Group-2

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.

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%.

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%

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.

Using various combinations of debt and equity, with the assumption that the cost of each component stays constant, the increasing leverage makes the WACC lower.

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.

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

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. No its unfair, no matter how much the amount of debt is if the profit is increasing significantly the stock price will increase as well.

Thankyou.