LOOK
BEFORE
YOU
LEVERAGE
By
Yohanes Kristiawan Hartono 16668
Yulia Martha 16870
Juventius Willieyanto Rudmel 16933
Caroline Eva Mursito 16945
International Business Management Program
Atma Jaya University
Yogyakarta
Summary
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. 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. Business
went good and sales doubled every 4 years after that. Bob managed to grow the business by
using internal equity and spontaneous financing sources. However, about 5 years ago when
the need of financial support was overwhelming, he decided to take the company to IPO in
OTC market. The company sold 1 million shares at $5 per share. Stock price grown steadily
and traded at book value of $15 per share.
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.
Answers
1. For sure, the company can do thing that they want to do, like investing in maintenance,
machine, stocks, etc. They also can leverage the investment to their assets. But by taking
debt, the company increases the risk of investment. Debt providers are conservative.
They cannot share any upside or profits. Therefore, they want to eliminate all possible
loss or downside risks. They need to be careful about the value of the debt; the debt can
grow beyond the ability to pay due to either external events (income loss) or internal
difficulties (poor management of resources). For addition, debt has little or no impact on
control of the company.
2. Homemade leverage can be explained as:
-
A substitution of risks that investors may undergo in order to move from overpriced
shares in highly levered firms to those in unlevered firms by borrowing in personal
accounts;
-
the situation where individuals borrowing on the exact same terms as large firms can
duplicate corporate leverage through purchasing and financing options;
-
Idea that as long as individuals borrow (or lend) on the same terms as the firm, they
can duplicate the affects 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
-
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.
-
Approach stating that when individuals borrow on the same terms as a firm, they can
get the same affects of corporate leverage on their own.
The shareholder might be able to use homemade leverage to create the same
payoffs by the M&M Proposition I (with taxes).
V =V +T B
L
U C
When the firm paid off its debt to shareholders, then shareholder pays the same amount
of payoffs to the brokers.
3. WACC is the average of the costs of these sources of financing, each of which is weighted
by its respective use in the given situation. By taking a weighted average, we can see
how much interest the company has to pay for every dollar it finances.

Cost of equity =4% + 1.11*(12%-4%)=12.88%

Cost of Equity = Runlevered + (Runlevered - Interest Rate on Debt)*(Debt/Value)*(1-Tax
Rate) = 12.88% + (12.88% - 10%)*(0.333)*(0.6) = 13.45%
So:
WACC = (15,000,000/20,000,000)*(13.45%) + (5,000,000/20,000,000)*(10%)(0.6) =
11.59%
4. If the firm has no debt : 𝑉 𝐸𝐵𝐼𝑇−(1−𝑇𝑐) 1,350,000
𝑈=
= 0,1098 =$12,295,082
𝑅
𝑈
Suppose the company uses 100% debt :
𝑉𝐿 = 𝑉𝑈 + Tc x D
= $12,295,082 + 0.4 x $5,000,000
= $14,295,082
E
= 𝑉𝐿 – D
= $14,295,082 - $12,295,082
= $2,000,000
Based on Modigliani and Miller’s Proposition II with tax, the cost of equity is:
𝑅𝐸 = 𝑅𝑈 + (𝑅𝑈 - 𝑅𝐷 ) x (D/E) x(1 – Tc)
= 0.1098 + (0.1098 – 0.084) x ($14,295,082 / $2,000,000) x 0.6
= (0.1098 + 0.0258) x (7.15 x 0.6)
= 0.1356 x 4.29
= 0.5817
= 58.17%
WACC = ($2,000,000/$14,295,082) x 0.5817 + ($12,295,082 / $14,295,082) x 0.6
= (0.1399 x 0.5817) + (0.86 x 0.6)
= 0.5974
= 59.74%
Debt /
Val
Equity /
V
D/E
Beta
0.01
0.02
0.03
0.04
0.05
0.06
0.07
0.08
0.09
0.1
0.11
0.12
0.13
0.14
0.15
0.16
0.17
0.18
0.19
0.2
0.99
0.98
0.97
0.96
0.95
0.94
0.93
0.92
0.91
0.9
0.89
0.88
0.87
0.86
0.85
0.84
0.83
0.82
0.81
0.8
0.01
0.02
0.03
0.041
0.052
0.063
0.075
0.087
0.098
0.111
0.123
0.136
0.149
0.162
0.176
0.19
0.204
0.219
0.234
0.25
1.117
1.124
1.131
1.138
1.145
1.153
1.16
1.168
1.176
1.184
1.192
1.201
1.21
1.218
1.228
1.237
1.246
1.256
1.266
1.277
Cost Of
12,.88%
12.90%
12.92%
12.93%
12.95%
12.97%
12.99%
13.01%
13.03%
