Case24. Debt Versus Equity FinancingLook Before You Leverage!“Why do things have
ID: 2653252 • Letter: C
Question
Case24. Debt Versus Equity FinancingLook Before You Leverage!“Why do things have to be so complicated?” said Bob to Andrew, as he sat at his deskshuffling papers around. “I need you to come up with a convincing argument.” Bob’scompany, Symonds Electronics, had embarked upon an expansion project, which had thepotential of increasing sales by about 30% per year over the next 5years. The additionalcapital needed to finance the project had been estimated at $5,000,000. What Bob waswondering about was whether he should burden the firm with fixed rate debt or issuecommon stock to raise the needed funds. Having had no luck with getting the board of directors to vote on a decision, Bob decided to call on Andrew Lamb, his Chief FinancialOfficer, to shed some light on the matter.Bob Symonds, the Chief Executive Officer of Symonds Electronics, established hiscompany about 10years ago in his hometown of Cincinnati, Ohio. After taking earlyretirement at age 55, Bob felt that he could really capitalize on his engineeringknowledge and contacts within the industry. Bob remembered vividly how easily he hadmanaged to get the company up and running by using $3,000,000 of his own savingsand a five-year bank note worth $2,000,000. He recollected how uneasy he had feltabout that debt burden and the 14% per year rate of interest that the bank had beencharging him. He remembered distinctly how relieved he had been after paying off theloan one year earlier than its five-year term, and the surprised look on the bankmanager’s face.Business had been good over the years and sales had doubled about every 4 years.As sales began to escalate with the booming economy and thriving stock market, thefirm had needed additional capital. Initially, Bob had managed to grow the business byusing internal equity and spontaneous financing sources. However, about 5 years ago,when the need for financing was overwhelming, Bob decided to take the company publicvia an initial public offering (IPO) in the over-the-counter market. The issue was verysuccessful and oversubscribed, mainly due to the superb publicity and marketing effortsof the investment underwriting company that Bob hired. The company sold 1 millionshares at $5 per share. The stock price had grown steadily overtime and was currentlytrading at its book value of $15 per share.When the expansion proposal was presented at last week’s board meeting, thedirectors were unanimous about the decision to accept the proposal. Based upon theestimates provided by the marketing department, the project had the potential of increasing revenues by between 10 %( Worst Case) and 50 %( Best Case) per year. The internal rate of return was expected to far outperform the company’s hurdle rate.Ordinarily, the project would have been started using internal and spontaneous funds.However, at this juncture, the firm had already invested all its internal equity into thebusiness. Thus, Bob and his colleagues were hard pressed to make a decision as towhether long-term debt or equity should be the chosen method of financing this timearound.Upon contacting their investment bankers, Bob learned that they could issue 5-yearnotes, at par, at a rate of 10% per year. Conversely, the company could issue commonstock at its current price of $15 per share. Being unclear about what decision to make,Bob put the question to a vote by the directors. Unfortunately, the directors were equallydivided in their opinion of which financing route should be chosen. Some of the directorsfelt that the tax shelter offered by debt would help reduce the firm’s overall cost of capital and prevent the firm’s earnings per share from being diluted. However, othershad heard about “homemade leverage” and would not be convinced. They were of theopinion that it would be better for the firm to let investors leverage their investmentsthemselves. They felt that equity was the way to go since the future looked ratheruncertain and being rather conservative, they were not interested in burdening the firmwith interest charges. Besides, they felt that the firm should take advantage of thebooming stock market.Feeling rather frustrated and confused, Bob decided to call upon his chief financialofficer, Andrew Lamb, to resolve this dilemma. Andrew had joined the company about two years ago. He held an MBA from a prestigious university and had recently completedhis Chartered Financial Analysts’ certification. Prior to joining Symonds, Andrew hadworked at two other publicly traded manufacturing companies and had been successfulin helping them raise capital at attractive rates, thereby lowering their cost of capitalconsiderably.Andrew knew that he was in for a challenging task. He felt, however, that this was agood opportunity to prove his worth to the company. In preparation of his presentation,he got the latest balance sheet and income statement of the firm (see Tables 1 and 2)and started crunching out the numbers. The title of his presentation read, “Look Before You Leverage!”
