Solution to Case 06

Debt Versus Equity Financing

Look before you Leverage!

Questions
1. If Symonds Electronics Inc. were to raise all of the required capital by issuing debt,
what would the impact be on the firms 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
Current
Growth in Revenues
Revenues
EBIT
Interest
EBT
EBT*(1-T)
# of shares
EPS
Debt
Equity
Debt/Equity Ratio
Return on Equity

15,000,000
2,250,000
0
2,250,000
1,350,000
1,000,000
1.35
0
15,000,000
0.00%
9.00%

With $5,000,000 Expansion

Worst Case Expected Case
Best Case
10%
30%
50%
16,500,000
19,500,000 22,500,000
2,475,000
2,925,000
3,375,000
500,000
500,000
500,000
1,975,000
2,425,000
2,875,000
1,185,000
1,455,000
1,725,000
1,000,000
1,000,000
1,000,000
1.185
1.455
1.725
5,000,000
5,000,000
5,000,000
15,000,000
15,000,000 15,000,000
33.33%
33.33%
33.33%
7.90%
9.70%
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 with the
expected EPS being about $0.11 higher than the current EPS of $1.35. Likewise, the firms
ROE could vary between 7.9% and 11.5%, with the most likely ROE being 9.7%.
See spreadsheet solution
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.
Lets say an investor owns 200 shares of Symonds Electronics at the 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 the 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
With $5,000,000 Expansion
Current Worst Case Expected Case
Best Case
Growth in Revenues
10%
30%
50%
Revenues
15,000,000
16500000
19500000
22500000
EBIT
2,250,000
2475000
2925000
3375000
Interest
0
0
0
0
EBT
2,250,000
2,475,000
2,925,000
3,375,000
EBT*(1-T)
1,350,000
1,485,000
1,755,000
2,025,000
# of shares
1,000,000 1333333.333
1333333.333 1333333.333
EPS
1.35
1.11375
1.31625
1.51875
Debt
0
0
0
0
Equity
15,000,000
20,000,000
20,000,000
20,000,000
Debt/Equity Ratio
0
0
0
0
Return on Equity
9.00%
7.43%
8.78%
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 investors EPS before and after homemade leverage
is 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 Capital structure and Homemade Leverage:

EPS
Earnings for 266.67 shares

$1.11
$297

Less After-tax interest on $1000 at

10% (1 - 0.4) 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) + (D/V) x RD x (1-TC)
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
firms 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 D/E ratio will be 33.33%
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%) + (5,000,000/20,000,000)*10%*.6
= 11.59%
4. The firms beta was estimated at 1.11. 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.

Debt/Value
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

Equity/Value
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

RE

WACC
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
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

Vl
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

20000000
18000000
16000000

Value of Firm

14000000
12000000
Vu

10000000

Vl

8000000
6000000
4000000
2000000
0
0

2000000

4000000

6000000

8000000

10000000

12000000

14000000

16000000

Debt

As shown in the graph above, with 100% debt the firms 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
Current
Growth in Revenues
Revenues
15,000,000
EBIT
2,250,000
Interest
0
EBT
2,250,000
Net Income
1,350,000
# of shares
1,000,000

With $5,000,000 Expansion

Worst Case Expected Case
Best Case
10%
30%
50%
16,500,000
19,500,000 22,500,000
2,475,000
2,925,000
3,375,000
500,000
500,000
500,000
1,975,000
2,425,000
2,875,000
1,185,000
1,455,000
1,725,000
1,000,000
1,000,000
1,000,000

EPS
Current Liabilities
Debt
Equity
Total Assets
Debt/Equity Ratio
Net Profit Margin
Return on Equity
Return on Assets

1.35
5,000,000
0
15,000,000
20,000,000
0.00%
9.00%
9.00%
6.75%

1.185
5,000,000
5,000,000
15,000,000
25,000,000
33.33%
7.18%
7.90%
4.74%

1.455
5,000,000
5,000,000
15,000,000
25,000,000
33.33%
7.46%
9.70%
5.82%

1.725
5,000,000
5,000,000
15,000,000
25,000,000
33.33%
7.67%
11.50%
6.90%

6. 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 EBIT is good and the firms 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. Is it fair to assume that if profitability is positively affected 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. If the firms
profitability is positively affected in the short run and analysts and investors dont expect
an increase in risk, the firms stock price would increase. However, if the market expects
the firms risk level to increase, the Price-Earnings ratio will decrease and the stock price
could fall as well.
9. (Optional) 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).
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:
VL = VU + TcD

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

VU = EBIT (1-Tc)
RU
Under Proposition II with taxes: The cost of equity (RE), is:
RE = RU + (RU RD) X (D/E) x (1-TC)
Under the Most likely scenario,
Vu = $1,755,000/0.1288 = $13,625,776.4 (see spreadsheet)
As the amount of debt increases the value of the firm would also increase and the firms
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) + (D/V) X RD x (1-TC)
M&M Proposition I with Taxes
20000000
18000000
16000000

Value of Firm

14000000
12000000
Vu

10000000

Vl

8000000
6000000
4000000
2000000
0
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%

Cost%

12.00%
10.00%

RE

8.00%

WACC

6.00%
4.00%
2.00%
0.00%
0

0.1

0.2

0.3

0.4

Debt-Equity Ratio

0.5

0.6