Look Before You Leverage

Debt Versus Equity Financing

Mohamad Farid Zaini

Senin, 17 Oktober 2011

Background
Bob as CEO od Symonds Electronics had
embark upon an expansion project

The expansion had the potential of

increasing sales about 30% per year over the next 5 years that had been estimated at $ 5,000,000.

Bob needs additional fund for the project

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Why Expand?
By using $3,000,000 of his own saving and a
5 years bank note worth $2,000,000, Bob could manage to get the company up and running stock market

The economy was booming and thriving Successful IPO, from $5 per share (5 years
ago) to $15 per share (current)
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The Issues

After presenting the expansion proposal at the board meeting, the directors were equally divided in their opinion of which nancing route should be chosen First option: long-term xed-rate debt Second option: issue common stock Feeling rather frustated and confused, Bob, decided to call upon his CFO, Andrew Lambs, to resolve this dilemma

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Question 1
If Symonds Electronics Inc. were to raise all the required capital by issuing debt, what would the impact be on the rms shareholders?

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Answer 1
Using Debt
Simulation 1 Current Sales Increase 10% Sales Increase 30% Sales Increase 50% Simulation 2 Simulation 3

Sales $15,000,000 EBIT $ 2,250,000 Net Income $ 1,350,000 Equity $15,000,000 ROE = Net Income x 100%
Equity ROE = $1,350,000 x 100%
$15,000,000 ROE = 9%

Sales = $15,000,000 x 110% = $16,500,000 EBIT = $2,250,000 x 110% = $2,475,000 Debt Interest = $5,000,000 x 10% = $500,000 EBT = $2,475,000 - $500,000 = $1,975,000 Net Income = (EBT - 40% Taxes) = $1,975,000 - $790,000 = $1,185,000 Equity = $15,000,000 ROE = 7.9%

Sales = $15,000,000 x 130% = $19,500,000 EBIT = $2,250,000 x 130% = $2,925,000 Debt Interest = $5,000,000 x 10% = $500,000 EBT = $2,925,000 - $500,000 = $2,425,000 Net Income = (EBT - 40% Taxes) = $2,425,000 - $970,000 = $1,455,000 Equity = $15,000,000 ROE = 9.7%

Sales = $15,000,000 x 150% = $22,500,000 EBIT = $2,250,000 x 150% = $3,375,000 Debt Interest = $5,000,000 x 10% = $500,000 EBT = $3,375,000 - $500,000 = $2,875,000 Net Income = (EBT - 40% Taxes) = $2,875,000 - $1,150,000 = $1,725,000 Equity = $15,000,000 ROE = 11,5%

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Answer 1

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The impact on the rms shareholders can be seen in ROE (Return on Common Equity) The percentage of ROE decreases when the sales decrease 10% with net income $1,185,000 But when the sales increases 30% and 50%, the ROE is increasing as well up to 9.7% and 11.5% The shareholders will get higher return when the sales increase 30% and up
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Question 2
What does homemade leverage mean? Using the data in the case, explain how a shareholder might be able to use homemade leverage to create the same payoffs as achieved by the rm

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Answer 2
Homemade leverage is investors method of
substituting their own borrowing or lending for corporate borrowing

Investor who want more leverage than a

company has taken on can buy the companys stock on margin that is, borrow money from a broker and use the borrowed funds to pay for a portion of the stock in order to the corporate borrowing

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Answer 2
Using Homemade Leverage
Simulation 1 Current Sales Increase 10% Sales Increase 30% Sales Increase 50% Simulation 2 Simulation 3

Sales $15,000,000 EBIT $ 2,250,000 Taxes $900,000 Net Income $ 1,350,000 Equity $15,000,000 ROE = Net Income x 100%
Equity ROE = $1,350,000 x 100%
$15,000,000 ROE = 9%

Sales = $15,000,000 x 110% = $16,500,000 EBIT = $2,250,000 x 110% = $2,475,000 Debt Interest = $0 EBT = $2,475,000 Taxes = $2,475,000 x 40% = $990,000 Net Income = (EBT - 40% Taxes) = $2,475,000 - $990,000 = $1,480,000 Equity =$15,000,000 + $5,000,000 = $20,000,000 ROE = 7.43%

