Case 18 Look Before You Leverage 87 Business had been good over the years, and sales had doubled about every four years. As sales began to escalate with the booming economy and thriving stock market, the firm had needed additional capital. Initially, Debt versus Equity Financing Mark had managed to grow the business by using internal equity and spontaneous financing sources. However, about five years ago, when the need for financing was overwhelming, Mark decided to take the company public via an initial public offering (IPO) in the over-the-counter market. The issue was very successful and oversubscribed, mainly due to the superb publicity and marketing efforts of the investment underwriting company that Mark had hired. The company sold 1 million shares at \$5 per share. The stock price had grown steadily over time and was currently trading at its book value of $15 per share. Look Before You Leverage When the expansion proposal was presented at last week's board meeting, the directors were unanimous about the decision to accept the proposal. Based upon the estimates 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 "Why do things have to be so complicated?" said Mark to Clive, as he sat and spontaneous funds. However, at this juncture, the firm had already invested all its internal equity into the business. Thus, Mark and his colat his desk shuffling papers around. "I need you to come up with a conleagues were hard pressed to make a decision as to whether long-term debt vincing argument." Mark's company, Norton Electronics, had embarked upon an expansion project that had the potential of increasing sales or equity should be the chosen method of financing this time around. by about 30% per year over the next five years. The additional capital needed to finance the project had been estimated at $5,000,000. What issue five-year notes, at par, at a rate of 10% per year, Converscly, the Mark was wondering about was whether he should burden the firm with fixed rate debt or issue common stock to raise the needed funds. Having Being unclear about what decision to make, Mark put the question to a had no luck with getting the board of directors to vote on a decision, vote by the directors. Unfortunately, the directors were equally divided Mark decided to call on Clive Jones, his chief financial officer, to shed in their opinion of which financing route should be chosen. Some directors felt that the tax shelter offered by debt would help reduce the firm's some light on the matter. Mark Norton, the chief executive officer of Norton Electronics, estaboverall cost of capital and prevent the firm's earnings per share from belished his company about 10 years ago in his hometown of Cleveland, ing diluted. However, others had heard about "homemade leverage" and would not be convinced. They were of the opinion that it would be better Ohio. After taking early retirement at age 55, Mark felt that he could really capitalize on his engineering knowledge and contacts within the industry. for the firm to let investors leverage their investments themselves. They felt that equity was the way to go because the future looked rather uncerMark remembered vividly how easily he had managed to get the company tain and, being rather conservative, they were not interested in burdening up and running by using $3,000,000 of his own savings and a five-year the firm with interest charges. Besides, they felt that the firm should take bank note worth $2,000,000. He recollected how uneasy be had felt about advantage of the booming stock market. that debt burden and the 14% per year rate of interest that the bark had Feeling rather frustrated and confused, Mark decided to call upon his been charging him. He remembered distinctly how relicved he had been chief financial officer, Clive Jones, to resolve this dilemma. Clive had after paying off the loan one year earlier than its five-year term, and the joined the company about two years ago. He held an MBA from a pressurprised look on the bank manager's face. tigious university and had recently completed his Chartered Financial Analysts" certification. Prior to joining Norton, Clive had worked at two other publicly traded manufacturing companies and had been successful in helping them raise capital at attractive rates, thereby lowering their cost of capital considerably. Clive knew that he was in for a challenging task. He feit, however, that this was a good 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 (Tables 1 and 2) and started crunching out the numbers. The title of his presentation was "Look Before You Leverage!" 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? Case 18 Look Before You Leverage 87 Business had been good over the years, and sales had doubled about every four years. As sales began to escalate with the booming economy and thriving stock market, the firm had needed additional capital. Initially, Debt versus Equity Financing Mark had managed to grow the business by using internal equity and spontaneous financing sources. However, about five years ago, when the need for financing was overwhelming, Mark decided to take the company public via an initial public offering (IPO) in the over-the-counter market. The issue was very successful and oversubscribed, mainly due to the superb publicity and marketing efforts of the investment underwriting company that Mark had hired. The company sold 1 million shares at \$5 per share. The stock price had grown steadily over time and was currently trading at its book value of $15 per share. Look Before You Leverage When the expansion proposal was presented at last week's board meeting, the directors were unanimous about the decision to accept the proposal. Based upon the estimates 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 "Why do things have to be so complicated?" said Mark to Clive, as he sat and spontaneous funds. However, at this juncture, the firm had already invested all its internal equity into the business. Thus, Mark and his colat his desk shuffling papers around. "I need you to come up with a conleagues were hard pressed to make a decision as to whether long-term debt vincing argument." Mark's company, Norton Electronics, had embarked upon an expansion project that had the potential of increasing sales or equity should be the chosen method of financing this time around. by about 30% per year over the next five years. The additional capital needed to finance the project had been estimated at $5,000,000. What issue five-year notes, at par, at a rate of 10% per year, Converscly, the Mark was wondering about was whether he should burden the firm with fixed rate debt or issue common stock to raise the needed funds. Having Being unclear about what decision to make, Mark put the question to a had no luck with getting the board of directors to vote on a decision, vote by the directors. Unfortunately, the directors were equally divided Mark decided to call on Clive Jones, his chief financial officer, to shed in their opinion of which financing route should be chosen. Some directors felt that the tax shelter offered by debt would help reduce the firm's some light on the matter. Mark Norton, the chief executive officer of Norton Electronics, estaboverall cost of capital and prevent the firm's earnings per share from belished his company about 10 years ago in his hometown of Cleveland, ing diluted. However, others had heard about "homemade leverage" and would not be convinced. They were of the opinion that it would be better Ohio. After taking early retirement at age 55, Mark felt that he could really capitalize on his engineering knowledge and contacts within the industry. for the firm to let investors leverage their investments themselves. They felt that equity was the way to go because the future looked rather uncerMark remembered vividly how easily he had managed to get the company tain and, being rather conservative, they were not interested in burdening up and running by using $3,000,000 of his own savings and a five-year the firm with interest charges. Besides, they felt that the firm should take bank note worth $2,000,000. He recollected how uneasy be had felt about advantage of the booming stock market. that debt burden and the 14% per year rate of interest that the bark had Feeling rather frustrated and confused, Mark decided to call upon his been charging him. He remembered distinctly how relicved he had been chief financial officer, Clive Jones, to resolve this dilemma. Clive had after paying off the loan one year earlier than its five-year term, and the joined the company about two years ago. He held an MBA from a pressurprised look on the bank manager's face. tigious university and had recently completed his Chartered Financial Analysts" certification. Prior to joining Norton, Clive had worked at two other publicly traded manufacturing companies and had been successful in helping them raise capital at attractive rates, thereby lowering their cost of capital considerably. Clive knew that he was in for a challenging task. He feit, however, that this was a good 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 (Tables 1 and 2) and started crunching out the numbers. The title of his presentation was "Look Before You Leverage!" 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