Why would a company forgo their debt financing and take on equity financing?© BrainMass Inc. brainmass.com October 24, 2018, 11:36 pm ad1c9bdddf
Investments into companies usually require both debt and equity. The optimal ratio needs to be carefully determined for each individual situation. It is unlikely that this ratio will consist of 100% equity. If the long-term prospects are so poor that a company can never make sufficient profits to benefit from ...
Why would a company forgo their debt financing and take on equity financing?
Debt versus Equity Financing
Debt versus Equity Financing
"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 5 years. 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
10 years 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 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.
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 weighted average cost of
capital (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-year notes, 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 had 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 and 2) and started crunching out the
numbers. The title of his presentation read, "Look Before You Leverage!"
Symonds Electronics Inc.
Latest Balance Sheet
Cash 1,000,000 Accounts Payable 3,000,000
Accounts Receivable 3,000,000 Accruals 2,000,000
Inventory 4,000,000 Current Liabilities 5,000,000
Current Asset 8,000,000 Paid in Capital 5,000,000
Net Fixed Assets 12,000,000 Retained Earnings 10,000,000
Total Assets 20,000,000 Total Liabilities and Owners' Equity 20,000,000
Symonds Electronics Inc.
Latest Income Statement
Cost of Goods Sold 10,500,000
Gross Profits 4,500,000
Selling and Administrative Expense 750,000
Earnings before Interest and Taxes (EBIT) 2,250,000
Taxes (40%) 900,000
Net Income 1,350,000
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?
5. If you were Andrew Lamb, what would you recommend to the board and why?
6. What are some issues to be concerned about when increasing leverage?
7. 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.
8. What is stock price in layman terms?Will firm will maximise shareholders wealth by foregoing short term profitability? Is it fair to assume stock price will increase in this scenario?
9. Using suitable diagrams and the data in the case explain how Andrew Lamb could enlighten the board members about Modigliani and Miller's Propositions I and II (with corporate taxes)