Case Study:

“Look Before You Leverage! ”

Submitted By:

Alemany, Anela
Camacho, Elaiza
Cepeda, Mizpah
Leuterio, Eisha
Perez, Delfin Jr.
Roca, Gareth

Submitted To:
Sir Felix D. Cena
 I. Background of the Study

Since its founding by Bob Symonds ten years ago, Symonds

Electronics has expanded dramatically, tripling its revenues roughly
every four years. Bob's market knowledge and astute use of both internal
and external funding are key factors in the company's success. The
business was first financed by Bob's own savings and a bank loan. Later,
it went public through an initial public offering (IPO), raising a
significant amount of money and seeing a consistent rise in the value of
its stock. A thriving economy and strong market conditions are reflected
in this growth trajectory.

Over the next five years, Symonds Electronics is set to embark on a

significant expansion initiative that might increase yearly revenues by
30%. However, there is a financial obstacle because this project requires
$5 million in financing. To finance the project, the company must choose
between issuing additional shares or long-term debt. While debt gives a
tax shelter and prevents equity dilution, it also entails interest obligations.
On the other hand, stock avoids fixed costs but runs the danger of
diluting current ownership and earnings per share.

The board of directors is split on the financing strategy, reflecting broader

debates about leveraging versus maintaining financial flexibility. Some
directors favor debt due to its cost efficiency and tax benefits, while
others advocate for equity issuance to capitalize on favorable market
conditions and minimize financial risk.

Bob Symonds has turned to Andrew Lamb, the Chief Financial Officer,
to analyze the situation and recommend the most advantageous financing
strategy. With his strong financial credentials and experience in
optimizing capital structures, Andrew is tasked with presenting a
compelling argument to resolve the deadlock. His presentation, aptly
titled “Look Before You Leverage,” seeks to address the company's
financial health, project feasibility, and the broader implications of the
financing decision on the firm’s future stability and growth.
 II. Statement of the Problem

After Andrew checks thoroughly the financial statements of the

company, these are following the questions that arise.

1. What is the best option to take in raising additional funds?

2. Is it better to issue a long term bank note, and pay the fixed
interest rate?

3. Or to issue new common stock, and take advantage of the

booming stock market?

III. Areas of Consideration

A. Impact of Debt Financing on Shareholders

A highly leveraged company has more debt than equity. Most firms take
on debt to finance their operations and growth, this is included or part of
a capital structure. Debt is favorable to issuing equity capital but too
much of it can increase the riskiness of the businesses of default.
Leverage could be operating and financial and using both is indeed a
risky investment. High operating leverage means that a firm makes dew
sales but with higher margins which could lead to unreliable future sales
forecasts. And those forecasts which are higher than usual could lead to a
huge discrepancy between actual and budgeted cash flow, which also has
an effect on the ability of the firm to properly operate. And in terms of
financial leverage, a huge risk implies when the ROA does not exceed the
interest on loan which decreases the ROE of the company or simply the
profitability of the company.

B. Financial Losses
Profit indicates that a firm is offering services or goods that are in
demand by customers and losses resulting from business operations have
the opposite effect. All firms encounter downturns and those facing
reduced market share from lower consumer demand may reduce
operational output. And as a result, firms must take additional measures
depending on the business losses. What is worse is that losses may lead
to bankruptcy. In this case, on leverages, investors may mostly want to
employ to leverage to generate greater ROA but losses are more possible
from highly leveraged positions, therefore it is important to keep the
firm’s options in track to know whether it is healthy to take the risk since
there is a direct relationship between financial leverage and solvency
since a company that makes too much debt or images in higher
borrowings may face bankruptcy in downturns, and some with only less
leverage could avoid it because of higher liquidity.

C. Homemade Leverage
Homemade Leverage refers to the concept that investors can
replicate the effects of corporate financial leverage on their own by
adjusting their personal investment portfolios, without the company
needing to undertake debt financing. This idea stems from Modiglani and
Miller’s Proposition I, which asserts that in a perfect capital market, the
value of the firm is unaffected by its capital structure. If a firm decides
not to use debt, an investor who desires the benefits of leverage can
borrow money personally and invest it in the firm’s equity to achieve the
same pay off as if the firm had issued debt. Conversely, if the firm uses
debt but an investor prefers an unleveraged position, the investor can sell
part of their equity holdings and pay off personal debt to “deliver” their
position.

D. Conservative Views of Board Members

The views and decisions of board members are very important. A
board of directors is a body of people who are chosen to represent
shareholders. The board of directors is a governing body that meets on a
regular basis to establish policies for corporate management and
oversight. A board of directors is required for every public corporation.
The board members have enough knowledge in decision making for what
is best for the company. The board of directors acts on behalf of the
company’s shareholders, making policy decisions and overseeing the
company’s operations. They have fiduciary responsibilities to the
company’s shareholders as well. This ensures that the board of directors
is in charge of financial oversight and other critical duties that contribute
to the corporation’s smooth operation.

IV. Alternative Courses of Action

A. Issuance of Debt to raise required capital

The impact on a firm’s shareholders is clearly revealed through its Return

on Equity (ROE). A 10% decline in sales, leading to a net income of
$1,320,000, directly results in a lower ROE, showcasing the vulnerability
of shareholder returns to sales fluctuations. Conversely, when sales
increase by 10%, 30%, or even 50%, ROE experiences a significant
boost, reaching levels of 12.4% and 16% with higher sales. This
compelling evidence underscores that increased sales are vital for
maximizing shareholder returns, especially with a 30% rise or more.

