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. Technology company Grocery store Business Risk Total risk Total risk Financial Risk Financial Risk Basic business risk Basic business risk amount of debt amount of debt

6. 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.

7. Advantages Less risky for investor; therefore cheaper source of capital than stock Tax deduction for interest results in lower after taxcost to company Use someone else’s money to increase return to Stockholders (ROE) pay interest $10 borrow $100 earn $15 pay stockholders $5 Disadvantages Increased Financial Risk (risk of Bankruptcy) Advantages/Disadvantages of Debt Financing In bankruptcy, the creditors are paid first. Stockholders are last in line.

8. 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) After Tax Cost of Debt Pre-Tax Cost of Debt: After-Tax Cost of Debt:

9. 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. Advantages/Disadvantages of Equity Financing (issuing stock)

10. 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

11. WhichBond Will Carry the Higher Interest Rate?

12. Bond Yield Comparisons Compare the bonds in each of the two sets.

13. 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 Summary Characteristics of Bonds/Loans

14. 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 ?????

15. 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

16. 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)