Case 1 Look Before You Leverage The People 1. Bob Symonds, the Chief Executive Officer of Symonds Electronics, established his company 10 years ago in his hometown of Cincinnati, Ohio. 2. Andrew Lamb, had joined the company about two years ago. He held an MBA from a prestigious university and had completed his Chartered Financial Analysts’ certification. Summary of the Case Bob’s company, Symonds Electronics, had embarked upon an expansion project, which had the potential of increasing sales by about 30% per year over the next 5 years. The additional capital needed is $5,000,000. The main discussion in this case is that whether he should burden the firm with fixed rate debt or issue common stock to raise the needed funds. When the expansion proposal was presented at the board meeting, the directors were unanimous about the decision to accept the proposal. Based on the estimation provided by the marketing department, the project had the potential of increasing revenues by between 10% (Worst Case) and 50% (Best Case) per year. Thus, Bob and his colleagues were hard pressed to make a decision as to whether long-term debt or equity should be the chosen method of financing this time around. Being unclear on what decision to make, Bob put the question to a vote by the directors. Some of the directors felt that the tax shelter offered by debt would help reduce the firm’s overall cost of capital and prevent the firm’s earning per share from being diluted. Other said that it would be better for the firm to let investors leverage (control) their investment themselves. The firm should take advantage of the booming stock market. Feeling frustrated, Bob, called his chief financial officer, Andrew Lamb, to resolve this dilemma. Andrew knew that he was in for a challenging task. He felt that this was good opportunity to prove his worth to the company. He then made a presentation titled,” Look Before You Leverage!”, which was based on the latest income statement and balance sheet of the firm. Answer of the Question: 1. The impact would be on the firm’s shareholders if Symonds Electronics Inc. were to raise all the required capital by issuing debt is the change in the investor’s investment to the company directly. The sale of the share may in good number and position in the market, and the investors hope to get valuable and big benefit of that, but id the dividend given is not as the investor expected, it can effect the amount of money will be invested because any investor invest their money to get profit as high as the company gave as the dividend. So if the company gives low dividend in order they pay the debt first, it might less the interest of the investor. Both investors are actual or “future” investor. 2. Homemade leverage is the idea that as long as individuals borrow (or lend) on the same terms as the firm, they can duplicate the effects of corporate leverage on their own. Thus, if levered firms are priced too high, rational investors will simply borrow on personal accounts to buy shares in unlevered firms. The shareholder might be able to use homemade leverage to create the same payoffs as achieved by the firm with the M&M Proposition I (with taxes). VL = VU + TC B Proposition I holds because shareholders can achieve any pattern of payouts they desire with homemade leverage. 3. The effect of the change in the debt to equity ratio have on the weighted average cost of capital and the cost of equity capital of the firm it will be affect of the cost of debt. It can be decrease or increase based on the change. The traditional view of WACC (Weighted Average Cost of Capital) assumes that: a) As the level of debt financing increases the cost of debt remains unchanged up to a certain level of gearing. Beyond this level, the cost of debt will increase b) The cost of equity rises as the level of gearing increases c) The weighted average of cost does not remain constant, but rather falls initially as of the proportional of debt capital increases, and then begins to increase as the rising cost of equity (and possibly of debt0 becomes more significant. d) The optimal level of gearing is where the company’s WACC is minimized. 4. The capital structure that will maximize the value of the firm are some component in the firm that fixed and sometime, stock price also change if there are some change in the company itself like the change of CEO or anything. So there are many possibilities that the value of the firm can change. 5. The key of probability ratios of the firm be affected if the firms were to raise all of the capital by issuing 5-year notes because the method and financing time around that chosen is correct when the condition of the 5 years economics will be fine. In case that not will be any inflation. Control the leverage of the investor will become easier if they have already invest some money in fix time, like the 5 years period. 6. If I were Andrew Lamb, I recommend is to prepare financial projections under different scenarios and with different assumptions. The goal is to find the debt/equity mix that provides the highest expected long-term shareholder value. If the after-tax cost of debt is lower than the company’s Net Return On Assets Symonds Electronics Inc. should take on as much debt as it can. This concept is known as leverage. If net profit margins are higher than net interest rates Symonds Electronics Inc. can maximize your Return On Equity by minimizing equity and maximizing debt. If not, do the exact opposite. If Symonds Electronics Inc. cannot afford to pay debt then it will have to minimize debt and finance through equity. 7. Some issues to be concerned about when increasing the leverage are the amount of money that will be borrowed. When a company borrows constantly, they are creating an image that they might be of high risk. As a result there might be an increase in interest rates and some restrictions could be given to the borrowing organization. The higher the debt ratio, the riskier Symonds Electronics Inc will be, hence the higher its cost of both debt and equity. Another issue is the value of the stock. It could drop substantially if the stockholders become concerned. If Symonds Electronics Inc falls on hard times and operating income is not sufficient to cover interest charges, its stockholders will have to make up the shortfall, and if they cannot, bankruptcy will result. The more debt in the capital structure of the firm, the greater the financial risk to the lender. This results in higher average interest rates to be paid and restrictions on the corporation. Common stockholders may become concerned and drive down the price of t he stock. 8. The profitability that can see from the short run period (less than 1 year) can be affect the stock price. But remember, the company will have their business not only for 1 year but also for many years in the future. If the company have good record in the first year in order to attract the investor, and if there are something unpredictable in the future and make the investor run away, it will be worse. So by own group opinion, better if the company had fixed the debt every year annually and the other will be variable and keep the investor focus in their stock of the company. 9. Investments into companies usually require both debt and equity. The optimal ratio needs to be carefully determined for each individual situation. It is unlikely that this ratio will consist of 100% equity. If the long-term prospects are so poor that a company can never make sufficient profits to benefit from leverage then the opportunity is probably not worth pursuing. Conversely, relying on 100% debt financing often places a heavy cash drain on companies and leads to sub-optimal growth. The Conclusion Equity finance is provided by the sale of ordinary shares to investors. This may be a sale of shares to new owners, perhaps through the stock market as part of a company seeking a quotation, or it may be a sale of shares to existing shareholders, for example by means of a rights issue. Ordinary shares are bought and sold on a regular basis on stock exchanges all over the world. By law, the ordinary shares of a company must have a nominal, or par value and cannot be issued for less than this amount. The nominal value of a share bears no relation to its market value. New shares, whether issued at the foundation of a company or subsequently, are almost always issued at a premium above their nominal value. And if the company decides to have a debt, the main advantage of borrowing is that debt has a cheaper direct cost than equity. There are two distinct reasons for this: • debt is less risky to the investor than equity (low risk results in a low required return) and • interest payments are allowable against corporate taxation, whereas dividends are not. So by managing the debt and pay for the dividend in interest number and also pay for the debt balance will make the company attract as many as investors to invest the money. By: angeline89
