Chapter 7
Debt and Equity Financing
Go to the Chapter 7 folder in the Additional Instructor Resources & Solutions folder to find
the Excel spread sheets that accompany the material in this chapter.
Chapter Overview
I. Required rate of return
a. Factors influencing the required rate of return
i. Production opportunities
1. Return on equity capital
iv. Gifts
b. Stocks
i. Common stock
1. Capital gain
III. Debt
a. Bonds
i. Coupon rate
ii. Call provisions and premiums
iii. Rating a bond
1. Default risk
2. Junk bonds
b. Loans
c. Trade Credit
d. Bankruptcy
Key Concepts
When reading this chapter, students should focus on the following key concepts:
1. Factors that impact the required rate of return
2. Methods that can be used to raise capital
Quiz Questions
1. In order for investors to purchase stock in a company, they will require a return of at
least a certain amount. The amount investors require depends on which of the
following?
a. Production opportunities
b. Time preferences for consumption
2. Which of the following is added to the risk-free rate to reflect the likelihood that the
issuer will default?
d. Maturity risk premium
e. None of the above
3. Of the following, which is NOT a form of equity financing?
a. A loan
b. Retained earnings
4. What percentage of businesses have equity ownership?
d. 75%
e. 100%
5. Which league prohibits the publicly traded ownership model?
a. NBA
b. MLB
6. The __________ of a bond is the face value, or amount of principal that the bond is
worth when the principal amount is due.
d. Current yield
e. Yield to maturity
7. Which of the following is the amount earned annually from the interest payment
compared with the price of the bond reflected as a percentage return?
c. Maturity
d. Current yield
e. Yield to maturity
8. Of the following, which is an indirect source of public financing?
a. Sales tax revenue
b. Sin tax revenue
Answers to Quiz Questions
Numbers in parentheses represent where, in the text, you’ll find this discussed.
1. e (pp. 170–171)
2. b (pp. 171; 179–180)
Responses
1. Does higher expected inflation increase, decrease, or have no effect on the required rate
of return?
See pages 170–171. Higher expected inflation increases the required rate of return
because the “real” rate of return will be lower if inflation is higher. It will cost more in
2. What methods can a company use to raise capital?
See page 170. The company may allow investors to own part of the company in
3. Does a company share its risk by issuing equity or debt?
See pages 178–179. Issuing equity allows the company to raise capital in exchange for
giving some of the ownership to another person or entity. This person or entity then
4. What are some of the advantages of equity financing?
See pages 185–186. As mentioned in the answer to Question #3, equity financing allows
the owner to share some of the risk in the venture without having to pay interest on the
5. What are some of the disadvantages of equity financing, specifically for sport teams?
See pages 186–188. One reason a sport team may not want to issue publicly traded
equity (carry out an IPO) is that it would lose operating confidentiality. Its financials
would become public, allowing skeptical fans to complain about under-spending for
6. Is the liquidity spread typically upward or downward sloping? Why?
See pages 172–173. The liquidity spread is the difference between a long-term interest
rate and a short-term rate. It is usually graphically expressed as the yield curve.
Typically, yield curves are upward sloping because there is more uncertainty in the far
7. How are the features of a convertible bond similar to both debt and equity?
See page 182. A convertible bond is similar to debt in that bondholders receive fixed
payments over time. However, if the stock price rises enough, convertible bondholders
Responses
1. Using the information in Exhibit 7.4 for NewFangled Sports Products, Inc., calculate the
new NPV of a share of stock if the perpetual growth rate doubled from 4% to 8%.
Additionally, if the terminal year dividend payment went from $1.40 to $2.80, what is
the new share price?
See pages 175–176. From the table, change the perpetual growth rate from 4% to 8%.
That means that in the years beyond the terminal year, the stock dividend per share is
expected to rise by 8% each year. In the short run that might be reasonable, but over a
(c) Based upon estimated long term cash flow growth rate of the economy in general.
NewFangled Sports Products, Inc.
Valuation of Stock
Value of Stock Based on Dividend Payments
Projected
FYE FYE FYE FYE FYE Terminal
Current Year CY+1 CY+2 CY+3 CY+4 Year
Expected Dividend Payment Per Share $1.00 $1.10 $1.15 $1.20 $1.30 $2.80
Discount Period in Years 0.00 1.00 2.00 3.00 4.00
(a) Discount Factor 1.0000 0.8890 0.7904 0.7027 0.6247 0.6247
Present Value – Cash Flow/Terminal Value $1.00 $0.98 $0.91 $0.84 $0.81 $39.05
Net Present Value $43.59
Notes:
(a) Reflects end-of-year discounting convention.
(b) Based upon the Cost of Equity Capital as reported in Ibbotson’s Cost of Capital Yearbook (data through June 2006) for SIC 3949.
2. A share of NewFangled Sports stock is expected to provide a $1 per year dividend
payment the first year, growing at 8% thereafter. Using a discount rate of 12%, what is
the share worth with a 15-year horizon? What is it worth valued into infinity? Compare
the differences.
