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 1 : 10 2 : 10 3 : 10 4 : 10 E:V 9 : 10 8 : 10 7 : 10 6 :10 D:E 1:9 2:8 3:7 4 :6 1.1 1.1 1.1 1.1 1.1 Requity 12.8% 12.8% 12.8% 12.8% 12.8% WACC 12.8 % 12.12% 10.84% 9.56% 7.68% debt 0 $ 5,000,000 $ 6,000,000 $ 7,000,000 $ 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?

P/M

Current $ 1,350,000/$15,000,000= 9% $ 2,250,000/ $15,000,000= 15% $1,350,000/ $15,000,000= 9% $1,350,000/ $15,000,000= 9%

BEP

ROA

ROE

10% $1,185,000/ $16,500,000= 7% $ 2,475,000/ $20,000,000= 12% $1,185,000/ $20,000,000= 6% $ 1,185,000/ $15,000,000= 8%

30% $1,455,000/ $19,500,000= 7% $ 2,925,000/ $20,000,000= 15% $1,455,000/ $20,000,000= 7% $ 1,455,000/ $15,000,000= 10%

50% $1,725,000/ $22,500,000= 8% $ 3,375,000/ $20,000,000= 17% $ 1,725,000/ $20,000,000= 9% $ 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.