Firms beta was estimated at 1.1. Treasury bills were yielding 4% and expected rate of return on market index was estimated 12%. Using various combinations of debt and equity 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

18 Case 18 Look Before You Leverage 87 Press Esc to exit full screen 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 cquity 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 and spontaneous funds. However, at this juncture, the firm had already "Why do things have to be so complicated?" said Mark to Clive, as he sat invested all its internal equity into the business. Thus, Mark and his col- at his desk shuffling papers around. "I need you to come up with a con- leagues were hard pressed to make a decision as to whether long-term debt vincing argument." Mark's company, Norton Electronics, had embarked or equity should be the chosen method of financing this time around. upon an expansion project that had the potential of increasing sales Upon contacting their investment bankers, Mark learned that they could by about 30% per year over the next five years. The additional capital issue five-year notes, at par, at a rate of 10% per year. Conversely, the needed to finance the project had been estimated at $5,000,000. What company could issue common stock at its current price of $15 per share. Mark was wondering about was whether he should burden the firm with Being unclear about what decision to make, Mark put the question to a fixed rate debt or issue common stock to raise the needed funds. Having vote by the directors. Unfortunately, the directors were equally divided had no luck with getting the board of directors to vote on a decision, in their opinion of which financing route should be chosen. Some direc- Mark decided to call on Clive Jones, his chief financial officer, to shed tors felt that the tax shelter offered by debt would help reduce the firm's some light on the matter. overall cost of capital and prevent the firm's earnings per share from be- Mark Norton, the chief executive officer of Norton Electronics, estab- ing diluted. However, others had heard about "homemade leverage" and lished his company about 10 years ago in his hometown of Cleveland, 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 for the firm to let investors leverage their investments themselves. They capitalize on his engineering knowledge and contacts within the industry. felt that equity was the way to go because the future looked rather uncer- Mark 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 he 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 relieved 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 pres- surprised look on the bank manager's face. tigious university and had recently completed his Chartered Financial Questions: 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 felt, 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 num- bers. The title of his presentation was Look Before You Leverage!" 1. If Norton Electronics Inc. were to raise all of the required cap ital by issuing debt, what would the impact be on the firm's shareholders? 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. 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 cquity capital of the firm? Table 1 Norton Electronics Inc. Latest Balance Sheet Cash Accounts Payable Accruals 3,000,000 2,000,000 Accounts Receivable Inventories Current Assets Net Fixed Assets 1,000,000 3,000,000 4,000,000 8,000,000 12,000,000 4. The firm's 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 stay constant, show the effect of increasing lever- age on the weighted average cost of capital of the firm. Is there a particular capital structure that maximizes the value of the firm? Explain. Current Liabilities Pald In Capital Retained Earnings Total Liabilities & Owner's Equity 5,000,000 5,000,000 10,000,000 Total Assets 20,000,000 20,000,000 5. How would the key profitability ratios of the firm be affected if the firm were to raise all of the capital by issuing five-year notes? 6. If you were Clive Jones, what would you recommend to the board, and why? Table 2 7. What are some issues to be concerned about when increasing leverage? Norton Electronics Inc. Latest Income Statement 15,000,000 10,500,000 8. Is it fair to assume that if profitability were positively affected in the short run, due to the higher debt ratio, the stock price would increase? Explain. Sales Cost of Goods Sold Gross Profit Selling and Adm. Exp Depreciation EBIT 4.500.000 750,000 1.500.000 2.250.000 900,000 1,350,000 9. Using suitable diagrams and the data in the case, explain how Clive could cnlighten the board members about Modigliani and Miller's Propositions I and II (with corporate taxes). Taxes Net Income