Good afternoon everyone today’s case titled look before you leverage.

Before analyzing the case we

must first know the background of the study.

 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 5 years. The additional capital
needed is $5,000,000. When the expansion proposal was presented at the board meeting, the
directors were unanimous about the decision to accept the proposal.
 Based on the estimation provided by the marketing department, the project had the potential of
increasing revenues by between 10% (Worst Case) and 50% (Best Case) per year. Business went
good and sales doubled every 4 years after that. Bob managed to grow the business by using
internal equity and spontaneous financing sources.
 However, about 5 years ago when the need of financial support was overwhelming, he decided
to take the company to Initial public offering in the over the counter market.
 The company sold 1 million shares at $5 per share. Stock price grown steadily and traded at
book value of $15 per share.
 Being unclear on what decision to make whether to burden the firm with fixed-rate debt or
issue common stock for such funds or capital, Bob put the question to be voted by the directors.
 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 earning per share from being diluted. Others said
that it would be better for the firm to let investors leverage (control) their investment
themselves and heard about the homemade leverage and not convinced. The firm should take
advantage of the booming stock market.

Second is the use of homemade leverage homemade leverage is a substitution of risk of the firms
borrowing or lending for corporate borrowing. It is the situation where the individuals borrowing on the
exact terms as large firms can duplicate leverage through purchasing and financing options. Moreover,
when individuals borrow on the same terms as a firm, they can get the same effects of corporate
leverage on their own. The homemade leverage is known with some advantages such as reduce the risk
of the firm from being bankrupt and allow an individual using leverage to borrow such as a large
corporation does.

For the second option is to raise all of the additional needed capital by issuing a long-term debt with 10

% interest. Same process with the option 1 but here there is a 10% interest which means that we need
to deduct 500,000 interest. This affects the earnings before taxes and the net income.

Since all debt will be issued to raise the additional capital needed the 5,000,000 debt we will include

First is to find the Cost of equity, 12.8% was computed in option 1 that represents the cost of equity that
has no debt then substitute the interest rate which is 10%, debt of 5million, equity of 15Million and tax
rate of 40%. This give us cost of equity of 13.36%. Next is to compute for the wacc with debt, this
represents the percentage debt in the firm’s capital structure. Ang 10% represents the yield to maturity
multiplied by 1- the tax rate wchic the after tax cost of debt plus the percentage of equity mulptiplie by
the cost of equity.

 Between equity and debt, debt financing is preferable to the other because it has its advantages
that can maximize the firm’s profit and minimize the firm’s WACC. The fact that interest paid is a
deductible expense makes the debt less expensive than common or preferred stock (Brigham,
2019). Theory suggests that if the company sees an opportunity in the future, it will most likely
issue a long-term fixed-rate debt because this keeps the benefits within the firm.
 In other words, if the future of the company is favorable, the directors and/or investors don’t
want to share the benefits of the new product with the new investor, hence they refuse to issue
stocks. Moreover, this kind of financing is preferred by most finance professionals so long as the
ratio is proportionate. The idea of debt financing is too perfect which makes it quite
questionable. In practice, issuing debt may also cause the company its downfall or go bankrupt,
for example.
 If the debt ratio is too high, the expenses may be lesser because of the tax shelter but just to be
offset with the bankruptcy cost that goes with it. Issuing long-term debt makes the company
more profitable not only because it has a lot of advantages compared to equity but in a way that
it urges the managers to do well and avoid unnecessary expenses because the payment for the
debt is prioritized. If the firm decides to finance the additional capital through debt, the WACC
will be 10.02% which is lower compared to issuing common stocks and much more preferable. A
lower WACC means a high intrinsic value. The current EPS is 1.35/share. After using debt as a
way of financing the expansion, the EPS will be 1.19/share, 1.46/share, 1.73/share for worse
case, expected, and best case, respectively.