1. For sure, the company can do thing that they want to do, like investing in maintenance, machine, stocks, etc. They also can leverage the investment to their assets. But by taking debt, the company increases the risk of investment. Debt providers are conservative. They cannot share any upside or profits. Therefore, they want management of resources). For addition, debt has little or no impact on control of the company. able to use homemade leverage to create the same payoffs as achieved by the firm. to eliminate all possible loss or downside risks. They 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
The calculations show that if Symonds Electronics Inc. were to raise all of the required capital by issuing debt, its EPS would vary between $1.19 and $1.73 per share with the expected EPS being about $0.11 higher than the current EPS of $1.35. Likewise, the firm’s ROE could vary between 7.9% and 11.5%, with the most likely ROE being 9.7%.
2. What does “homemade leverage” mean? Using the data in the case explain how a shareholder might be
Homemade leverage refers to the use of personal borrowing by an investor to change the overall amount of financial leverage to which he or she is exposed. Let’s say an investor owns 200 shares of Symonds Electronics at the current price of $15 per share ($3000). Now, if the firm finances its expansion with $5,000,000 worth of debt, its EPS will vary between $1.18, $1.46, and $1.73 under the alternative scenarios (see Table in Answer 1 above). On the other hand, if the company was
to finance its expansion with all equity, its EPS would vary between, $1.11, $1.32, and $1.52, respectively as shown in the table below: No Debt With $5,000,000 Expansion Current Growth in Revenues Revenues EBIT Interest EBT EBT*(1-T) # of shares EPS Debt Equity Debt/Equity Ratio Return on Equity 15,000,000 2,250,000 0 2,250,000 1,350,000 1.35 0 15,000,000 0 9.00% Worst Case 10% 16500000 2475000 0 2,475,000 1,485,000 1.11375 0 20,000,000 0 7.43% Expected Case 30% 19500000 2925000 0 2,925,000 1,755,000 1.31625 0 20,000,000 0 8.78% Best Case 50% 22500000 3375000 0 3,375,000 2,025,000 1.51875 0 20,000,000 0 10.13%
Now, rather than the company borrowing the money to finance the expansion, it can be shown that similar EPS could be realized by investors themselves via personal borrowing. The amount to be borrowed is based on the proposed debt-equity ratio, i.e. 33.33%. Thus if the investor borrows $1,000 at 10% per year and buys stock, his personal debt-equity ratio will be $1000/$3000 or 33.33%. The investor’s EPS before and after homemade leverage is as follows: Under proposed capital structure of $5,000,000 debt Worst Case EPS Earnings for 200 shares Net Cost = 200 shares x $15 =$3,000 $1.185 $237 Expected Case $1.455 $291 Best Case $1.725 $345
Under Original Capital structure and Homemade Leverage: EPS Earnings for 266.67 shares Less After-tax interest on $1000 at 10%...