Reading: Debt Versus Equity Financing: Look Before You Leverage!

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 the business. 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. 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 common stock at its current price of $15 per share.

QUESTIONS:

1. Compute a pro forma statement (income statement) showing the income statement projections for the next year, include the computing of the EPS, Net Profit Margin, ROA and ROE (based Table 1, Table 2, & Table 3) for two funding options being considered, one using (i) equity and another using (ii) debt. For each funding option, consider three scenarios: base case (25% increase in sales), optimistic (40% increase) and pessimistic (5% increase). Use the following assumptions below in your income statement projection for both funding options:

• Of the total investment of $5 million required for the expansion project, $4 million will be for fixed assets and $1 million for net working capital. Note: Additional Current Assets required will be $2.5 million, but current liabilities will also increase by $1.5 million. So the net NWC requirement is $1 million. This information is needed to compute ROA.
• The life of the project is 5 years and the company uses straight line depreciation.
• All operating costs other than depreciation are directly proportional to sales.

What would be the impact of the project in terms of short-term profitability?

2. Suppose that the firm's current beta is estimated to be 1.25. Treasury bills yield 4%, and the expected rate of return on the market index is 12%. Assume that the NPV of the project if it were funded entirely by equity is $1.5 million.

• What is the current value of the firm (before taking up the project) according to the information provided in the case? (Hint: Note that the market value of the firm's stock is given in the case.)
• Now suppose the project is accepted. Use the Modigliani-Miller theory with taxes to estimate the value of the firm, the firm's cost of equity and the firm's WACC under both options, namely, funding the project using equity and funding the project using debt.

3. What are some issues to be concerned about when increasing leverage? Is it reasonable to assume that if using debt were to increase profitability, the stock price would definitely increase? Explain.

TABLE 1 Norton Electronics Inc. Latest Balance Sheet Cash 1,000,000 Accounts Payable 3.000.000 Accounts Receival 3,000,000 Accruals 2,000,000 Inventories 4,000,000 Current Assets 8,000,000 Current Liabilities 5,000,000 Net Fixed Assets 12.000.000 Paid in Capital 5,000,000 Retained Earnings 10.000.000 Total Assets 20.000.000 Total Liabilities & Owner's Equity 20.000.000 TABLE 2 Norton Electronics Inc. Latest Income Statement Sales Cost of Goods Sold Gross Profit Selling and Adm. Exp Depreciation EBIT Taxes (40%) Net Income 15.000.000 10,500,000 4.500.000 750,000 1,500,000 2.250.000 900,000 1,350.000 Year TABLE 3 Unit Sales Unit Price 0 1 $30,000.00 $ 2 $ 34,000.00 $ 3 $38.800.00 $ 4 $38,000.00 $ 5 $36,000.00 $ 6 $36,000.00 S 7 $35,500.00 $ 8 $35,000.00 $ 9 $34,500.00 $ 10 $ 34,000.00 S 1,000.00 1.000.00 1,000.00 950.00 950.00 950.00 950.00 900.00 900.00 900.00 TABLE 1 Norton Electronics Inc. Latest Balance Sheet Cash 1,000,000 Accounts Payable 3.000.000 Accounts Receival 3,000,000 Accruals 2,000,000 Inventories 4,000,000 Current Assets 8,000,000 Current Liabilities 5,000,000 Net Fixed Assets 12.000.000 Paid in Capital 5,000,000 Retained Earnings 10.000.000 Total Assets 20.000.000 Total Liabilities & Owner's Equity 20.000.000 TABLE 2 Norton Electronics Inc. Latest Income Statement Sales Cost of Goods Sold Gross Profit Selling and Adm. Exp Depreciation EBIT Taxes (40%) Net Income 15.000.000 10,500,000 4.500.000 750,000 1,500,000 2.250.000 900,000 1,350.000 Year TABLE 3 Unit Sales Unit Price 0 1 $30,000.00 $ 2 $ 34,000.00 $ 3 $38.800.00 $ 4 $38,000.00 $ 5 $36,000.00 $ 6 $36,000.00 S 7 $35,500.00 $ 8 $35,000.00 $ 9 $34,500.00 $ 10 $ 34,000.00 S 1,000.00 1.000.00 1,000.00 950.00 950.00 950.00 950.00 900.00 900.00 900.00