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.