Summary of the case

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 years bank 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 share 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 the impact 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
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%) = $ 19,500,000
EBIT $ 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 shareholder 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
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
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= $ 1,52
Shares 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.

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 the capital 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?
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 rate. When 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 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.
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
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 term 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 sells to 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.