Question 1

If Symonds Electronics Inc. were to raise all the required capital by issuing debt, what
would the impact be on the firm’s shareholders?

SIMULATION 1 SIMULATION 2 SIMULATION 3

Current
Sales increase 10% Sales increase 30% Sales increase 50%
Sales $15,000,000 Sales Sales Sales
EBIT $2,250,000 =$15,000,000x110% =$15,000,000x130% =$15,000,000x150%
Net Income $1,350,000 = $16,500,000 = $19,500,000 = $22,500,000
Equity $15,000,000 (-) COGS (-) COGS (-) COGS
ROE= Net Incomex100% =$10,500,000 x 110% =$10,500,000 x 130% =$10,500,000x130%
Equity =$11,550,000 =$13,650,000 =$15,750,000
= $1,350,000 x100% (-) Selling & admin (-) Selling & admin (-) Selling & admin
$15,000,000 expenses expenses expenses
= 9% =$750,000 =$750,000 =$750,000
(-) Depreciation (-) Depreciation (-) Depreciation
=$1,500,000 =$1,500,000 =$1,500,000
EBIT EBIT EBIT
=$2,700,000 =$3,600,000 =$4,500,000
(-) Interest on Debt Interest on Debt Interest on Debt
= $5,000,000 x 10% = $5,000,000 x 10% = $5,000,000 x 10%
= $500,000 = $500,000 = $500,000
EBT EBT EBT
=$2,700,000- =$3,600,000- =$4,500,000-
$500,000 $500,000 $500,000
= $2,200,000 = $3,100,000 = $4,000,000
Net Income Net Income Net Income
= (EBT - 40% Taxes) = (EBT - 40% Taxes) =(EBT - 40% Taxes)
=$2,200,000- =$3,100,000- =$4,000,000-
$880,000 $1,240,000 $1,600,000
= $1,320,000 = $1,860,000 = $2,400,000
Equity Equity Equity
= $15,000,000 = $15,000,000 = $15,000,000
ROE ROE ROE
 = Net Income x 100% = Net Income x 100% =Net Income x100%
Equity Equity Equity
= $1,320,000 x 100% = $1,860,000 x 100% = $2,400,000 x100%
$15,000,000 $15,000,000 $15,000,000
= 8.8% = 12.4% = 16%

The impact on the firm’s shareholders can be seen in ROE (Return on Common Equity).
The percentage of ROE decreases when the sales decrease 10% with net income $1,320,000.
But when the sales increases from 10% to 30% and 50%, the ROE is increasing as well up to
12.4% and 16%. Therefore, by increasing their sales, the shareholders will get higher return
when the sales increase 30% and above.

The positive impact of issuance of debt is having a tax benefit. The interest payments to
debt owners are expensed, causing a reduction taxable income. A company with a higher tax
rate thus has a higher tax benefit from debt issuance. Some assert that debt adds discipline to
management because interest expenses cause lower left over cashflows, which makes
management more likely to be efficient and non-complacent. Also, future debt obligations can
be easily forecasted and planned for.

Otherwise, the negative impact of debt issuance is it might increase bankruptcy risk
because debt owners can take control of the company if interest payments are not made. It
also means that the shareholder of the company will be controled also by lenders. Future
financial flexibility may be reduced by issuance of debt. Lenders must make consistent
interest payments on issued debt, reducing financial flexibility. In addition, issuance of debt
may reduce the amount or increase the cost of future debt financing. Level of total borrowing.
This is a function of the optimal capital structure and the level and timing of desired capital
return to shareholders. One need to be careful about the value of the debt; the debt can grow
beyond the ability to pay due to either external events (income loss) or internal difficulties
(poor management of resources).
Question 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.

