look before you leverage

Look Before You Leverage

Debt Versus Equity Financing

Mohamad Farid Zaini

1Senin, 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

• Bob needs additional fund for the project that had been estimated at $ 5,000,000.


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

• The economy was booming and thriving stock market

• Successful IPO, from $5 per share (5 years ago) to $15 per share (current)


The Issues• After presenting the expansion proposal at the

board meeting, the directors were equally divided in their opinion of which financing route should be chosen

• First option: long-term fixed-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


Question 1

If Symonds Electronics Inc. were to raise all the required capital by issuing debt, what

would the impact be on the firm’s shareholders?


Answer 1

CurrentCurrentSimulation 1 Simulation 2 Simulation 3

Sales Increase 10% Sales Increase 30% Sales Increase 50%

• 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%

Using Debt


Answer 1

• The impact on the firm’s 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


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 firm


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 company’s 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


Answer 2

CurrentCurrentSimulation 1 Simulation 2 Simulation 3

Sales Increase 10% Sales Increase 30% Sales Increase 50%

• 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


= $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


= $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%

Using Homemade Leverage


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 = $1,52Shares 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 firm


Question 3

What is the current weighted average cost of capital of the firm? 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 firm?


Answer 3• Given data:

Beta = 1.1rf = 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%


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


Question 4The firm’s 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 firm. Is

there a particular capital structure that maximizes the value of the firm? Explain


Answer 4

• 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 firm, when a leveraged firm increases in proportion to D : E, expressed in market values is getting higher.

D : E E : V D : E Beta Requity WACC Debt

1.1 12.8% 12.8% $0

1 : 10 9 : 10 1 : 9 1.1 12.8% 12.12% $5,000,000

2 : 10 8 : 10 2 : 8 1.1 12.8% 10.84% $6,000,000

3 : 10 7 : 10 3 : 7 1.1 12.8% 9.56% $7,000,000

4 : 10 6 : 10 4 : 6 1.1 12.8% 7.68% $8,000,000


Question 5

How would the key profitability ratios of the firm be affected if the firm were to raise all

of the capital by issuing 5-year notes?


Answer 5

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

Current 10% 30% 50% Analysis

P/M$1,350,000$15,000,000

= 9%

$1,185,000$16,500,000

= 7%

$1,455,000$19,500,000

= 7%

$1,725,000$22,500,000

= 8%Bad

BEP$2,250,000$15,000,000

= 15%

$2,475,000$20,000,000

= 12%

$2,925,000$20,000,000

= 15%

$3,375,000$20,000,000

= 17%Good

ROA$1,350,000$15,000,000

= 9%

$1,185,000$20,000,000

= 6%

$1,455,000$20,000,000

= 7%

$1,725,000$20,000,000

= 9%Good

ROE$1,350,000$15,000,000

= 9%

$1,185,000$15,000,000

= 8%

$1,455,000$15,000,000

= 10%

$1,725,000$15,000,000

= 12%Good


Question 6

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


Answer 6• Recommend the firm to issues 5-year notes to the

bank

• The result of profitability 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 firm 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%


Question 7What are some issues to be concerned about

when increasing leverage?

• Profit- One of the company’s powers to run the business- We have to know whether our profit is enough to pay the debt and its interest

• Interest rateWhen we are increasing leverage, we must consider about its interest rate. Whether it is high or not.

Answer 7


Question 8Is it fair to assume that if profitability 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 the profit is increasing significantly, the stock price will increase as well


Question 9

Using suitable diagrams and the data in the case, explain how Andrew Lamb could enlighten

the board members about Modigliani and Miller’s Propositions I and II (with corporate

taxes)


Answer 9• MM’s proposition I

Value levered. The value of a firm is unaffected by its capital structure. It shows that under the ideal conditions the firm debt policy should not matter to the shareholders

• MM’s proposition IIThe required rate of return on equity as the firms the firms’ deincrease by equity ratio increases. It states that the expected rate of return on the common stock of a levered firm increases in proportionto debt equity ratio (D/E), expressed in market values.


Conclusion

• Using debt:ROE current 9%Increasing sales 10% become 7.9% ROE & $1,185 EPSIncreasing sales 30% become 9.7% ROE & $1,455 EPSIncreasing sales 50% become 11.5% ROE & $1,725 EPSNumber of shares 1,000,000

• Using homemade leverage (no debt):ROE current 9%Increasing sales 10% become 7.43% ROE and $1,11 EPSIncreasing sales 30% become 8.78% ROE and $1,32 EPSIncreasing sales 50% become 10.13% ROE and $1,52 EPSNumber of shares 1,000,000 + 333,333.33 = 1,333,333.33 shares


Conclusion• Using debt result higher profitability ratio and EPS rather than

using homemade leverage

• It reflects 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 firm to increase it sells to get higher return of profit. The higher the debt the lower the WACC (no 4)

• Suggestion: Expand the business by using leverage


look before you leverage

Documents

equity roe

net income x

sales decrease

sales increases

roe return

percentage of roe

potential of increasing

common equity