CASE STUDY:

LOOK BEFORE YOU LEVERAGE

Submitted to:
Mr. Johnel Fil T. Arcipe

Submitted by:
Constantino, Welshfyn
Dela Raya, Franz Ghynelle
Gaturian, Helery Joy
Orolfo, Dipsy
Villa, Mejoy
Yap, Lynnel

April 7, 2021
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?

Calculating the firm's EPS and ROE under different conditions may be used to determine the
effect on shareholders.
Formula:
Earnings per share (EPS) Return on Common Equity (ROE)

Net Income Net Income

Common SharesOutstanding Common Equity

CURRENT SALES INCREASE SALE INCREASE SALE INCREASE

10% 30% 50%
Sales $15,000,000 $15,000,000 x 110% $15,000,000 x 130% $15,000,000 x 150%
=$16,500,000 =$19,500,000 =$22,500,000
EBIT $2,250,000 2,250,000 x 110% $2,250,000 x 130% $2,250,000 x 150%
= 2,475,000 = 2,925,000 = 3,375,000
Interest 0 $5,000,000 x 10% $5,000,000 x 10% $5,000,000 x 10%
= $500,000 = $500,000 = $500,000
EBT $2,250,000 $2,475,000 - $500,000 $2,925,000 - $500,000 $3,375,000 - $500,000
=$1,975,000 =$2,425,000 =$2,875,000
Net $1,350,000 $1,975,000 – $790,000 $2,425,000 – $970,000 $2,875,000-1,150,000
Income =$1,185,000 =$1,455,000 =1,725,000
# of Shares 1,000,000 - - -
EPS 1.35 1.185 1.455 1.725
Debt 0 $5,000,000 $5,000,000 $5,000,000
Equity $15,000,000 $15,000,000 $15,000,000 $15,000,000
ROE 9% 7.90% 9.70% 11.50%

According to the projections, Symonds Electronics Inc.'s EPS would range between
$1.19 and $1.73 per share if it raised all of the necessary capital by issuing debt, with the
estimated EPS being around $0.11 higher than the current EPS of $1.35. Similarly, the firm's
ROE could range from 7.9% to 11.5 percent, with a 9.7% ROE being the most probable. The
shareholders will get higher return when the sales increase 30% and up.
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 a method often used by investors, wherein they substitute their own
borrowing or lending for corporate borrowing. Also, when an investor wanted more leverage
than a company has taken on, he can buy a company’s stock on margin or borrow money from a
broker and use the borrowed funds to pay for the portion of a stock in accordance to corporate
borrowing.
 Using homemade leverage:
Current Simulation 1 Simulation 2 Simulation 3
Sales increase 10% Sales increase 30% Sales increase 50%
Sales = $15,000,000 Sales: Sales: Sales:
EBIT = $2,250,000 = 15,000,000 x 110% = 15,000,000 x 130% = 15,000,000 x 150%
Taxes = $900,000 = $16,500,000 = $19,500,000 = $22,500,000
Net income = $ 1,350,000 EBIT: EBIT: EBIT:
ROE: = 2,250,000 x 110% = 2,250,000 x 130% = 2,250,000 x 150%
=Net income / Sales = 2,475,000 = 2,925,000 = 3,375,000
=1,350,000/15,000,000 Debt interest = $0 Debt interest = $0 Debt interest = $0
=9% Taxes: Taxes: Taxes:
= 2,475,000 x 40% = 2,925,000 x 40% = 3,375,000 x 40%
=990,000 =1,170,000 =1,350,000
Net income: Net income: Net income:
= 2,475,000 – 990,000 =2,925,000–1,170,000 = 3,375,000 – 1,350,000
= $1,485,000 = $1,755,000 = $2,025,000
Equity: Equity: Equity:
=15,000,000+5,000,00 =15,000,000+5,000,00 =15,000,000+5,000,000
0 0 = $20,000,000
= $20,000,000 = $20,000,000 ROE:
ROE: ROE: =2,025,000/20,000,000
=1,485,000/20,000,000 =1,755,000/20,000,000 =10.13%
=7.43% =8.78%

