Solution to Case 19

Debt Versus Equity Financing

Look Before You Leverage

1.

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

what would the impact be on the firm's shareholders?

The impact on shareholders can be analyzed by calculating the EPS and ROE of the firm
under the alternative scenarios as follows:

All Debt

With $5,000,000 Expansion

Current Worst Case Ex~ected Case

Growth in Revenues
10%
Revenues
15,000,000 16,500,000
EBIT
2,250,000
2,475,000
Interest
500,000
0
EBT
2,250,000
1,975,000
EBT*(l-T)
1,350,000
1,185,000
# of shares
1,000,000
1,000,000

EPS

1.35
0

1.185

Debt
Equity
Debt/Equity Ratio

15,000,000
0.00%

5,000,000
15,000,000
33.33%

Return on Equity

9.00%

7.90%

Best Case

30%
50%
19,500,000
22,500,000
2,925,000
3,375,000
500,000
500,000
2,425,000
2,875,000
1,455,000
1,725,000
1,000,000
1,000,000

1.455
5,000,000
15,000,000
33.33%

9.70%

1.725
5,000,000
15,000,000
33.33%

11.50%

The calculations show that if Symonds Electronics Inc. were to raise all of the required
capital by issuing debt, its EPS would vary between $1.19 and $1.73 per share witb the

expected EPS being about $0.11 higher than the current EPS of $1.35. Likewise, the
firm's ROE could vary between 7.9% and 11.5%, with the most likely ROE being 9.7%.

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.
Homemade leverage refers to the use of personal borrowing by an investor to change the
overall amount of financial leverage to which he or she is exposed.
Let's say an investor owns 200 shares of Symonds Electronics at tbe current price of $15
per share ($3000). Now, if the firm finances its expansion with $5,000,000 worth of debt,
its EPS will vary between $1.18, $1.46, and $1 .73 under tbe alternative scenarios (see
Table in Answer 1 above). On the other hand, if the company was to finance its
expansion with all equity, its EPS would vary between, $1.11,
$1.32, and $1.52,
respectively as shown in the table below:

No Debt
Current
Growth in Revenues
Revenues

EBIT
Interest
EBT
EBT*(l-T)
# of shares
EPS
Debt
Equity
Debt/Equity Ratio
Return on Equity

With $5,000,000 Expansion

Worst Case Ex~ected Case
Best Case
10%

15,000,000

30%

50%

16500000

19500000

22500000

2,250,000
2475000
0
0
2,250,000
2,475,000
1,350,000
1,485,000
1,000,000 1333333.333
1.35
1.11375

2925000

3375000

0
15,000,000

0
20,000,000

2,925,000
1,755,000

3,375,000
2,025,000

1333333.333

1333333.333

1.31625

1.51875

20,000,000

9.00%

7.43%

8.78%

20,000,000
0
10.13%

Now, rather than the company borrowing the money to finance the expansion, it can be
shown that similar EPS could be realized by investors themselves via personal
borrowing. The amount to be borrowed is based on the proposed debt-equity ratio, i.e.
33.33%. Thus if the investor borrows $1,000 at 10% per year and buys stock, his personal
debt-equity ratio will be $1000/$3000 or 33.33%. The investor's EPS before and after
homemade leverage are as follows:

Under proposed capital structure of $5,000,000 debt

Worst Case
EPS

Expected Case

Best Case

$1.185

$1.455

$1.725

$237

$291

$345

Earnings for 200 shares

Net Cost= 200 shares X $15 =$3,000

Under Original Capitalstructure and Homemade Leverage:

$1.11
$297

EPS
Earnings for 266.67 shares
Less After-tax interest on $1000 at
10%(1-.4) or 6%

$60

Net earnings

$237

$1.32
$351

$1.52
$405.

$60

$60

$291

$345

** It

is assumed that the investor is in the 40% tax bracket and can write off the interest
on the debt , for example by using a home equity line of credit.
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?
WACC = (E/V) X (RE)+ (DN) X RD X (1-Tc) =Weighted Average Cost of Capital
RE =Ru+ (Ru-RD) X (D/E) X (1-Tc) = Cost of Equity
Since the firm currently has no debt, its WACC would be the same as its cost of equity
or the cost of an unlevered firm. Based upon the information given in question 4 below,
the firm's cost of equity (RE)= Risk-free rate+ Beta (Market Rate- Risk-free rate)
(RE)= 4% + 1.11 *(12% - 4%) = 12.88%
If the firm takes on debt, its debt-equity ratio will increase, causing its WACC to fall (in

the absence of bankruptcy costs) and its cost of equity to rise.

For example, if the firm borrows $5,000,000 at 10% per year, its DIE ratio will be
33.33%
Its Cost of Equity (RE)= 12.88% + (12.88%-10%) X (.333)(.6) = 13.45%
It weighted average cost of capital (WACC) will be as follows:
WACC = ($15,000,000/$20,000,000)*(13.45%)
3

+ (5,000,000/20,000,000)* 10%* .6

4.

11.59%

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.