Sales = $15,000,000 x 130% = $19,500,000 EBIT = $2,250,000 x 130% = $2,925,000 Debt Interest = $0 EBT = $2,925,000 Taxes = $2,925,000 x 40% = $1,170,000 Net Income = (EBT - 40% Taxes) = $2,925,000 - $1,170,000 = $1,755,000 Equity =$15,000,000 + $5,000,000 = $20,000,000 ROE = 8.78%

Sales = $15,000,000 x 150% = $22,500,000 EBIT = $2,250,000 x 150% = $3,375,000 Debt Interest = $0 EBT = $3,375,000 Taxes = $3,375,000 x 40% = $1,350,000 Net Income = (EBT - 40% Taxes) = $3,375,000 - $1,350,000 = $2,025,000 Equity =$15,000,000 + $5,000,000 = $20,000,000 ROE = 10.13%

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Answer 2

Using debt $5,000,000 Increasing sales EPS (Net income/#shares)

10% $1,185,000/1,000,000 = $1,185
30% $1,455,000/1,000,000 = $1,455
50% $1,725,000/1,000,000 = $1,725 Using homemade leverage (no debt) Increasing sales EPS (Net income/#shares)
10% $1,485,000/1,333,333.33 = $1,11
30% $1,755,000/1,333,333.33 = $1,32
50% $2,025,000/1,333,333.33 = $1,52 Shares outstanding = 1,000,000 + ($5,000,000/$15) = 1,333,333.33 shares By using homemade leverage, the calculation above shows that the ROE and EPS is getting higher. By the increasing stock sold $5,000,000 it creates the same payoffs as achieved by the rm
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Question 3
What is the current weighted average cost of capital of the rm? What effect would a change in the debt to equity ratio have on the weighted average cost of capital and the cost of equity capital of the rm?

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Answer 3

Given data: Beta = 1.1 rf = 4% rm = 12% Weighted Average Cost of Capital (WACC) = [(1 - t) Rdebt (D/(D+E))] + Requity (E/(D+E)) Requity (no debt) = rf + Beta (rm - rf) = 4% + 1.1 (12% - 4%) = 12.8% WACC current = [(1 - 40%) 0 (0/(0 + $15,000,000))] + 12.8% ($15,000,000/(0+$15,000,000)) = 0 + 12.8% =12.8%
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Senin, 17 Oktober 2011

Answer 3

Requity debt = R (no debt) + (R no debt - interest rate on debt) (D/E) (1 - tax rate) = 12.8% + (12.8% - 10%) ($5,000,000/$15,000,000)(1 - 40%) = 12.8% + (2.8%)(0.333)(0.6) = 12.8% + 0.0056 = 0.1336 = 13.36% WACC with debt = [(1 - t) Rdebt (D/D+E))] + Requity (E/D+E)) = [(1 - 40%) 10% ($5,000,000/($5,000,000 + $15,000,000))] + 13.36%($15,000,000/($5,000,000 + $15,000,000)) = (0.6) (10%) (0.25) + (13.36%) (0.75) = 0.015 + 0.1002 = 0.1152 = 11.52% The effect on change in debt: The WACC with debt is 11.52% decrease from current WACC as much as 1.28%. It is good for the company because the lower the WACC the lower of cost of capital

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Question 4
The rms beta was estimated at 1.1. Treasury bills were yielding 4% and the expected rate of return on the market index was estimated to be 12%. Using various combinations of debt and equity, under the assumption that the costs of each component stays constant show the effect of increasing leverage on the weighted average cost of capital of the rm. Is there a particular capital structure that maximizes the value of the rm? Explain
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Answer 4
D :E E :V D :E Beta 1.1 1 : 10 2 : 10 3 : 10 4 : 10 9 : 10 8 : 10 7 : 10 6 : 10 1 :9 2 :8 3 :7 4 :6 1.1 1.1 1.1 1.1 Requity 12.8% 12.8% 12.8% 12.8% 12.8% WACC 12.8% 12.12% 10.84% 9.56% 7.68% Debt $0 $5,000,000 $6,000,000 $7,000,000 $8,000,000

Using various combinations of debt and equity, with the assumption that the cost of each component stays constant, the increasing leverage makes the WACC is getting lower. There is a particular capital structure that maximizes the value of the rm, when a leveraged rm increases in proportion to D : E, expressed in market values is getting higher.
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Question 5
How would the key protability ratios of the rm be affected if the rm were to raise all of the capital by issuing 5-year notes?