Q) what capital structue we should go with ? 100% debt or 100% equity ? or mix between the two ?
Q) If Symonds Electronics Inc. were to raise all of the required capital by issuingdebt, what would the impact be on the firm’s shareholders?
Q) If you were Andrew Lamb, what would you recommend to the board and why?
Q) What are some issues to be concerned about when increasing leverage?
Thanks
Explanation / Answer
Debt/Value
Equity/Value
D/E
RE
WACC
Debt
Vu
Vl
0
1
0
12.88%
12.88%
0
13625776
13625776
0.01
0.99
0.010
12.90%
12.83%
136257.8
13625776
13680280
0.02
0.98
0.020
12.92%
12.78%
272515.5
13625776
13734783
0.03
0.97
0.031
12.93%
12.73%
408773.3
13625776
13789286
0.04
0.96
0.042
12.95%
12.67%
545031.1
13625776
13843789
0.05
0.95
0.053
12.97%
12.62%
681288.8
13625776
13898292
0.06
0.94
0.064
12.99%
12.57%
817546.6
13625776
13952795
0.07
0.93
0.075
13.01%
12.52%
953804.3
13625776
14007298
0.08
0.92
0.087
13.03%
12.47%
1090062
13625776
14061801
0.09
0.91
0.099
13.05%
12.42%
1226320
13625776
14116304
0.1
0.9
0.111
13.07%
12.36%
1362578
13625776
14170807
0.11
0.89
0.124
13.09%
12.31%
1498835
13625776
14225311
0.12
0.88
0.136
13.12%
12.26%
1635093
13625776
14279814
0.13
0.87
0.149
13.14%
12.21%
1771351
13625776
14334317
0.14
0.86
0.163
13.16%
12.16%
1907609
13625776
14388820
0.15
0.85
0.176
13.18%
12.11%
2043866
13625776
14443323
0.16
0.84
0.190
13.21%
12.06%
2180124
13625776
14497826
0.17
0.83
0.205
13.23%
12.00%
2316382
13625776
14552329
0.18
0.82
0.220
13.26%
11.95%
2452640
13625776
14606832
0.19
0.81
0.235
13.29%
11.90%
2588898
13625776
14661335
0.2
0.8
0.250
13.31%
11.85%
2725155
13625776
14715839
0.21
0.79
0.266
13.34%
11.80%
2861413
13625776
14770342
0.22
0.78
0.282
13.37%
11.75%
2997671
13625776
14824845
0.23
0.77
0.299
13.40%
11.70%
3133929
13625776
14879348
0.24
0.76
0.316
13.43%
11.64%
3270186
13625776
14933851
0.25
0.75
0.333
13.46%
11.59%
3406444
13625776
14988354
0.26
0.74
0.351
13.49%
11.54%
3542702
13625776
15042857
0.27
0.73
0.370
13.52%
11.49%
3678960
13625776
15097360
The partial data table above shows that as the debt-equity ratio increases the WACC of the firm decreases and approaches the after-tax cost of debt.
As shown in the graph above, with 100% debt the firm’s value will be maximized. Of course, no firm can legally operate with 100% debt.
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If Symonds Electronics Inc. were to raise all of the required capital by issuing debt, what would the impact be on the firm’s shareholders?