See pages 175–176. The essence of this question is to compare a 15-year horizon and
an infinite horizon. As can be seen in the two tables below, ending the valuation at 15
NewFangled Sports Products, Inc.
Valuation of Stock
Value of Stock Based on Dividend Payments
Projected
FYE FYE FYE FYE FYE FYE FYE FYE FYE FYE FYE FYE FYE FYE FYE FYE
Current Year CY+1 CY+2 CY+3 CY+4 CY+5 CY+6 CY+7 CY+8 CY+9 CY+10 CY+11 CY+12 CY+13 CY+14 CY+15
Expected Dividend Payment Per Share $1.00 $1.08 $1.17 $1.26 $1.36 $1.47 $1.59 $1.71 $1.85 $2.00 $2.16 $2.33 $2.52 $2.72 $2.94 $3.17
Discount Period in Years 0.00 1.00 2.00 3.00 4.00 5.00 6.00 7.00 8.00 9.00 10.00 11.00 12.00 13.00 14.00 15.00
Present Value – Cash Flow/Terminal Value $1.00 $0.96 $0.93 $0.90 $0.86 $0.83 $0.80 $0.78 $0.75 $0.72 $0.70 $0.67 $0.65 $0.62 $0.60 $0.58
Net Present Value $12.35
Notes:
(a) Reflects end-of-year discounting convention.
3. A minor league professional hockey team embarks on an aggressive facility expansion
that requires additional capital. Management decides to finance the expansion by
borrowing $40 million and halting dividend payments to increase retained earnings. The
projected free cash flows are $5 million for the current year, $10 million for the
following year, and $20 million for the third year. After the third year, free cash flow is
projected to grow at a constant 6%. The overall cost of capital is 10%. What is the total
value? If the company has 10 million shares of stock and $40 million total debt, what is
the price per share?
See pages 175–176. As shown in the table below, the free cash flows in perpetuity,
leading to a value of $428 million. Subtracting $40 million in debt and dividing by ten
NewFangled Sports Products, Inc.
Valuation of Stock
Value of Stock Based on Dividend Payments
Projected
FYE Terminal
Current Year Year
Expected Dividend Payment Per Share $1.00 $1.08
Discount Period in Years 0.00
Present Value – Cash Flow/Terminal Value $1.00 $27.00
Net Present Value $28.00
Notes:
(a) Reflects end-of-year discounting convention.
(b) Based upon the Cost of Equity Capital as reported in Ibbotson’s Cost of Capital Yearbook (data through June 2006) for SIC 3949.
(c) Terminal Value = (Terminal Year Cash Flow / (Discount Rate – Perpetual Growth Rate))
Responses to Questions
St. Louis Cardinals’ expenses:
Player salaries 50%
Team operations 10%
1. Has the Cardinals’ decision to use debt financing hurt the on-field performance of the
organization? If so, how?
▪ While equity financing wouldn’t require the Cardinals to make more than $20 million
per year in debt payments, those equity holders would likely want to see a return on
Minor League Hockey
Valuation of Stock
Value of Stock Based on Dividend Payments
Projected
FYE FYE FYE Terminal
Current Year CY+1 CY+2 Year
Free Cash Flows $5,000,000 $10,000,000 $20,000,000 $21,200,000
Discount Period in Years 0.00 1.00 2.00
(a) Discount Factor 1.0000 0.9091 0.8264 0.7513
(c) Terminal Value $530,000,000
Present Value – Cash Flow/Terminal Value $5,000,000 $9,090,909 $16,528,926 $398,196,844
Net Present Value $428,816,679
Amount of Debt $40,000,000
NPV including Debt $388,816,679
Number of Shares 10,000,000
Price Per Share $39
Notes:
(a) Reflects end-of-year discounting convention.
▪ Also, the real financial calculation that the Cardinals should make is whether the
marginal or incremental revenue of signing more talent (spending more on player
2. What form of debt financing was likely used by the team to raise its $300 million portion
of the construction costs?
▪ Bonds were likely used, rather than loans, as this method is much more common in
the sport industry.
3. What equity financing options could the club have considered to raise some of the
capital needed to build a new stadium?
▪ The team could have sold shares in the franchise in order to raise capital.
Additional Classroom/Exam Problems
1. The Broomfield Bricklayers has a bond issue outstanding with an annual coupon rate
of 9%. The par value of the bond is $1,000. Calculate the current yield of the bond if
the bond’s current price was $974. See pages 179–182.
Current yield = annual coupon interest payment/current price of bond
2. Refer to Additional Problem 1. If the sale price of this bond was $1,103 a year later,
what is the capital gains yield? See pages 179–182.
3. Refer to Additional Problems 1 and 2. What would the total expected return for the
bond be? See pages 179–182.
Total Expected Return = current yield + capital gains yield
4. Refer to the bond valuation calculation on page 181 of the text. Using a financial
calculator, solve for the present value of the 10-year bond on its issue date. The
bond has a par value of $1,000, coupon rate of 10%, and a discount rate of 8%.