13.05%
13.07%
13.09%
13.12%
13.14%
13.16%
13.18%
13.21%
13.23%
13.26%
13.29%
13.31%
WAC
12.88
12.83
12.78
12.73
12.67
12.62
12.57
12.52
12.47
12.42
12.36
12.31
12.26
12.21
12.16
12.11
12.06
12
11.95
11.9
11.85
Amount
of
0
136257
272515
408773
545031
681288
817546
817546
953804
1090062
1226320
1362578
1498835
1635093
1771351
1907609
2043866
2180124
2316382
2452640
2725155
Value
(unlv)
1362577
1362577
1362577
1362577
1362577
1362577
1362577
1362577
1362577
1362577
1362577
1362577
1362577
1362577
1362577
1362577
1362577
1362577
1362577
1362577
Vlvrd
13625
13680
13734
13789
13843
13898
13952
14007
14061
14116
14170
14225
14279
14334
14443
14497
14552
14606
14661
14715
5. The profitability ratios include: operating profit margin, net profit margin, return on
assets and return on equity.
Profit margin measures how much a company earns relative to its sales. A company with
a higher profit margin than its competitor is more efficient. There are two profit margin
ratios: operating profit margin and net profit margin. Operating profit margin measures
the earnings before interest and taxes, and is calculated as follows:
Operating Profit Margin =
Earnings Before Interest and Taxes
Sales
Net profit margin measures earnings after taxes and is calculated as follows:
Net Profit Margin =
Earnings After Taxes
Sales
While it seems as if these both measure the same attribute, their results can be
dramatically different due to the impact of interest and tax expenses. Similarly, the next
two ratios appear to be similar but they tell different stories. As an investor, you are
interested in getting a return on your investment. So is a corporation.
Return on assets (ROA) tells how well management is performing on all the firm's
resources. However, it does not tell how well they are performing for the stockholders. It
is calculated as follows:
Return on Assets =
Earnings After Taxes
Total Assets
Return on equity (ROE) measures how well management is doing for you, the investor,
because it tells how much earnings they are getting for each of your invested dollars. It
is calculated as follows:
Return on Equity =
Earnings After Taxes
Equity
These ratios are easy to calculate and the information is readily available in a company's
annual report. All you need do is review the income statement and balance sheet to
come up with the data to plug into the formulas.
ROA = EAT / Total Assets = 1,350,000/20,000,000 = 0.0675
ROE = EAT / Equity = 1,350,000/15,000,000 = 0.09
Operating Profit Margin = EBIT / Sales = 2,250,000 / 15,000,000 = 0.15
Net Profit Margin = EAT / Sales = 1,350,000 / 15,000,000 = 0.09
6. I recommend is to prepare financial projections under different scenarios and with
different assumptions while in the other hand also applying the homemade leverage.
The goal is to find the debt/equity mix that provides the highest expected long-term
shareholder value. 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. The
homemade leverage known with some advantages such as reduce the risk of the firm
from being bankruptcy and allow an individual using leverage to borrow such as a large
corporation does.
7. One of the most important issues that need to be concerned about increasing the
leverage is the amount of money that will be borrowed.
Thus, the issues can be concluded as :
-
The term of the leverage, whether it is a long term or a short term
-
The ability to fulfill the payment
-
The amount of money that is borrowed
-
The value of interest
8. Companies with high debt/asset ratios are said to be "highly leveraged," not highly liquid
as stated above. A Company with a high debt ratio (highly leveraged) could be in danger
if creditors start to demand repayment of debt. 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. It is 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. Firm can deduct interest payments. Leverage also lowers the
tax payments since the debt decreases. Lamb could explain that as the level of gearing
increases by replacing equity with cheap debt, the level of the WACC drops. The lower
WACC makes it easier for the company to pay off the remaining debt.