The impact on shareholders can be analyzed by calculating the EPS and ROE of the firm under the alternative scenarios as follows:
All Debt
With $5,000,000 Expansion
Current
Worst Case
Expected Case
Best Case
Growth in Revenues
10%
30%
50%
Revenues
15,000,000
16,500,000
19,500,000
22,500,000
EBIT
2,250,000
2,475,000
2,925,000
3,375,000
Interest
0
500,000
500,000
500,000
EBT
2,250,000
1,975,000
2,425,000
2,875,000
EBT*(1-T)
1,350,000
1,185,000
1,455,000
1,725,000
# of shares
1,000,000
1,000,000
1,000,000
1,000,000
EPS
1.35
1.185
1.455
1.725
Debt
0
5,000,000
5,000,000
5,000,000
Equity
15,000,000
15,000,000
15,000,000
15,000,000
Debt/Equity Ratio
0.00%
33.33%
33.33%
33.33%
Return on Equity
9.00%
7.90%
9.70%
11.50%
The calculations show that if Symonds Electronics Inc. were to raise all of the required capital by issuing debt, its EPS would vary between $1.19 and $1.73 per share with the expected EPS being about $0.11 higher than the current EPS of $1.35. Likewise, the firm’s ROE could vary between 7.9% and 11.5%, with the most likely ROE being 9.7%.
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I would recommend that the firm issue debt in order to raise the $5,000,000 for the expansion, since the firm currently has no debt and is not in any immediate risk of bankruptcy. The expected EBIT is good and the firm’s value will increase with the inclusion of debt in the capital structure, due to the lower after-tax cost of debt.
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Some of the issues to be concerned about when increasing leverage are: taxes and financial distress costs. The main advantage of issuing debt is the interest tax-shield. Unless the firm is capable of earning sufficient profits to utilize the tax-shields it should not increase its debt ratio. Higher debt ratios can cause firms to experience financial distress during periods of low profitability. Firms with a greater risk of experiencing financial distress i.e. those whose profits vary considerably, should borrow less than firms with more stable revenues and profits.
Debt/Value
Equity/Value
D/E
RE
WACC
Debt
Vu
Vl
0
1
0
12.88%
12.88%
0
13625776
13625776
0.01
0.99
0.010
12.90%
12.83%
136257.8
13625776
13680280
0.02
0.98
0.020
12.92%
12.78%
272515.5
13625776
13734783
0.03
0.97
0.031
12.93%
12.73%
408773.3
13625776
13789286
0.04
0.96
0.042
12.95%
12.67%
545031.1
13625776
13843789
0.05
0.95
0.053
12.97%
12.62%
681288.8
13625776
13898292
0.06
0.94
0.064
12.99%
12.57%
817546.6
13625776
13952795
0.07
0.93
0.075
13.01%
12.52%
953804.3
13625776
14007298
0.08
0.92
0.087
13.03%
12.47%
1090062
13625776
14061801
0.09
0.91
0.099
13.05%
12.42%
1226320
13625776
14116304
0.1
0.9
0.111
13.07%
12.36%
1362578
13625776
14170807
0.11
0.89
0.124
13.09%
12.31%
1498835
13625776
14225311
0.12
0.88
0.136
13.12%
12.26%
1635093
13625776
14279814
0.13
0.87
0.149
13.14%
12.21%
1771351
13625776
14334317
0.14
0.86
0.163
13.16%
12.16%
1907609
13625776
14388820
0.15
0.85
0.176
13.18%
12.11%
2043866
13625776
14443323
0.16
0.84
0.190
13.21%
12.06%
2180124
13625776
14497826
0.17
0.83
0.205
13.23%
12.00%
2316382
13625776
14552329
0.18
0.82
0.220
13.26%
11.95%
2452640
13625776
14606832
0.19
0.81
0.235
13.29%
11.90%
2588898
13625776
14661335
0.2
0.8
0.250
13.31%
11.85%
2725155
13625776
14715839
0.21
0.79
0.266
13.34%
11.80%
2861413
13625776
14770342
0.22
0.78
0.282
13.37%
11.75%
2997671
13625776
14824845
0.23
0.77
0.299
13.40%
11.70%
3133929
13625776
14879348
0.24
0.76
0.316
13.43%
11.64%
3270186
13625776
14933851
0.25
0.75
0.333
13.46%
11.59%
3406444
13625776
14988354
0.26
0.74
0.351
13.49%
11.54%
3542702
13625776
15042857
0.27
0.73
0.370
13.52%
11.49%
3678960
13625776
15097360