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Equity vs. debt

Debt vs. Equity. Market Capitalization, Asset Value, and Enterprise Value. Created by Sal Khan.

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  • blobby green style avatar for user Omar Sayyed
    What happens to current issued shares when new equity is raised? How are the current issued shares diluted?
    (13 votes)
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    • blobby green style avatar for user Brian McLeod
      Currently issued shares often remain outstanding when new equity is raised. Shares are diluted by a reduction in voting power if the shareholder does not participate in the new equity offering at least to the extent of his present ownership. For example, if you own 5 shares of an original 100 share issuance, you have voting authority of 5% of total shares outstanding. If another 100 shares are issued and you do not participate in the new offering, you now own 5 shares of 200 total oustanding and your voting power is reduced to 2.5% of total shares outstanding.
      (21 votes)
  • piceratops ultimate style avatar for user Akhil Krishnan
    At , Sal adds the debt of the company to the total value of it's assets, but shouldn't debt be subtracted from the total value of the company's assets?
    (3 votes)
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  • blobby green style avatar for user sweeneyr82
    Is there any limit to which a publicly traded company can raise equity? If say the market capitalisation is worth 100m, and the company wanted to raise 300m why would this be done through debt wich you need to pay interest on? Is it because flooding the market with so many shares would depress share price?
    (3 votes)
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    • leaf green style avatar for user Pureum Kim
      Yes, there is a limit to the amount of equity the company can raise. When you do an IPO, there has to be a demand for your shares and institutional investors cannot have infinite demand or money to buy your shares. The number of shares should not matter theoretically, it is the amount of the equity offering that is important. However, financial research finds that stock prices go up when they split the stock, meaning reducing the price of the stock by dividing into smaller priced stocks. Also, remember that debt provides tax shields, meaning you pay less taxes. Hence, a company might consider whether raising debt or equity would be more beneficial.
      (3 votes)
  • blobby green style avatar for user Derick Mok
    So, do we learn this in a finance class or an economics class?
    (2 votes)
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    • male robot hal style avatar for user Rahul Chopra
      economics class basically deals with macro and micro economics. That means that you learn about sutff such as the world wide market situation,(macroeconomics) or small scale economy (micro economics).(Example:How much will Joe pay for an ice cream till he thinks it es too much).Finance is really what deals with VC's and entrepreneurship.
      (5 votes)
  • starky ultimate style avatar for user Sudhanshu Sisodiya
    -- so that 1 million shares created in equity is worth $14 million in assets according to the markets? What I'm a little confused about is how easy it is to just create new equity/shares. I thought it would have been more..limited.
    (2 votes)
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    • male robot hal style avatar for user Andrew M
      All the shares of the company have the same value.
      The sale of the new shares brought $14 million into the company, so the company is worth $14 million more than it was worth before.
      So if it was worth $150 million now it is worth $164 million
      But it used to be divided into 10 million shares, so each share was worth $15
      Now it is divided into, say, 11 million shares, so each share is worth 164/11.

      No one is getting anything for free, and only companies that are already established as public companies can do "follow-on" offerings like this, and even then, there has to be an appetite among investors for the shares. Usually that is not a problem because the market price of the stock already tells you about how much people will be willing to pay for new shares. If people are buying the stock for $15, they shouldn't really care whether the seller of that stock is another shareholder or the company itself. In practice, a follow-on usually takes place at a discount to the current market price, because you are trying to dump a lot of shares onto the market at once. Also, the very announcement that a follow-on is going to take place often depresses the price of the stock, not only because of this dumping problem but also because a need to raise money sometimes indicates a company is in trouble, and because investors may fear that the money raised will not be put to good use by management of the company. So the company hires an investment bank to try to find investors and to market the stock so that it can be sold at the smallest discount possible.
      (5 votes)
  • blobby green style avatar for user Kongwei Ying
    Say the company receives a certain amount from the underwriter when it issues new stocks, and then the price goes up. How would that additional money actually make its way into the equity of the company?
    (3 votes)
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  • leaf blue style avatar for user Victor Strandmoe
    at . He said Pre money valuation is 1m but post money is 2m? How come, didn't the investors invest 2m, and then adding the company's value from before it makes 3m? please answer?
    (2 votes)
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    • male robot hal style avatar for user Andrew M
      The closer you get to becoming a viable company, the higher valuation you can claim when you try to raise more money the next time around. If you can convince investors the company is worth more, then you dont' have to give away as big a share in exchange for the money they are going to put in.

