Risk and Return and the Financing Decision:

1
Risk and Return and the Financing Decision
Bonds vs. Stock
2
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.

3
Sources of Capital for Growth

• Profits (earnings, net income)
• Issue new shares of stock
• Borrowings
• Loan from bank
• Issue bonds in bond market

4
Examples of Basic Business Risk in the
Creemee Business
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

5
Business Risk

• Grocery store

• Technology company

Total risk
Total risk
Financial Risk
Financial Risk
Basic business risk
Basic business risk
amount of debt
amount of debt
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The Financing Decision

• 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.

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Advantages/Disadvantages of Debt Financing

• Advantages
• 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 elses money to increase return to
  Stockholders (ROE)
• pay interest 10
• borrow 100
• earn 15
• pay stockholders 5

• Disadvantages
• Increased Financial Risk (risk of Bankruptcy)

In bankruptcy, the creditors are paid first.
Stockholders are last in line.
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After Tax Cost of Debt

• CO. A
• Sales 500
• Operating
• Expenses 400
• EBIT
• (operat.income) 100
• Int. Expense 0
• Earnings
• before taxes 100
• Taxes (40) 40
• Net Income 60

• CO. B (borrowed 100)
• 500
• 400
• 100
• 10
• 90
• 36
• 54
• ( 4 Tax savings)

Pre-Tax Cost of Debt
After-Tax Cost of Debt
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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 companys bonds.

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Why Lenders Charge Interest

• Default risk risk of not getting your money back
  
• Opportunity cost You could invest your money in
  something else.
• Inflation risk

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Which Bond Will Carry the Higher Interest Rate?
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Bond Yield Comparisons
Compare the bonds in each of the two sets.
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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

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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 ?????

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Creemee Company Valuation
Co. A has the higher relative valuation, and the
market is valuing the companies differently from
you.
Co. B has the higher relative valuation, and the
market is valuing the company appropriately.
Fin. Application Assignment
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Summary Characteristics of Common Stock (Equity)

• Stockholders can receive a return through
• Increase in Stock Price (buy low/sell high)
• Dividends
• Dividend Decision
• 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)