In finance, homemade leverage is the use of personal borrowing of investors to change the
amount of financial leverage of the firm. Investors can use homemade leverage to change an
unleveraged firm into a leveraged firm. Homemade leverage is also investors’ method of
substituting their own borrowing or lending for corporate borrowing. Investor who want more
leverage than a company has taken on can buy the company’s stock on margin that is, borrow
money from a broker and use the borrowed funds to pay for a portion of the stock in order to
the corporate borrowing.

Homemade leverage is the situation where individuals borrowing on the exact same
terms as large firms can duplicate corporate leverage through purchasing and financing
options. It is the idea that as long as individuals borrow (or lend) on the same terms as the
firm, they can duplicate the affects of corporate leverage on their own. Thus, if levered firms
are priced too high, rational investors will simply borrow on personal accounts to buy shares
in unlevered firms. It is also the idea that as long as individuals borrow (or lend) on the same
terms as the firm, they can duplicate the effects of corporate leverage on their own. Thus, if
levered firms are priced too high, rational investors will simply borrow on personal accounts
to buy shares in unlevered firms. There is approach stating that when individuals borrow on
the same terms as a firm, they can get the same affects of corporate leverage on their own.
When the firm paid off its debt to shareholders, then shareholder pays the same amount of
payoffs to the brokers.

SIMULATION 1 SIMULATION 2 SIMULATION 3

Current
Sales increase 10% Sales increase 30% Sales increase 50%
Sales Sales Sales Sales
$15,000,000 =$15,000,000x110% = =$15,000,000x130% =$15,000,000x150%
EBIT $16,500,000 = $19,500,000 = $22,500,000
$2,250,000 (-) COGS (-) COGS (-) COGS
Net Income =$10,500,000 x 110% =$10,500,000 x 130% =$10,500,000x130%
$1,350,000 =$11,550,000 =$13,650,000 =$15,750,000
Equity (-) Selling & admin (-) Selling & admin (-) Selling & admin
$15,000,000 expenses expenses expenses
ROE= Net =$750,000 =$750,000 =$750,000
Incomex100% (-) Depreciation (-) Depreciation (-) Depreciation
Equity =$1,500,000 =$1,500,000 =$1,500,000
= EBIT EBIT EBIT
$1,350,000 =$2,700,000 =$3,600,000 =$4,500,000
x100% (-) Interest on Debt Interest on Debt Interest on Debt
= $0 = $0 = $0
$15,000,000 EBT EBT EBT
= 9% =$2,700,000-$0 =$3,600,000-$0 =$4,500,000-$0
=$2,700,000 = $3,600,000 = $4,500,000
Net Income Net Income Net Income
= (EBT - 40% Taxes) = (EBT - 40% Taxes) =(EBT - 40% Taxes)
=$2,700,000-$1,080,000 =$3,600,000-$1,440,000 =$4,500,000-$1,800,000
= $1,620,000 = $2,160,000 = $2,700,000
Equity Equity Equity
=$15,000,000+5,000,000 =$15,000,000+5,000,000 =$15,000,000+5,000,000
=$20,000,000 =$20,000,000 =$20,000,000
ROE ROE ROE
= Net Income x 100% = Net Income x 100% =Net Income x100%
Equity Equity Equity
= $1,620,000 x 100% = $2,160,000 x 100% = $2,700,000 x100%
$20,000,000 $20,000,000 $20,000,000
= 8.1% = 10.8% = 13.5%
Using debt $5,000,000

Increasing sales EPS (Net income/#shares)

 10% = $1,320,000/1,000,000 = $1.32

 30% = $1,860,000/1,000,000 = $1.86
 50% = $2,400,000/1,000,000 = $2.40

Using homemade leverage (no debt)

Shares outstanding = 1,000,000 + ($5,000,000/$15)

= 1,333,333.33 shares

Increasing sales EPS (Net income/#shares)

 10% $1,620,000/1,333,333.33 = $1.22

 30% $2,160,000/1,333,333.33 = $1.62
 50% $2,700,000/1,333,333.33 = $2.03

Therefore, by using homemade leverage, the calculation above shows that the ROE
and EPS is getting higher. By the increasing stock sold $5,000,000 it creates the same
payoffs as achieved by the firm.
Question 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?

