Look Before You Leverage Symonds

8/2/2019 Look Before You Leverage Symonds

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the story so far is about Bob and his whole problem which is Symonds electronic, had

embark upon an expansion project, which had the potential of increasing sales about 30% per

year over the next 5 years. He needs additional fund for the project that had been estimated at $

5,000,000.

He wants to expand his company because at the beginning of the company he could

manage to get the company up and running by using $3,000,000 of his own saving and a 5 yearsbank note worth $2,000,000 with 14% per year rate of interest by the bank. In the end he can pay

off the loan 1 year earlier from its 5 years term. As sales began to escalate with the booming

economy and thriving stock market, the firm had needed additional capital. And then he decided

to take the company public via Initial Public Offering (IPO). The company sold $1,000,000 shares

at $5 per share. The stock price had grown steadily overtime and was currently trading at its book

value of $15 per share.

When the expansion proposal was presented at the board meeting, the directors were

unanimous about the decision to accept the proposal. 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. Unfortunately, the directors were equally divided in their opinion of

which financing route should be chosen. Some of the directors felt that the tax shelter offered by

debt would help reduce the firms overall cost of capital and prevent the firms earnings per sh are

from being diluted. While some others felt that equity was the way to go since the future looked

rather uncertain and being rather conservative, they were not interested in burdening the firm with

interest charges. Besides, they felt that the firm should take advantage of the booming stock

market. Feeling rather frustrated and confused, Bob, decided to call upon his chief financial

officer, Andrew Lamb, to resolve this dilemma.

Question and answer

1.If Symonds Electronic Inc. were to raise all of the required capital by issuing debt, what would theimpact be on the firms shareholders?

Using debt

Current:

Sales $ 15,000,000

EBIT $ 2,250,000

Net Income $ 1,350,000

Equity $ 15,000,000

ROE = net income/equity*100%

= $ 1,350,000/ $ 15,000,000*100%

= 9%

Sales increase 10%

Sales $ 15,000,000 + ($15,000,000 * 10%) = $ 16,500,000

EBIT $ 2,250,000 + ($ 2,250,000*10%) = $ 2,475,000

Debt interest $ 5,000,000*10% = $ 500,000

EBT $ 2,475,000 - $ 500,000 = $ 1,975,000

Net Income (EBT Taxes 40%)

$ 1,975,000 (($ 1,975,000*40%) = $ 1,185,000


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Equity = $ 15,000,000


= $ 1,185,000/ $ 15,000,000*100%

= 7.9%

Sales increase 30%

Sales $ 15,000,000 + ($15,000,000 *30%) = $ 19,500,000EBIT $ 2,250,000 + ($ 2,250,000*30%) = $ 2,925,000

Debt interest $ 5,000,000*10% = $ 500,000

EBT $ 2,925,000 - $ 500,000 = $ 2,425,000


$ 2,425,000 (($ 2,425,000*40%) = $ 1,455,000

Equity = $ 15,000,000


= $ 1,455,000/ $ 15,000,000*100%

= 9.7%

Sales increase 50%

Sales $ 15,000,000 + ($15,000,000 *50%) = $ 22,500,000

EBIT $ 2,250,000 + ($ 2,250,000*50%) = $ 3,375,000

Debt interest $ 5,000,000*10% = $ 500,000

EBT $ 3,375,000 - $ 500,000 = $ 2,875,000


$ 2,875,000 (($ 2,875,000*50%) = $ 1,725,000

Equity = $ 15,000,000


= $ 1,725,000/ $ 15,000,000*100%

= 11.5%

Comparing ROE

Current 9%

Increasing sales 10%= 7.9%



If Symonds Electronic Inc. were to raise all of the required capital by issuing debt, the impact on

the firms 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 increase

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 50%.

2.What does homemade leverage mean? Using the data in the case explain how a sha reholder might be

able to use homemade leverage to create the same payoffs as achieved by the firm.Homemade leverage is investors' method of substituting their own borrowing or lending for

corporate borrowing. Investors 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 add to the corporate borrowing.