      The reason the company's valuation would be greater than the $2m that people previously put in is that the company has (hopefully) done something useful with that $2 million, using it to make progress toward being able to offer a great product or service. At some point, a company starts to become valued on the money it can make rather than the money that has been put into it. The job of the money-raiser is to convince people to think of the company as a money-maker sooner rather than later, and to convince them that the amount of money the company can make is going to be big.
      (3 votes)
  • leaf green style avatar for user DJ
    Towards the end of the video Sal says "assets= equity + liabilities" .
    Why is the debt counted towards the assets? If the company decides to spend some of the debt on advertising or other payments then the company loses cash without creating assets.
    (1 vote)
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    • old spice man green style avatar for user TerryMHogan
      A=L+E is a fundamental accounting equation.

      When the company issues debt, there are 2 entries on the balance sheet: An increase in assets (cash from the debt issuance), and an increase in liabilities (money owed on debt). They balance each other out.

      If the company then spends cash on advertising, there will be a decrease in assets (cash spent on advertising) and a corresponding decrease in Owner's equity. (because the liabilities will remain the same)

      If the advertising results in higher revenue and profits, well then there will be an increase in assets (cash) and an increase in Owner's equity (because the liabilities remain the same).

      If the company has enough money to pay back some debt, there will be a decrease in assets (the cash used to pay off the debt), and a decrease in liabilities (reduction in debt)
      (3 votes)
  • blobby green style avatar for user mohammad islam
    how does the market cap of the company suddenly goes down when its worth 150 million dollars to 103 million dollars on the stock exchange? i dont get it.
    (1 vote)
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  • male robot johnny style avatar for user markbratanov
    Wouldn't the assets be equal to the equity minus the debt / liabilities?
    I'm confused about how an asset can express a debt if it's summed?
    (0 votes)
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    • blobby green style avatar for user MikeWrightANU
      Equity and debt are just different ways to fund assets. A simple example: say investors contribute $100 in equity to your company (you would then have $100 in cash from them) and then the bank gives you a loan of $50 (you get $50 in cash from the bank). In total you have $150 in assets (cash) - this is partly from equity ($100) and partly from debt ($50). Assets = Liabilities + Equity.
      (5 votes)