Using debt $5,000,000:

Increasing sales EPS (Net income / # of shares)
10% = 1,485,000 / 1,000,000 = $1,485
30% = 1,755,000 / 1,000,000 = $1,755
50% = 2,025,000 / 1,000,000 = $2,025
Using homemade leverage:
No. of shares = Shares outstanding + (Pain in capital / Current price per share)
= 1,000,000 + (5,000,000 / $15)
= 1,000,000 + 333,333.33
= 1,333,333.33
10% = 1,485,000 / 1,333,333.33 = $1,114
30% = 1,755,000 / 1,333,333.33 = $1,316
50% = 2,025,000 / 1,333,333.33 = $1,519
 As shown above, by using the homemade leverage method, ROE and EPS is increasing.
Additionally, by increasing the stock sold of $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?
The cost of equity must be calculated first using the CAPM method. The formula to compute
cost of equity are as follows:
Cost of equity (unlevered)= Rf + B(Rm+Rf)
Rf = Risk free rate
B = Beta
Rm = Expected market return
Cost of equity (unlevered) = 4%+ 1.1(12%-4%) = 12.8%

The method for calculating WACC can be expressed in the following formula.
E D
WACC= ∗ℜ+ ∗Rd∗( 1−Tc )
V V
Re= cost of equity
Rd= cost of debt
E= market value of the firm’s equity
D= market value of the firm’s debt
V= total market value of the firm’s financing
E/V= percentage of financing that is equity
D/V= percentage of financing that is debt
Tc= corporate tax rate
There is no debt as the case stated the cost of debt from bank is already cleared by the firm,
so the current WACC is actually equals to the cost of equity which is 12.80%.
The Weighted Average Cost of Capital (WACC) assumes that:
a. Up to a certain degree of leverage, the cost of debt remains constant as the amount of debt
financing rises. The cost of debt would rise above this amount.
b. When the degree of leverage increases, the cost of equity increases.
c. The weighted average cost does not stay unchanged, but instead drops at first as the
proportional cost of debt capital rises, then rises again as the cost of equity rises.
d. The highest level of leverage is when the company's WACC is reduced.
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 stay 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.
With the use of debt and equity combination with the assumption of cost being constant,
WACC becomes lower because of the increase in leverage. There's this certain capital structure
that help maximizes the value of the company, when a levered firm increases in proportion to D:
E, expressed in market values getting higher.
D:E E:V D:E BETA EQUITY WACC DEBT
1:1 12.80% 12.80% 0
1:10 9:10 1:09 1:1 12.80% 12.12% 5,000,000
2:10 8:10 2:08 1:1 12.80% 10.84% 6,000,000
3:10 7:10 3:07 1:1 12.80% 9.56% 7,000,000
4:10 6:10 4:06 1:1 12.80% 7.68% 8,000,000

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 capital by issuing 5-year notes, the firm’s key profitability
ratios would be as follows:
Current 10% Increase 30% Increase 50% Increase

Debt/Equity 0 5,000,000 5,000,000 5,000,000

=0 % =33.33 % =33.33 % =33.33 %
Ratio 15,000,000 15,000,000 15,000,000 15,000,000

