Loo ook k Be Befo fore re You Leverage Debt Versus Equity Financing
Mohamad Farid Zaini
Background •
Bob as CEO od Symonds Electronics Electronics had embark upon an expansion project
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The expansion had the potential of increasing sales about 30% per year over the next 5 years
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Bob needs additional fund for the project that had been estimated at $ 5,000,000.
Why Expand? •
By using $3,000,000 of his own saving and a 5 years bank note worth $2,000,000, Bob could manage to get the company up and running
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The economy was booming and thriving stock market
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Successful IPO, from $5 per share (5 years ago) to $15 per share (current)
The Issues •
After presenting the expansion proposal at the board meeting, the directors were equally divided in their opinion of which financing route should be chosen
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First option: long-term fixed-rate debt
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Second option: issue common stock
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Feeling rather frustated and confused, Bob, decided to call upon his CFO, Andrew Lambs, to resolve this dilemma
Question 1 If Symonds Electronics Inc. were to raise all the required capital by issuing debt, what would the impact be on the firm’s shareholders?
Answer 1 Using Debt
• • • • • •
Sales $15,000,000 EBIT $ 2,250,000 Net Income $ 1,350,000 Equity $15,000,000 ROE = Net Income x 100% Equity ROE = $1,350,000 x 100% $15,000,000
• ROE = 9%
Simulation 1
Simulation 2
Simulation 3
Sales Increase 10%
Sales Increase 30%
Sales Increase 50%
• Sales • • • •
• •
= $15,000,000 x 110% = $16,500,000 EBIT = $2,250,000 x 110% = $2,475,000 Debt Interest = $5,000,000 x 10% = $500,000 EBT = $2,475,000 - $500,000 = $1,975,000 Net Income = (EBT - 40% Taxes) = $1,975,000 - $790,000 = $1,185,000 Equity = $15,000,000 ROE = 7.9%
• Sales • • • •
•
= $15,000,000 x 130% = $19,500,000 EBIT = $2,250,000 x 130% = $2,925,000 Debt Interest = $5,000,000 x 10% = $500,000 EBT = $2,925,000 - $500,000 = $2,425,000 Net Income = (EBT - 40% Taxes) = $2,425,000 - $970,000 = $1,455,000 Equity = $15,000,000
• ROE = 9.7%
• Sales • • • •
•
= $15,000,000 x 150% = $22,500,000 EBIT = $2,250,000 x 150% = $3,375,000 Debt Interest = $5,000,000 x 10% = $500,000 EBT = $3,375,000 - $500,000 = $2,875,000 Net Income = (EBT - 40% Taxes) = $2,875,000 - $1,150,000 = $1,725,000 Equity = $15,000,000
• ROE = 11,5%
Answer 1 •
The impact on the firm’s shareholders can be seen in ROE (Return on Common Equity)
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The percentage of ROE decreases when the sales decrease 10% with net income $1,185,000
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But when the sales increases 30% and 50%, the ROE is increasing as well up to 9.7% and 11.5%
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The shareholders will get higher return when the sales increase 30% and up
Question 2 What does “homemade leverage” mean? Using the data in the case, explain how a shareholder might be able to use homemade leverage to create the same payoffs as achieved by the firm
Answer 2 •
Homemade leverage is investors’ method of substituting their own borrowing or lending for corporate borrowing
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Investor 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 the corporate borrowing
Answer 2 Using Homemade Leverage
• • • • • • •
Sales $15,000,000 EBIT $ 2,250,000 Taxes $900,000 Net Income $ 1,350,000 Equity $15,000,000 ROE = Net Income x 100% Equity ROE = $1,350,000 x 100% $15,000,000
Simulation 1
Simulation 2
Simulation 3
Sales Increase 10%
Sales Increase 30%
Sales Increase 50%
• Sales • • • •
• ROE = 9%
•
• •
= $15,000,000 x 110% = $16,500,000 EBIT = $2,250,000 x 110% = $2,475,000 Debt Interest = $0 EBT = $2,475,000 Taxes = $2,475,000 x 40% = $990,000 Net Income = (EBT - 40% Taxes) = $2,475,000 - $990,000 = $1,480,000 Equity =$15,000,000 + $5,000,000 = $20,000,000 ROE = 7.43%
• Sales • • • • •
• •
= $15,000,000 x 130% = $19,500,000 EBIT = $2,250,000 x 130% = $2,925,000 Debt Interest = $0 EBT = $2,925,000 Taxes = $2,925,000 x 40% = $1,170,000 Net Income = (EBT - 40% Taxes) = $2,925,000 - $1,170,000 = $1,755,000 Equity =$15,000,000 + $5,000,000 = $20,000,000 ROE = 8.78%
• Sales • • • • •
• •
= $15,000,000 x 150% = $22,500,000 EBIT = $2,250,000 x 150% = $3,375,000 Debt Interest = $0 EBT = $3,375,000 Taxes = $3,375,000 x 40% = $1,350,000 Net Income = (EBT - 40% Taxes) = $3,375,000 - $1,350,000 = $2,025,000 Equity =$15,000,000 + $5,000,000 = $20,000,000 ROE = 10.13%
Answer 2 •
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 50% $1,725,000/1,000,000 = $1,725
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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 = $1,52 Shares outstanding = 1,000,000 + ($5,000,000/$15) = 1,333,333.33 shares
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By using homemade leverage, the calculation above shows that the ROE and EPS is getting higher.