Video transcript

Everything we've talked about so far with this startup company selling socks and all of that, has been raising money from an equity. We raised private money-- when the company was private it went to VCs and it went to angel investors, and maybe you could go to your friends and family to raise money. And then the company could go public and raise money from the public markets. But there's actually two ways that a company can raise capital. So this is why this playlist is called capital markets, or it's part of it, the name of raise capital. Capital is just essentially-- I mean the easy way to think about it is you're raising cash that you want to invest in some way to grow your business or to sustain your business or start your business. So everything we talked about so far was equity, and that's essentially selling shares in your company to raise money. And so that's all of those VC examples. The equity investor-- so when you sell equity, you're essentially selling-- you're kind of making that person who's buying the stock-- you know, an equity is the same thing as stock-- you're making the person who's buying a stock kind of a partner in the company. So if the company-- let's say there's two situations-- if the company goes bankrupt-- and I'll talk a lot more about what bankruptcy even means-- but if the company goes bankrupt, all the shareholders end up with nothing. They end up with nil. But if the company has a lot of upside, the stock gets a lot of upside. Because they're partners in it. If this was a company, that start-up that we talked about, if it turns into Amazon.com and becomes a billion-dollar company, everyone is going to do really well. Everyone's going to share in that upside. But there's another way to raise money, and actually this is probably something that's more familiar at the household level. I mean at the household level you never raise equity. You never say, you know what-- well you can, but you're not going to say hey, I need to buy a house, why don't I go to my rich friend and offer to sell 10% of the stake in my house to him and he'll be kind of a partner in my house. That could happen but for the most part it doesn't. Usually when you do something on a personal level you raise money through debt. And that's interesting. So what's good about debt is it's-- so let's think about it from the point of view of the person who's lending the money to you. Debt is just borrowing money. I think all of us know what borrowing money is. I go to my rich friend and I say hey, could I borrow $1 and I'll give you $1.25 in a year? And he says, OK, you're good for it. But I'm essentially promising I'm going to give the money back at some future date. If I sell equity, I'm not promising anything. I'm like hey, I got a great business, why don't you give $1 and then you get a 20% cut of my business. If my business does awesome, you get 20% of all of the profits of my business. If my business does horrible, well you took a risk, you get nothing and I get nothing. Debt says regardless of how my business does, if it does awesome all you're going to get is the interest. That's kind of the upside. So the upside's limited, right? If I borrow money at 9% interest, all that person's going to get is 9%. Even if my company becomes the next Google or Microsoft or whatever else, that person's just going to get 9% on their money. While this person might have gotten a hundred times their money because they made a bet. On the other hand, this downside is much lower. So limited downside. Because they're going to get their money back at a certain-- you know, there's a certain payment schedule. And they're going to get their money back before the stockholders-- so let's say in a situation where the company's going into difficulty-- and we'll do a whole playlist on bankruptcy-- the people who lend money to the company will see their money before the stockholders see anything. So how does all of this come out from the balance sheet? So let's say we have a public company. If you wonder what a CFO at a company does, this is really the main decision that they're always making. Do we raise money-- well, how do we raise money if we need it, and do we raise money from the equity markets or from the debt markets? So let's come up with a company again. Let's say that that's its current assets. Not current-- I don't want to say current assets, it's the assets that it currently has. Current assets means something different, and we'll talk about that in the future. But let's say, so that's its assets. You know it might have some cash here. We'll go into more detail. We'll actually look at real company balance sheets and decipher what all of the terms on the balance sheet mean. But that's its assets for now. And let's say right now all of its money it's raised so far has been equity. And let's say it's a publicly listed company. It doesn't have to be. Let's say that's all of its equity, and let's say it has, I don't know, 10 million shares. And the other interesting thing about when a company's public-- remember, every time when a company was private and it took an investor, when it took equity investors, they had to sit and have a negotiation saying what is this worth? What are these assets worth? But what's cool is, is when you have a publicly traded company, these shares are traded on an exchange, right? These shares are on, let's say it's on the New York Stock Exchange. So every day you could go to Yahoo! Finance or wherever and you can look at a chart. Let me draw a chart. You can draw a chart. And we've all seen stock charts, I think. So let's say that this is this could have been its IPO date or it could just be the start that we're looking at, and let's say the stock IPO went up, and then the whole market went down a little bit. But the stock-- maybe it's there, right? But on any given, really almost any given second, there's a price that somebody traded that stock at and it might not be the best price, but it is a price. And we'll talk about why that happens, because you might have 10 million shares, and if only, I don't know, 100 shares get traded at any second, or let's say only 100 shares get traded in the day, is that an indicative price? Because that's not a huge percentage of all of the shares. But anyway, we'll talk more about what volume means relative to the total float and all of that. But let's say at this split second the company shares traded at $15 a share. This is $15, right, at this second in time. This is like right now. Traded at $15 a share, and you could look it up on your Bloomberg terminal or whatever else. So essentially the market is providing us a value for this company. The market is saying wow, the market is willing to trade the share at $15. There was a willing buyer and a willing seller at