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Answer 5
Current $1,350,000 $15,000,000 = 9% $2,250,000 $15,000,000 = 15% $1,350,000 $15,000,000 = 9% $1,350,000 $15,000,000 = 9% 10% $1,185,000 $16,500,000 = 7% $2,475,000 $20,000,000 = 12% $1,185,000 $20,000,000 = 6% $1,185,000 $15,000,000 = 8% 30% $1,455,000 $19,500,000 = 7% $2,925,000 $20,000,000 = 15% $1,455,000 $20,000,000 = 7% $1,455,000 $15,000,000 = 10% 50% $1,725,000 $22,500,000 = 8% $3,375,000 $20,000,000 = 17% $1,725,000 $20,000,000 = 9% $1,725,000 $15,000,000 = 12% Analysis P/M Bad

BEP

Good

ROA

Good

ROE

Good

So, it is good for the company if it issues 5-year notes

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Question 6

If you were Andrew Lamb, what would you recommend to the board and why?

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Answer 6

Senin, 17 Oktober 2011

Recommend the rm to issues 5-year notes to the bank The result of protability ratios is good especially in ROE that measures the rate of return of common stockholders investment. WACC also showed that there were a lower WACC which was good when the rm using debt EPS was also higher as well means that the earning of selling shares is getting higher. The increasing sales have to be above 30%
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Question 7
What are some issues to be concerned about when increasing leverage?

Answer 7

Senin, 17 Oktober 2011

Prot - One of the companys powers to run the business - We have to know whether our prot is enough to pay the debt and its interest Interest rate When we are increasing leverage, we must consider about its interest rate. Whether it is high or not.
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Question 8
Is it fair to assume that if protability is positively affected in the short run, due to higher debt ratios, the stock price would increase? Explain

Answer 8
It is unfair No matter how much the amount of debt, if
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the prot is increasing signicantly, the stock price will increase as well
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Question 9
Using suitable diagrams and the data in the case, explain how Andrew Lamb could enlighten the board members about Modigliani and Millers Propositions I and II (with corporate taxes)

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Answer 9

MMs proposition I Value levered. The value of a rm is unaffected by its capital structure. It shows that under the ideal conditions the rm debt policy should not matter to the shareholders MMs proposition II The required rate of return on equity as the rms the rms deincrease by equity ratio increases. It states that the expected rate of return on the common stock of a levered rm increases in proportionto debt equity ratio (D/E), expressed in market values.

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Conclusion

Using debt: ROE current 9% Increasing sales 10% become 7.9% ROE & $1,185 EPS Increasing sales 30% become 9.7% ROE & $1,455 EPS Increasing sales 50% become 11.5% ROE & $1,725 EPS Number of shares 1,000,000 Using homemade leverage (no debt): ROE current 9% Increasing sales 10% become 7.43% ROE and $1,11 EPS Increasing sales 30% become 8.78% ROE and $1,32 EPS Increasing sales 50% become 10.13% ROE and $1,52 EPS Number of shares 1,000,000 + 333,333.33 = 1,333,333.33 shares

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Conclusion

Using debt result higher protability ratio and EPS rather than using homemade leverage It reects that the company condition is good in term on returning on common stockholders investment (ROE) The earning per share is good when using leverage. Notes that the company has it sells above 30%. The risk is when the increasing sales are just 10%. High risk high return It is the responsibity for the rm to increase it sells to get higher return of prot. The higher the debt the lower the WACC (no 4) Suggestion: Expand the business by using leverage
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Senin, 17 Oktober 2011