Using homemade leverage

Current case:

Sales $ 15,000,000


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EBIT $ 2,250,000

Taxes $ 900,000

Net income $ 1,350,000

Equity $ 15,000,000

ROE = net income/ equity*100%

= $ 1,350,000/ $ 15,000,000*100%= 9%

Sales increase 10%

Sales $ 15,000,000 + ($15,000,000 *10%) = $ 16,500,000

EBIT $ 2,250,000 + ($ 2,250,000*10%) = $ 2,475,000

Debt interest = $ 0

EBT = $ 2,475,000

Taxes $ 2,475,000*40% = $ 990,000

Net income $ 2,475,000 - $ 990,000 = $ 1,480,000

Equity $ 15,000,000 + $ 5,000,000 = $ 20,000,000


= $ 1,485,000/ $ 20,000,000*100%

= 7.43%

Sales increase 30%

Sales $ 15,000,000 + ($15,000,000 *30%) = $ 19,500,000

EBIT $ 2,250,000 + ($ 2,250,000*30%) = $ 2,925,000

Debt interest = $ 0

EBT = $ 2,925,000

Taxes $ 2,925,000*40% = $ 1,170,000

Net income $ 2,925,000 - $ 1,170,000 = $ 1,755,000

Equity $ 15,000,000 + $ 5,000,000 = $ 20,000,000


= $ 1,755,000/ $ 20,000,000*100%

= 8.78%

Sales increase 50%

Sales $ 15,000,000 + ($15,000,000 *50%) = $ 22,500,000

EBIT $ 2,250,000 + ($ 2,250,000*50%) = $ 3,375,000

Debt interest = $ 0

EBT = $ 3,375,000

Taxes $ 3,375,000*40% = $ 1,350,000

Net income $ 3,375,000 - $ 1,350,000 = $ 2,025,000

Equity $ 15,000,000 + $ 5,000,000 = $ 20,000,000

ROE = net income/ equity*100%= $ 2,025,000/ $ 20,000,000*100%

= 10.13%

We can consider it by comparing its EPS.

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


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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.

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?

Given data:

= 1.1

rf = 4%

rm = 12%

WACC = [(1 - t) Rdebt (D /( D + E ))] + Requity (E/(D+E))

Requity ( no debt) = rf + (rm rf)

= 4% + 1.1 (12% - 4%)

= 12.8%

WACC current

= [(140%) 0 (0/( 0 + $ 15,000,000 ))] + 12.8% ($ 15,000,000/(0+$ 15,000,000))

= 0 + 12.8%

= 12.8%

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 + E$ 20,000,000))] + 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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4.The firms 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.

D : E E : V D : E 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

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 levered firm increases in

proportion to D : E, expressed in market values is getting higher.

5.How would the key profitability ratios of the firm be affected if the firm were to raise all of thecapital by issuing 5-year notes?

Current 10% 30% 50%

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%

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%

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%

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%

Based on profitability ratio

P/M : bad

BEP : good

ROA : good

ROE : good

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

6.If you were Andrew Lamb, what would you recommend to the board and why?If I were Andrew Lamb I would recommend the firm to issues 5-year notes to the bank because

based on the calculation of profitability ratios the result is good especially in ROE that measures

the rate of return of common stockholders investment. Beside that I also considered about WACC

and EPS, it showed that there were a lower WACC which was good when the firm using debt, and

there was a higher EPS as well means that the earning of selling shares is getting higher. Notes

that, the increasing sales have to be above 30%.

7.What are some issues to be concerned about when increasing leverage?


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Some issues to be concerned about when increasing leverage:

Profit

Profit is one of the companys powers to run the business. We need to be concerned about

the profit because 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.

8.Is 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.

It is unfair to assume that profitability is positively affected due to the higher debt ratio

because to calculate profitability ratio that consist of P/M, BEP, ROA, and ROE. No matter how

much the amount of debt if the profit is increasing significantly the stock price will increase as

well.

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)

MMs proposition IValue 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.

MMs proposition II

The required rate of return on equity as the firms deincrease bt equity ratio increases. It states

that the expected rate of return on the common stock of a levered firm increases in proportion

to debt equity ratio (D/E), expressed in market value.

Conclusion:

Consider of the calculation above we can see that:Using debt:

ROE current 9%

Increasing sales 10% 7.9%



EPS Increasing sales 10% $ 1,185

Increasing sales 30% $ 1,455


Number of shares 1,000,000

Using homemade leverage (no debt)

ROE current 9%




EPS Increasing sales 10% $ 1,11




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Number of shares 1,000,000 + 333,333.33 = 1,333,333.33 shares

The higher profitability ratio using debt reflects that the companys condition is good in the te rm

on returning on common stockholders investment. And the EPS is higher than using homemade

leverage means that the earnings 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%. But the principle is the

higher the risk, the higher the return. Therefore it is the responsibility f the firm to increase it sellsto get higher return or profit. It is supported by the calculation of WACC that shown in number 4,

that the higher the debt the lower the WACC. It is good for the company. If I were Andrew Lamb I

will suggest to the Symonds Electronic Inc. to expand its business by using leverage.

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Look Before You Leverage Symonds