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By the increasing stock sold $5,000,000 it creates the same payoffs as achieved by the firm
Question 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?
Answer 3 •
Given data: Beta = 1.1 rf = 4% rm = 12%
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Weighted Average Cost of Capital (WACC) = [(1 - t) Rdebt (D/(D+E))] + Requity (E/(D+E))
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Requity (no debt) = rf + Beta (rm - rf) = 4% + 1.1 (12% - 4%) = 12.8%
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WACC current = [(1 - 40%) 0 (0/(0 + $15,000,000))] + 12.8% ($15,000,000/(0+$15,000,000)) = 0 + 12.8% =12.8%
Answer 3 •
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%
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WACC with debt = [(1 - t) Rdebt (D/D+E))] + Requity (E/D+E)) = [(1 - 40%) 10% ($5,000,000/($5,000,000 + $15,000,000))] + 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%
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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
Question 4 The firm’s 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
Answer 4 D :E
E :V
D :E
Beta
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
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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.
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There is a particular capital structure that maximizes the value of the firm, when a leveraged firm increases in proportion to D : E, expressed in market values is getting higher.
Question 5
How would the key profitability ratios of the firm be affected if the firm were to raise all of the capital by issuing 5-year notes?
Answer 5 Current
10%
30%
50%
Analysis
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%
Bad
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%
Good
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%
Good
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%
Good
So, it is good for the company if it issues 5-year notes
Question 6
If you were Andrew Lamb, what would you recommend to the board and why?
Answer 6 •
Recommend the firm to issues 5-year notes to the bank
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The result of profitability ratios is good especially in ROE that measures the rate of return of common stockholders’ investment.
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WACC also showed that there were a lower WACC which was good when the firm using debt
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EPS was also higher as well means that the earning of selling shares is getting higher.
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The increasing sales have to be above 30%
Question 7 What are some issues to be concerned about when increasing leverage?
Answer 7 •
Profit - One of the company’s powers to run the business - We have to know whether our profit is enough to pay the debt and its interest
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Interest rate When we are increasing leverage, we must consider about its interest rate. Whether it is high or not.
Question 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
Answer 8 •
It is unfair
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No matter how much the amount of debt, if the profit is increasing significantly, the stock price will increase as well
Question 9 Using suitable diagrams and the data in the case, explain how Andrew Lamb could enlighten the board members about Modigliani and Miller’s Propositions I and II (with corporate taxes)
Answer 9 •
MM’s proposition I Value 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
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MM’s proposition II The required rate of return on equity as the firms the firms’ deincrease by equity ratio increases. It states that the expected rate of return on the common stock of a levered firm increases in proportionto debt equity ratio (D/E), expressed in market values.
Conclusion •
Using debt: ROE current 9% Increasing sales 10% become 7.9% ROE & $1,185 EPS Increasing sales 30% become 9.7% ROE & $1,455 EPS Increasing sales 50% become 11.5% ROE & $1,725 EPS Number of shares 1,000,000
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Using homemade leverage (no debt): ROE current 9% Increasing sales 10% become 7.43% ROE and $1,11 EPS Increasing sales 30% become 8.78% ROE and $1,32 EPS Increasing sales 50% become 10.13% ROE and $1,52 EPS Number of shares 1,000,000 + 333,333.33 = 1,333,333.33 shares
Conclusion •
Using debt result higher profitability ratio and EPS rather than using homemade leverage
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It reflects that the company condition is good in term on returning on common stockholders investment (ROE)
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The earning 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%.
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Suggestion: Expand the business by using leverage
High risk high return It is the responsibity for the firm to increase it sells to get higher return of profit. The higher the debt the lower the WACC (no 4)
