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

"Why do things have to be so complicated?" said Bob to Andrew, as he sat at his desk shuffling papers around. "I need you to come up with a convincing argument." Bob's company, Symonds Electronics, had embarked upon an expansion project, which had the potential of increasing sales by about 30% per year over the next 5years. The additional capital needed to finance the project had been estimated at $5,000,000. What Bob was wondering about was whether he should burden the firm with fixed rate debt or issue common stock to raise the needed funds. Having had no luck with getting the board of directors to vote on a decision, Bob decided to call on Andrew Lamb, his Chief Financial Officer, to shed some light on the matter. Bob Symonds, the Chief Executive Officer of Symonds Electronics, established his company about 10years ago in his hometown of Cincinnati, Ohio. After taking early retirement at age 55, Bob felt that he could really capitalize on his engineering knowledge and contacts within the industry. Bob remembered vividly how easily he had managed to get the company up and running by using $3,000,000 of his own savings and a five-year bank note worth $2,000,000. He recollected how uneasy he had felt about that debt burden and the 14% per year rate of interest that the bank had been charging him. He remembered distinctly how relieved he had been after paying off the loan one year earlier than its five-year term, and the surprised look on the bank manager's face. Business had been good over the years and sales had doubled about every 4 years. As sales began to escalate with the booming economy and thriving stock market, the firm had needed additional capital. Initially, Bob had managed to grow the business by using internal equity and spontaneous financing sources. However, about 5 years ago, when the need for financing was overwhelming, Bob 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 Bob hired. The company sold 1 million 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 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 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. Being unclear about what decision to make, Bob put the question to a vote by the directors. 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 firm's overall cost of capital and prevent the firm's earnings per share from being diluted. However, others had heard about "homemade leverage" and would not be convinced. They were of the opinion that it would be better for the firm to let investors leverage their investments themselves. They 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. Andrew had joined the company about two years ago. He held an MBA from a prestigious university and had recently completed his Chartered Financial Analysts' certification. Prior to joining Symonds, Andrew 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. Andrew 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 (see Tables 1, 2, and 3) and started crunching out the numbers. The title of his presentation read, "Look Before You Leverage!"

Table 1: Latest Balance Sheet

Cash | 1,000,000 | Accounts Payable | 3,000,000

Accounts Receivable | 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: Latest Income Statement

Sales | 15,000,000

Cost of Goods Sold | 10,500,000

Gross Profit | 4,500,000

Selling and Adm. Exp | 750,000

Depreciation | 1,500,000

EBIT | 2,250,000

Taxes (40%) | 900,000

Net Income | 1,350,000

Table 3

Year Unit Sales Unit Price

0

1 30,000 1,000

2 34,000 1,000

3 38,800 1,000

4 38,000 950

5 36,000 950

6 36,000 950

7 35,500 950

8 35,000 900

9 34,500 900

10 34,000 900