Before we calculate the WACC, we must calculate the cost of equity 1st. We will need to use
CAPM method to get the cost of equity. The formula for cost of equity is as below:

𝐶𝑜𝑠𝑡 𝑜𝑓 𝑒𝑞𝑢𝑖𝑡𝑦 (𝑢𝑛𝑙𝑒𝑣𝑒𝑟𝑒𝑑) = 𝑅𝑓 + 𝛽(𝑅𝑚 − 𝑅𝑓)

Rf = Risk free rate

B = Beta

Rm = Expected market return

Cost of equity (unlevered) = 4%+ 1.1(12%-4%)

= 12.8%

Then, we can calculate Weight Average Cost Of Capital (WACC). To calculate WACC,
multiply the cost of each capital component by its proportional weight and take the sum of the
results. The method for calculating WACC can be expressed in the following formula

When there is no debt as the case stated the cost of debt from bank is already cleared by the
firm, so the current WACC is actually equals to the cost of equity because there are no cost of
debt at all.

So, current WACC= Cost of equity = 12.80%.

As higher the debt to equity ratio, the higher the cost of debt in the component of the WACC
and the lower of cost of equity in the WACC component. The adverse effects will happen will
the debt to equity ratio goes lower. The effects of the changes of debt to equity ratio is shown
below:

Cost of debt Cost of equity WACC

Increase debt to equity ratio ↑ ↓ ?
Decrease debt to equity ratio ↓ ↑ ?

The result of the WACC either in situation of in increase debt to equity ratio or decrease debt
to equity ratio will based on the weighted of the debt and equity in addition of the cost of debt
and equity themselves. Basically talking, the financing method with the higher cost involved
will not be chosen as the financing method. For example, if cost of debt is high, then we
should not get financing through getting new debt because it leads to higher WACC need to
be acquire to compensate for the investment cost caused.
Question 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
effects 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.

Cost of equity with debt

= Ru+ (Ru- cost of debt)*(D/E) (1 - tax rate)

= 12.8% + (12.8% - 10%) (5,000,000/15,000,000)(1 - 40%)

= 12.8% + (2.8%)(0.333)(0.6)

= 12.8% + 0.0056

= 13.36%

WACC with debt

= [(1 – tax rate)*cost of debt* (D/V)] + cost of equity* (E/V)

= [(1 - 40%) 10% ($5,000,000/($5,000,000 + $15,000,000))]

+ 13.36%($15,000,000/($5,000,000+ $15,000,000))

= (0.6) (10%) (0.25) + (13.36%) (0.75)

= 0.015 + 0.1002 = 0.1152

= 11.52%

As we can compare with answer from question 3, the previous WACC was 12.8%. But now,
the WACC with debt is actually lower which is 11.52% only. It’s slighly lower with amount
of decreased in 1.28%. So, we can say that debt is actually good to lower the WACC required
to compensate the investment cost caused. A particular capital structure is where the debt to
equity ratio achieved a lowest WACC at the stage.
5. How would the key profitability ratios of the firm be affected if the firm were to raise
all of the capital by issuing 5-year notes?

Profitability Ratios measure the profitability and performance of a company. It uses to

calculate the ability of a company to make profit relative to sales, total asset and total equity.
There are four key ratios for measuring the profitability of a company, which is net profit
margin, basic earnings power ratio, return on asset, and return on equity.

