Question

Case24. Debt Versus Equity FinancingLook Before You Leverage!“Why do things have to be so complicated?” said Bob to Andrew, as he sat at his deskshuffling papers around. “I need you to come up with a convincing argument.” Bob’scompany, Symonds Electronics, had embarked upon an expansion project, which had thepotential of increasing sales by about 30% per year over the next 5years. The additionalcapital needed to finance the project had been estimated at $5,000,000. What Bob waswondering about was whether he should burden the firm with fixed rate debt or issuecommon stock to raise the needed funds. Having had no luck with getting the board of directors to vote on a decision, Bob decided to call on Andrew Lamb, his Chief FinancialOfficer, to shed some light on the matter.Bob Symonds, the Chief Executive Officer of Symonds Electronics, established hiscompany about 10years ago in his hometown of Cincinnati, Ohio. After taking earlyretirement at age 55, Bob felt that he could really capitalize on his engineeringknowledge and contacts within the industry. Bob remembered vividly how easily he hadmanaged to get the company up and running by using $3,000,000 of his own savingsand a five-year bank note worth $2,000,000. He recollected how uneasy he had feltabout that debt burden and the 14% per year rate of interest that the bank had beencharging him. He remembered distinctly how relieved he had been after paying off theloan one year earlier than its five-year term, and the surprised look on the bankmanager’s face.Business had been good over the years and sales had doubled about every 4 years.As sales began to escalate with the booming economy and thriving stock market, thefirm had needed additional capital. Initially, Bob had managed to grow the business byusing internal equity and spontaneous financing sources. However, about 5 years ago,when the need for financing was overwhelming, Bob decided to take the company publicvia an initial public offering (IPO) in the over-the-counter market. The issue was verysuccessful and oversubscribed, mainly due to the superb publicity and marketing effortsof the investment underwriting company that Bob hired. The company sold 1 millionshares at $5 per share. The stock price had grown steadily overtime and was currentlytrading at its book value of $15 per share.When the expansion proposal was presented at last week’s board meeting, thedirectors were unanimous about the decision to accept the proposal. Based upon theestimates provided by the marketing department, the project had the potential of increasing revenues by between 10 %( Worst Case) and 50 %( Best Case) per year. The internal rate of return was expected to far outperform the company’s hurdle rate.Ordinarily, the project would have been started using internal and spontaneous funds.However, at this juncture, the firm had already invested all its internal equity into thebusiness. Thus, Bob and his colleagues were hard pressed to make a decision as towhether long-term debt or equity should be the chosen method of financing this timearound.Upon contacting their investment bankers, Bob learned that they could issue 5-yearnotes, at par, at a rate of 10% per year. Conversely, the company could issue commonstock at its current price of $15 per share. Being unclear about what decision to make,Bob put the question to a vote by the directors. Unfortunately, the directors were equallydivided in their opinion of which financing route should be chosen. Some of the directorsfelt that the tax shelter offered by debt would help reduce the firm’s overall cost of capital and prevent the firm’s earnings per share from being diluted. However, othershad heard about “homemade leverage” and would not be convinced. They were of theopinion that it would be better for the firm to let investors leverage their investmentsthemselves. They felt that equity was the way to go since the future looked ratheruncertain and being rather conservative, they were not interested in burdening the firmwith interest charges. Besides, they felt that the firm should take advantage of thebooming stock market.Feeling rather frustrated and confused, Bob decided to call upon his chief financialofficer, Andrew Lamb, to resolve this dilemma. Andrew had joined the company about two years ago. He held an MBA from a prestigious university and had recently completedhis Chartered Financial Analysts’ certification. Prior to joining Symonds, Andrew hadworked at two other publicly traded manufacturing companies and had been successfulin helping them raise capital at attractive rates, thereby lowering their cost of capitalconsiderably.Andrew knew that he was in for a challenging task. He felt, however, that this was agood opportunity to prove his worth to the company. In preparation of his presentation,he got the latest balance sheet and income statement of the firm (see Tables 1 and 2)and started crunching out the numbers. The title of his presentation read, “Look Before You Leverage!”

Q) what capital structue we should go with ? 100% debt or 100% equity ? or mix between the two ?

Q) If Symonds Electronics Inc. were to raise all of the required capital by issuingdebt, what would the impact be on the firm’s shareholders?

Q) If you were Andrew Lamb, what would you recommend to the board and why?

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

Thanks