DebWalue
0
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
0.21
0.22
0.23
0.24
0.25
0.26
0.27

EquityNalue
1
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
0.79
0.78
0.77
0.76
0.75
0.74
0.73

D/E
0
0.010
0.020
0.031
0.042
0.053
0.064
0.075
0.087
0.099
0.111
0.124
0.136
0.149
0.163
0.176
0.190
0.205
0.220
0.235
0.250
0.266
0.282
0.299
0.316
0.333
0.351
0.370

WACC

Re
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%
13.34%
13.37%
13.40%
13.43%
13.46%
13.49%
13.52%

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%
12.00%
11.95%
11.90%
11.85%
11.80%
11.75%
11.70%
11.64%
11.59%
11.54%
11.49%

Debt
0
136257.8
272515.5
408773.3
545031.1
681288.8
817546.6
953804.3
1090062
1226320
1362578
1498835
1635093
1771351
1907609
2043866
2180124
2316382
2452640
2588898
2725155
2861413
2997671
3133929
3270186
3406444
3542702
3678960

Vu

Vl

13625776
13625776
13625776
13625776
13625776
13625776
13625776
13625776
13625776
13625776
13625776
13625776
13625776
13625776
13625776
13625776
13625776
13625776
13625776
13625776
13625776
13625776
13625776
13625776
13625776
13625776
13625776
13625776

13625776
13680280
13734783
13789286
13843789
13898292
13952795
14007298
14061801
14116304
14170807
14225311
14279814
14334317
14388820
14443323
14497826
14552329
14606832
14661335
14715839
14770342
14824845
14879348
14933851
14988354
15042857
15097360

The partial data table above shows that as the debt-equity ratio increases the WACC of
the firm decreases and approaches the after-tax cost of debt.

M&M Proposition

I with Taxes

18000000
16000000

12000000
10000000
8000000
6000000
4000000
2000000
0+--~~~~~~~~~~~~~~~~~~~~~~--<
0
2000000
4000000
6000000
8000000
10000000
12000000
14000000
16000000
Oebt

As shown in the graph above, with 100% debt the firm's value will be maximized. Of
course, no firm can legally operate with 100% debt.

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?
If the firm were to raise all of the $5,000,000 by issuing 5-year notes the key profitability
ratios would be as follows:

All Debt

With $5,000,000 Expansion

Current
Worst Case
Exl!ected Case
Best Case
Growth in Revenues
10%
30%
50%
Revenues
15,000,000
16,500,000
19,500,000
22,500,000
EBIT

Debt/Equity Ratio
Net Profit Margin
Return on Equity
Return on Assets

6.

0.00%
9.00%
9.00%
6.75%

33.33%
7.18%
7.90%
4.74%

33.33%
7.46%
9.70%
5.82%

33.33%
7.67%
11.50%
6.90%

If you were Andrew Lamb, what would you recommend to the board and why?
I would recommend that the firm issue debt in order to raise the $5,000,000 for the
expansion, since the firm currently has no debt and is not in any immediate risk of
bankruptcy. The expected EBlT is good and the firm's value will increase with the
inclusion of debt in the capital structure, due to the lower after-tax cost of debt.

7.

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

Some of the issues to be concerned about when increasing leverage are: taxes and
financial distress costs. The main advantage of issuing debt is the interest tax-shield.
Unless the firm is capable of earning sufficient profits to utilize the tax-shields it
should not increase its debt ratio. Higher debt ratios can cause firms to experience
financial distress during periods of low profitability. Firms with a greater risk of
experiencing financial distress i.e. those whose profits vary considerably, should borrow
less than firms with more stable revenues and profits.

8.

ls it fair to assume that if profitability is positively effected in the short run, due to
the higher debt ratio, the stock price would increase? Explain.
Stock prices depend on a number of factors including EPS, and risk. lf the firm's
profitability is positively effected in the short run and analysts and investors don't expect
an increase in risk, the firm's stock price would increase. However, if the market expects
the firm's risk level to increase, the Price-Earnings ratio will decrease and the stock price
could fall as well.

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).
Under M&M Proposition I with taxes: The value of the levered firm (VL) is equal to the
value of the unlevered firm (Vu) plus the present value of the interest tax shield:

Where Tc is the corporate tax rate and D is the amount of debt.

Vu= EBIT {l-Tc)

Ru
Under Proposition II with taxes: The cost of equity (RE), is:
RE =Ru+(Ru-Rv)X(D/E)X(l-Tc)

Under the Most likely scenario,

Vu= $1,755,000/0.1288 = $13,625,776.4 (click here for spreadsheet calculation)
As the amount of debt increases the value of the firm would also increase and the
firm's value at 99% debt would be $19,021,584.
The weighted average cost of capital (WACC) decreases from 12.88% to 7.78% and the
cost of equity (RE) increases from 12.88% to 183.95% as the firm relies more heavily on
debt financing.
WACC = (E/V) X (RE)+ (DN) X Rv X (1-Tc)
M&M Proposition I with Taxes
20000000
18000000

16000000
14000000

10000000

8000000
6000000
4000000
2000000
0

2000000

4000000

6000000

8000000
Debt

10000000

12000000

14000000

16000000

The Cost of Equity and the WACC: M&M

Proposition II with taxes

"-'

16.00%
14.00%
12.00%
10.00%
8.00%
6.00%
4.00%
2.00%
0.00%

FREI
~

0.1
0

0.2

0.3

0.4

Debt-Equity Ratio

0.5

0.6