Risk and Return and the Financing
Decision:
Bonds vs. Stock
Bonds
are debt instruments issued by financial
institutions, the municipal/state/federal
government, and companies to public
investors to obtain capital.
 have a set maturity, e.g. 10, 20, 30
years.
 carry a certain interest rate.

Sources of Capital for Growth
Profits (earnings, net income)
 Issue new shares of stock
 Borrowings

Loan from bank
 Issue bonds in bond market

What could go wrong in the Creemee
Business?





Weather
Running out of inventory
Ordering too much
inventory
Choosing wrong location
for the day
Too many/too few
employees
= Examples of Basic Business Risk in
the Creemee Business
Business Risk
Grocery store
Total risk
Technology company
Total risk
Basic business risk
Basic business risk
amount of debt
amount of debt
The Financing Decision
1.
2.
Assess the level of Basic Business
Risk.
Determine how much Financial Risk is
appropriate, given the level of Basic
Business Risk.


Basic Business Risk + Financial Risk =
Total Risk of the Firm
Stockholders care about Total Risk.
Advantages/Disadvantages of Debt
Financing
Advantages
Disadvantages




Less risky for investor;
therefore cheaper source
of capital than stock
Tax deduction for interest
results in lower after tax
cost to company
Use someone else’s
money to increase return
to Stockholders (ROE)
pay interest $10
borrow $100
earn $15
pay stockholders $5
Increased Financial
Risk (risk of Bankruptcy)
In bankruptcy, the creditors
are paid first. Stockholders
are last in line.
After Tax Cost of Debt
Sales
Operating
Expenses
CO. A
$ 500
CO. B (borrowed $100)
$ 500
Pre-Tax Cost of Debt:
Interest Expense
400
400
(operat.income) 100
100
Money Borrowed

10
 0.1  10%
100
EBIT
Int. Expense
0
10
After-Tax Cost of Debt:
Interest Exp. - Tax Savings
Earnings
Money Borrowed
before taxes
100
Taxes (40%)
40
Net Income
60
90
36
54
(= $4 Tax savings)
(10 - 4)
100
 0.06  6%

Advantages/Disadvantages of Equity
Financing (issuing stock)
Advantages
 Permanent Capital
 No increase in
Financial Risk
 No legal obligation to
pay dividends or
return stockholders’
money
Disadvantages
 Highest risk position
for investor makes it
the most expensive
form of capital

Stockholders want
a higher return for
investing in stock
than in the
company’s bonds.
Why Lenders Charge Interest
1.
2.
3.
Default risk: risk of not getting your
money back
Opportunity cost: You could invest
your money in something else.
Inflation risk
Which Bond Will Carry the Higher
Interest Rate?
A
Maturity
B
5 Years
10 Years
Inflation
Expectations
5%
7%
Default Risk
Low
Medium
Bond Yield Comparisons
Compare the bonds in each of the two sets.
Company
Emerson
Electric
Time
Warner
Time
Warner
Royal
Caribbean
Rating
Maturity Yield
A
10 Years 5.38 %
BBB
10 Years 5.78 %
BBB
10 Years 5.78 %
BBB
20 Years 7.48 %
Summary Characteristics of
Bonds/Loans

Pays Interest

Fixed Maturity Date

Legal Obligation

Rate set when issued
 Compensates investor for:
 Opportunity Cost
 Inflation Expectations
 Default Risk


Default gives lender right to
force bankruptcy
Payment before
stockholders in bankruptcy
Why Buy A Stock?





Become an Owner of a Company
Objective: Make money
Concerns: What level of return?
Return related to performance of the company
Forms of Return:
 Dividends
 Increase in Stock Price

Why would the stock price go up ?????
Creemee Company Valuation
A
Location:
ROE
DEBT/EQUITY
Expected Annual
Earnings Growth
Rate for next 5
years
VALUATION
What if …?
P/E using
proj. EPS
B
Small Town
USA
Big City
USA
10 %
25%
20 %
10%
5%
10X
(15X)
Co. A has
the higher
relative
valuation,
and the
market is
valuing the
companies
differently
from you.
10 %
Co. B has the
higher relative
valuation, and
the market is
valuing the
company
appropriately.
15X
(10X)
Fin. Application Assignment
Summary Characteristics of
Common Stock (Equity)

Stockholders can receive a return through:



Dividend Decision





Increase in Stock Price (buy low/sell high)
Dividends
Based on earnings performance of Company
Made by the Board
No requirement to pay dividends
No bankruptcy if dividend declared is not paid
Relative Valuation of Stock by Investors related to:



Future earnings growth prospects
Rate of return expected to be earned by equity holders (ROE)
Risk of not getting this expected return (business or financial risk)