i. Net profit margin is measure how well a company generate its profit from
each dollar of sales. It can be compute by dividing net income with sales.
The issuing of 5-year notes will result in interest expenses which must be
paid and decrease the net income.
ii. Basic Earnings Power ratio is a measure the effective of a firm generate
income from its asset disregards the financial leverage and taxes. It is
earnings before interest and taxed divided total asset.
iii. Return on Asset is how efficiency a company generates their profit through
its asset. Return on Equity is measure how efficiency a company generate
earnings for each dollar invested by shareholders. ROA can be compute by
dividing the net income with the total asset, whereas ROE is net income
divided by total equity. The higher the ROA and ROE, the higher the
efficiency a company in earning via its asset and equity. In this case, the
raising of all capital by issuing 5-year notes has decrease the net income as
a result of the increase in interest expenses.
 Current condition Sales +10% Sales +30% Sales +50%

Sales $ 15,000,000 $ 16,500,000 $ 19,500,000 $ 22,500,000

COGS $ 10,500,000 $ 11,550,000 $ 13,650,000 $ 15,750,000

Selling and
admin
expenses $ 750,000 $ 750,000 $ 750,000 $ 750,000

Depreciation $ 1,500,000 $ 1,500,000 $ 1,500,000 $ 1,500,000

EBIT $ 2,250,000 $ 2,700,000 $ 3,600,000 $ 4,500,000

Interest on
Debt $ - $ 500,000 $ 500,000 $ 500,000

EBT $ - $ 2,200,000 $ 3,100,000 $ 4,000,000

Net Income $ 1,350,000 $ 1,320,000 $ 1,860,000 $ 2,400,000

Expected Case
Current Worst Case (10%) Best Case (50%)
(30%)
Net Profit
Margin 1,350,000/15,000,000 1,320,000/16,500,00 1,860,000/19,500,00 2,400,000/22,500,0
=Net = 9% 0 = 8% 0 = 9.5% 00 = 10.67%
income/Sales
Basic Earnings
Power 2,250,000/20,000,000 2,700,000/20,000,00 3,600,000/20,000,00 4,500,000/20,000,0
=EBIT /total = 11.30% 0 = 13.50% 0 = 18% 00 = 22.50%
asset
Return on Asset
1,350,000/20,000,000 1,320,000/20,000,00 1,860,000/20,000,00 2,400,000/20,000,0
= Net income /
= 6.75% 0 = 6.60% 0 = 9.30% 00 = 12%
Total Asset
Return on Equity
1,350,000/15,000,000 1,320,000/15,000,00 1,860,000/15,000,00 2,400,000/15,000,0
= Net income /
= 9% 0 =8.8% 0 = 12.4% 00 = 16%
Equity
From the table above, the basic earning power of a company for three conditions are
increasing if the firm issuing the 5-year notes. The table shows the BEP for the three
conditions is higher than ROA. This indicates the difference between the BEP and ROA is
expenses that spend by company for the taxes and interest expense. For example, the BEP in
Worst case (10%) is 13.50%, whereas ROA shows 6.60%. It means that the 6.90% of
company’s revenue is spending for taxes and interest expenses. Other than that, the net profit
margin, ROA and ROE was increase in expected case (30%) and best case (50%), but
decrease in the worst case (10%) as compared to the former condition. Hence, the firm should
consider whether they want to take the risk by issuing the 5-year notes which decreases the
profitability if the worst case occur or increase in profitability for the expected case and best
case.
 Question 6

If you were Andrew Lamb, what would you recommend to the board and why?

I recommend prepare financial projection under different scenarios and with different
assumptions. The goal is to find the debt/equity mix that provides the highest expected
long-term shareholder value.

If net interest rates are lower than net profit margins Symonds Electronics Inc. can maximize
your return on equity by minimizing equity and maximizing debt. If not, do the exact
opposite which is to minimize debt and finance through equity. It's a good option if
you can't afford to take on debt.

Return on equity or return on capital is the ratio of net income of a business during a year to
its stockholders' equity during that year. It is a measure of profitability of stockholders'
investments. It shows net income as percentage of shareholder equity.

