This Week In Finance

Bowie Bonds and Rock-n-Roll Finance

This week's Teaching Tip is a valuation example from the December 5, 1996 issue of The Wall Street Journal. According to the Journal, rock star David Bowie hopes to get into the securitization business. Specifically, he "is considering packaging his future royalties into an asset-backed bond issue to be sold in the next several months . . . instead of waiting for royalties from future record sales to trickle in, Mr. Bowie would receive cash up front from institutional investors who are willing to pay some $50 million for a piece of Ziggy Stardust."

First, pose this relatively straightforward problem to your students.

You have been asked to value this issue. Make the following simplifying assumptions: (a) royalty payments in the most recent year totalled $6 million, and will be paid annually to investors beginning in one year, (b) the appropriate required return on this stream of future payments is 10 percent, and (c) the payments will be paid in perpetuity, but are expected to decline at a rate of 4 percent per year.

Given the data above, this constitutes a relatively straightforward constant-growth model problem. The PV of the royalty stream is ($5m)(1 - .04)/[.10 - (-.04)] = $41.14m.

Now, consider the underlying assumptions. You might want to use some of the following discussion questions to pique student interest:

What factors deteremine the shape of the future cash flow stream? If Mr. Bowie has a new hit song, the actual royalty growth rate could be positive. How might we take this uncertainty into account?

How should we arrive at a reasonable discount rate for the estimated cash flow stream? How does "risk" in this context differ from that in the financial markets?

Finally, the actual arrangement calls for future royalties to revert to Mr. Bowie once the investors have received $50 million "plus interest". How would this affect the valuation process?

My corpfin students found this scenario to be an intriguing way to put the time-value concept and valuation models to use. Good luck!