Look Before You Leverage Symonds
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Transcript of Look Before You Leverage Symonds
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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
ROE = net income/equity*100%
= $ 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
Net Income (EBT Taxes 40%)
$ 2,425,000 (($ 2,425,000*40%) = $ 1,455,000
Equity = $ 15,000,000
ROE = net income/equity*100%
= $ 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
Net Income (EBT Taxes 40%)
$ 2,875,000 (($ 2,875,000*50%) = $ 1,725,000
Equity = $ 15,000,000
ROE = net income/equity*100%
= $ 1,725,000/ $ 15,000,000*100%
= 11.5%
Comparing ROE
Current 9%
Increasing sales 10%= 7.9%
Increasing sales 30%= 9.7%
Increasing sales 50%= 11.5%
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
ROE = net income/ equity*100%
= $ 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
ROE = net income/ equity*100%
= $ 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%
Increasing sales 30% 9.7%
Increasing sales 50% 11.5%
EPS Increasing sales 10% $ 1,185
Increasing sales 30% $ 1,455
Increasing sales 50% $ 1,725
Number of shares 1,000,000
Using homemade leverage (no debt)
ROE current 9%
Increasing sales 10% 7.43%
Increasing sales 30% 8.78%
Increasing sales 50% 10.13%
EPS Increasing sales 10% $ 1,11
Increasing sales 30% $ 1,32
Increasing sales 50% $ 1,52
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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.