Debt issuers become worse when company will not be able to covers its financial
responsibilities. For example, if interest increases, EPS decreases and a lower stock
price is valued. If a company in the worst case, goes bankrupt. Minimum WACC is
the level where stock price is maximized. The capital structure that minimizes the
company's WACC. Capital structure is the combination of the debt and equity a
company uses to finance its long term operations and growth.

Question 7

What are some issues to be concerned about when increasing leverage?

That is issues to be concerned is the amount of debt used to finance a firm's assets. A firm
with significantly more debt than equity is considered to be highly leveraged.

Thus, the issues can be concluded as :

-The period whether short term or long term

- The ability to fulfill the payment

 We have to know whether our profit is enough to pay the debt and its interest.

- The figures of principal and interest (information of agreement)

 We need to consider about interest rate whether it is high or not.
Question 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.

It is not fair. A company that is profiting are more likely to see the price of stock rise despite
of higher or lower debt ratio. No matter how much the amount of debt is, if the profit is
increasing, the stock price will increase as well. But just by seeing the short run profit is not
good enough because the company is not only going to operate just for one year. It is going to
continue in future. In addition, high debt ratio means highly leveraged. This might cause the
investors to demand back their investment. This will make the situation worse. For Symonds
Electronics Inc., the debt ratio is Total Debt / Total Assets = $ 5,000,000 / $ 20,000,000 =
0.25 which is 25%. This means that the company is currently 25% depending on leverage.
The higher the debt ratio, the higher the risk that company is considered to have taken on.
Therefore, in my opinion, it is better fixed the debt annually and others keep variable so that
the investors will be focus to invest.
Question 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).

The M&M’s proposition I assume no taxes and no bankruptcy costs. It can be said that the
weighted average cost of capital (WACC) should remain constant with changes in the
company's capital structure. Since there are no changes or benefits from increases in debt, the
capital structure does not influence a company's stock price, and the capital structure has
nothing to do with company's stock price. It shows that under the ideal conditions, the firm
debt policy should not matter to the shareholders.

Cost of Cost of Equity WACC Value Value

Debt/Value Equity/Value Debt/Equity Equity (with debt) (with debt) Debt (Unlevered) (levered)
0 1 0 12.80% 12.80% 0.128 0 10546875 10546875
0.25 0.75 0.333333333 12.80% 0.1336 0.1152 5000000 10546875 12546875
0.5 0.5 1 12.80% 0.1448 0.1024 10000000 10546875 14546875
0.75 0.25 3 12.80% 0.1784 0.0896 15000000 10546875 16546875
1 0 0 12.80% 0 0.06 20000000 10546875 18546875

M & M Proposition 1 with taxes

20000000
V
18000000
a
l 16000000
u 14000000
e
12000000

o 10000000
Value (Unlevered)
f 8000000
Value (levered)
6000000
F
i 4000000
r 2000000
m
0
0 0.25 0.5 0.75 1
Debt/Equity ratio
As from the graph above, we can see that the value of firm after levered with debt is actually keep
increasing as the debt is increasing. Basically talking, the firm’s value can go highest if it is
financed by all in debt. But, it could lead to some problem such as a heavy cash drain on
companies and leads to sub-optimal growth.

M&M Proposition 2 with taxes

14.00%

12.00%
C
E 10.00%
o
q
s
u 8.00%
t
i 6.00%
t
o 4.00%
y
f
2.00%

0.00%
0 0.25 0.5 0.75 1
Debt/Value Ratio

MM II with corporate taxes acknowledges the corporate tax savings from the interest tax
deduction and thus concludes that changes in the debt-equity ratio do affect WACC.
Therefore, a greater proportion of debt lowers the company's WACC.

As a result from the graph above, we also noticed that as the firm get higher debt in the
financing method, the WACC required to compensate for the investment cost caused is
actually keep decreasing. It means that the firm should really use debt to financing the new
investment project and raise the financing. But, they should not financing all the amount
needed with only debt as it could lead to other unwanted problem such as heavy cash drain in
the interest obligation to pay in every period and leads to unsolvency problem.