exactly $15 a share. So that means that the market at that moment is valuing this company at $15 per share times 10 million shares. So $15 per share times 10 million shares-- not necessarily a dollar sign. So the market is assigning a, 15 times 10 is 100. $150 million market cap. Market capitalization for the company. And you could look on the kind of, I think it's the key statistics tab on Yahoo! Finance, and you'll see market capitalization for a company. And it's just the number of shares times the price of the shares. This is essentially what the market's value of the equity is. The market is saying that this piece right here is worth $150 million. And since this piece is the same size as the assets, we have nothing else on the right-hand side, the market's essentially saying that the assets right now are worth $150 million. And these aren't always going to be equal. We'll see probably in a few videos when you start raising debt you have to do an extra calculation to figure out what the asset value or-- and I'll throw out a new term here, the enterprise value of the firm is. The enterprise value's essentially the asset value minus excess cash. The cash the company really doesn't need to operate. And we'll go into more detail of that. But we'll just view it as the assets for now. So if I'm the CFO of this company, and let's say we need to raise another, I don't know, $15 million. I have two options. I could say OK, the company is trading at $15 per share, I need to raise $15 million, so I could issue another million shares. It wouldn't be the initial public offering because I'm already public. It would be a follow-on offering, or sometimes it's called a secondary offering. Although the word secondary has kind of two connotations. But it would be a follow-on offering where I would issue, I'd go to the board, we would essentially create another million shares, and then sell them into the market, and hopefully people will buy it at $15 a share or probably a little bit less because we're kind of flooding the market with a ton of shares. Maybe they buy it at $14 per share, and we would raise $14 million. And that would be a follow-on offering. So we can always use the public markets as a way to raise more money. We didn't have to go to all this-- I mean, for the most part we didn't have to do this huge valuation exercise and negotiations and do all of this, hire banks and all that. Although the banks will still collect fees. We actually would have to hire banks to do this. So that's one option. Or the other option is we're an established company, we're generating cash, we could make interest payments if we want to. We could go to a bank. And actually there's a lot of different ways to do this. But we could essentially borrow money. And let's just say we do that. Instead of doing this-- let's say we do both. So let's say we did a $1 million follow-on offering, that gave us $14 million. And let's say we want another $2 million, but this time instead of selling shares-- so right now how many shares do we have? We sold 1 million, we had 10 million, we have 11 million shares. Let's say, you know what, let's say as a CFO I feel like our shares are going to move up a lot more. So we don't like selling them at this low price. And let's say interest rates are really low. Instead we're going to borrow money. That's essentially raising debt. So let's say we borrow another $3 million because we need it. So actually this would be debt, $3 million of debt, and we would get $3 million of cash. So now our assets are all of this stuff on the left-hand side. And what are our liabilities now? Now, we didn't have liabilities before because everything we had were equities. But now we do. Now we owe somebody $3 million right here. And I'll talk more about all the different ways to kind of borrow money. But it's essentially, it could just literally be a bank loan. They might have just gone to Bank of America and said hey, we're a big company and we're good for the money, why don't you lend us $3 million. And maybe it would be $3 million at a low interest rate, at maybe 6% per year. And Bank of America feels good because you have a high-- we'll talk more about credit ratings and all of that-- but they say oh, you have essentially a good company credit score. So we'll give it to you at a low interest rate. So what happens in the future is, these assets are going to generate, hopefully, some cash. And before these guys see it-- let me do to it in the-- before these equity holders-- this is the equity holders right now-- before the equity holders see anything, these guys have to get paid their interest. And I'll show you all of that on a line-by-line basis in an income statement. Everything we've done so far has been a balance sheet. But something interesting is happening now. Now all of a sudden your assets, which is that side-- I know I just keep writing over the same drawing-- your assets are now larger than your equity. I think now, and this is just kind of a review of the balance sheet video, you see that the assets are equal to your equity, which is this right here, your equity plus your liabilities. Your liabilities now are $3 million. Plus liabilities. So if you wanted to know what your assets are worth, because your assets are equal to your equity. So what's your market value of your equity? Well, we figured that out already. We have 11 million shares now. And let's say the stock plummets to $10 a share for some strange reason or for a not-strange reason. So what's the market cap? $10 a share, 11 million shares, we have a $110 million market cap. We're doing a market value. And we'll talk more about the difference between market and book value. But this is the market value of your equity. And then what is your liabilities? Well we owe $3 million, so plus 3 million. So we could say that for the most part the market value of our assets, the market thinks that this entire left-hand side is going to be worth the value of our equity, the market cap of the company, plus the amount of debt, which is equal to $113 million. So the value of these assets are $113 million, and that for the most part is the enterprise value of the company. What is the company's assets worth? And we'll talk-- there's a little bit of a tweak we'll do in the future on enterprise value. But that's essentially how you kind of can value what the company's worth. A lot of people when they do a market capitalization calculation they say oh, that's what the company's worth. Well no, that's what the equity is worth. Market cap is what the equity's worth. If you want to know what the company's worth, you have to take the market cap and then add the debt. Another way-- well, I won't get too complicated because I just realized I've run out of time again. See you in the next video.