Net Profit 1,350,000 1,185,000 1,455,000 1,725,000

=9 % =7 % =7 % =8 %
Margin 15,000,000 16,500,000 19,500,000 22,500,000

2,250,000 2,475,000 2,925,000 3,375,000

BEP =15 % =12% =15 % =17 %
15,000,000 20,000,000 20,000,000 20,000,000

1,350,000 1,185,000 1,455,000 1,725,000

ROE =9 % =8 % =10 % =12%
15,000,000 15,000,000 15,000,000 15,000,000

1,350,000 1,185,000 1,455,000 1,725,000

ROA =9 % =6 % =7 % =9 %
15,000,000 20,000,000 20,000,000 20,000,000
 Base from the computations above, the key profitability ratios of the firm be affected if
the firm were to raise all of the capital issuing 5-year notes. Thus, it is good for the company to
issue 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 company to issue 5-year notes to the
bank because the results of the profitability ratio calculations are favorable, especially in terms of
ROE, which calculates the rate of return on common stockholders' investment. Aside from that, I
looked at WACC and EPS, which showed that there was a lower WACC, which was nice when
the company used debt, and a higher EPS, which means that the profit from selling shares is
increasing. It should be noted that the increase in revenue must be greater than 30%.
7. What are some issues to be concerned about when increasing leverage?
One of the issue to consider in terms of increasing leverage is the revenue. This signifies
a company's earning or net revenue earned in a normal operating cycle of a business. Part of the
revenue is use to pay cost associated with leverage which is why we need to be concerned as to
the increasing leverage cost while getting profit after the deduction to the revenue.
Another issue to consider is the amount of the leverage cost it self because obviously,
high debt ratio will gradually result to financial cost distress of the company especially in times
that they are also experiencing low profitability rate. Term of leverage is also to be consider
because they determine the ability to pay such obligation. These considerations will provide
insights and options to the company when increasing their leverage. When these considerations
are neglected and the company will continue to increase its leverage, the financial distress cost
might result in an event, specifically bankruptcy.
Ergo, if a company is facing distress towards there cost they should borrow lesser fund.
Being aware of their capital structure while building and comparing it to competing companies
that has more stable income can help the firm when their leverage increases.
8. Is it fair to assume that if profitability were positively affected in the short run, due to
the higher debt ratio, the stock price would increase? Explain.
The stock price can be affected by the profitability that can be seen for a short run (less
than a year). But bear in mind that the company will be in operation not only for a year, but for
several years to come. It would be worse if the company has a great track record in the first year
so as to attract investors, and then something unforeseen occurs in the future, causing the
investor to flee. In our view, it would be best if the company had established the debt every year
and left the rest to be changeable, enabling investors to concentrate on the company's stocks.
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)
No taxes and no bankruptcy costs are assumed in The M&M’s proposition I which may
presume that the weighted average cost of capital (WACC) should remain constant with changes
in the company's capital structure. Since there are no changes or advantages from increases in
debt, the capital structure does not influence a company's stock price and has nothing to do with
it. It shows that under the ideal situations, the firm debt policy should not matter to the
shareholders. In simpler terms, the firm’s value can go highest if it is financed by all in debt.
Debt
/
Cost of Roe/ WACC w/ Value Value Debt/ Equity Equit
Equity debt debt Debt (unlevered) (levered) Value /Value y
12.80
12.80% % 12.80% $0.00 10546875 10546875 0 1 0
13.36 $5,000,000 0.33
12.80% % 11.52% .00 10546875 12546875 0.25 0.75 333
14.48 $10,000,00
12.80% % 10.24% 0.00 10546875 14546875 0.5 0.5 1
17.84 $15,000,00
12.80% % 8.96% 0.00 10546875 16546875 0.75 0.25 3
$20,000,00
12.80% 0.00% 6.00% 0.00 10546875 18546875 1 0 0
20000000

18000000

16000000

14000000
value of the firm

12000000

10000000

14.00% 8000000
6000000
12.00%
4000000

10.00% 2000000

0
8.00% 0 0.25 0.5 0.75 1
Debt/Value
Value (unlevered) Value (levered)
6.00%

4.00% MM II
with corporate
2.00% taxes assumes

0.00%
0 0.25 0.5 0.75 1
Debt/Value

Cost of Equity WACC w/ debt

corporate tax savings from the interest tax deduction. Therefore, a greater proportion of debt
lowers the company's WACC. The firm get higher debt in the financing method, the WACC
required to compensate for the investment cost is decreasing. Which indicates that the firm
should use debt in financing the new investment project. But not all should be financed with
debt, as it could lead to other undesirable effects such as heavy cash drain in the interest liability
to pay in every period and may lead to insolvency.