTER.
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SO YOU HAVE TO EXPLAIN IT CONCEPTUALLY IN BUSINESS
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TERMS LIKE I JUST DID.
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OKAY. SO BASICALLY LONG STORY SHORT,
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ONE SENTENCE SUMMARY,
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JUST COST OF DEBT IS LOWER THAN
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COST OF EQUITY.
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SO YOU IDEALLY YOU WANT TO HAVE
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SOME PERCENTAGE OF YOUR CAPITAL STRUCTURE
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BEING DEBT BECAUSE IT'S GOING TO LOWER
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YOUR WEIGHTED AVERAGE COST OF
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CAPITAL. BUT THEN ONCE YOU GET
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TO A CERTAIN POINT, THERE'S A LIMIT TO
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THAT. BEYOND A CERTAIN POINT,
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IF YOU START HAVING TOO MUCH DEBT,
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THEN YOUR COST OF DEBT ACTUALLY STARTS
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TO GO UP AND SO DOES YOUR COST OF EQUITY
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SO THEN, THAT POINT WHERE IT GOES FROM
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BEING A POSITIVE TO A NEGATIVE.
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THAT'S THE OPTIMAL
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CAP STRUCTURE.
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YEAH. YEAH.
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IT'S GONNA BE DIFFERENT FOR EVERY COMPANY.
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NO, IT JUST DEPENDS ON THE FINANCIAL
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PROFILE OF THE BUSINESS.
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YEAH. GOT YOU.
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COOL.
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