Additionally, debt issuance critically shapes a firm’s financial landscape.

A heightened tax rate substantially enhances the tax benefits derived
from debt, as interest payments lower taxable income effectively.
Moreover, debt can enforce discipline on management by restricting
available cash flows, driving greater efficiency and accountability. The
predictability of debt obligations also aids in precise financial planning.

Nevertheless, it is important to acknowledge the risks associated with

debt issuance. The threat of increased bankruptcy is real, as lenders may
seize control of the company if interest payments falter, undermining
shareholder authority. Moreover, debt obligations can constrain a firm’s
financial flexibility and escalate the costs or limit the availability of
future financing. Thus, aligning total borrowing levels with the firm’s
optimal capital structure and capital return strategy is essential for
shareholders. Mismanagement of debt, whether due to external pressures
like income loss or internal challenges such as resource misallocation,
can deepen financial instability, emphasizing the necessity for careful and
strategic debt management.
B. Homemade leverage with Debt

The fluctuations in sales have a profound effect on a firm's shareholders,

evident through the changes in Return on Equity (ROE). A mere 10%
decrease in sales can lead to a decline in ROE, resulting in a net income
of $1,620,000. In sharp contrast, when sales experience increases of 10%,
30%, or even 50%, ROE shows remarkable growth, peaking at levels of
10.8% and 13.5% as sales rise. This highlights a compelling argument:
boosting sales, particularly by 30% or more, can significantly enhance
returns for shareholders.

Additionally, the connection between rising sales and Earnings Per Share
(EPS) is striking, especially against a debt backdrop of $5,000,000. With
a 10% increase in sales, EPS stands at $1.32; however, a 30% increase
propels it to $1.86, and a soaring 50% increase results in an impressive
$2.40 per share. These figures powerfully illustrate how effective sales
growth can translate into tangible benefits for shareholders.

Moreover, the concept of homemade leverage empowers investors to

replicate corporate leverage through personal borrowing, transforming an
unleveraged firm into a leveraged one without the financial strain of
interest payments. This strategic approach allows investors to capitalize
on corporate advantages while minimizing tax liabilities. By adeptly
managing sales growth, ROE, and tax implications, companies can not
only boost their earnings but also enhance shareholder value
significantly. Embracing these strategies is essential for driving long-term
success and ensuring robust returns for investors.

C. Homemade leverage without Debt

In scenarios where the company raises capital without debt, it must issue
additional shares, resulting in an inflated total of approximately
1,333,333.33 shares. This dilution inevitably diminishes the EPS,
contrasting sharply with the benefits derived from using debt to fund
operations.

For instance, with a 10% rise in sales, EPS without debt reaches only
$1.22, while EPS with debt climbs to $1.32. The disparity grows with
major sales increases: at 30% and 50%, EPS for the no-debt scenario
remains at $1.62 and $2.03, respectively, compared to $1.86 and $2.40
when employing debt. These figures powerfully illustrate that utilizing
debt effectively safeguards shareholder value by allocating net income
across a smaller pool of shares, thus resulting in a more favorable EPS.

Additionally, debt financing offers the vital advantage of interest payment

tax deductions, which lowers taxable income and can significantly
enhance net profitability. On the other hand, the method of raising funds
through new share issues lacks such tax benefits and risks diluting the
ownership stakes of existing shareholders.

In summary, both strategies aim to bolster financial flexibility and

leverage. However, through debt, companies can more effectively
preserve EPS, maintain shareholder interests, and reap tax advantages,
making it the more strategic and efficient option in the majority of
situations.

V. Conclusion & Recommendation

Recommendations
• Maintain a Balanced Capital Structure: It is advisable for
Symonds Electronics to adopt a balanced approach to debt
financing. While increasing leverage can reduce the WACC and
enhance profitability (EPS, ROE), it is essential to avoid
excessive reliance on debt. A moderate debt-to-equity ratio, such
as the 33.33% ratio in the current scenario, appears optimal. This
would allow the firm to benefit from the cost advantages of debt
while minimizing the financial risk associated with high levels of
leverage.
• Monitor Sales Growth: The effectiveness of debt financing is
highly dependent on achieving the anticipated sales growth. To
maximize the benefits of debt, the company should prioritize
strategies that increase sales, especially aiming for the 30% or
higher increase in revenue as projected. Failure to achieve these
growth targets could lead to a decrease in profitability due to the
added interest costs, which could undermine the potential benefits
of leveraging.

• Evaluate Debt Financing Costs: The company should carefully

assess the long-term impact of borrowing, including the stability
of interest rates. Although a 10% interest rate is currently factored
into the analysis, any significant changes in borrowing costs or
financial market conditions could affect profitability. Regularly
reviewing debt terms and refinancing options is crucial to
managing costs effectively.

• Focus on Return on Equity and Shareholder Value: Debt

financing enhances ROE due to the leverage effect, and the
company should prioritize maintaining high ROE by aligning its
financial strategy with long-term growth objectives. By ensuring
that the increase in equity value outpaces the cost of debt,
Symonds Electronics can continue to boost shareholder value.

Conclusion
In conclusion, raising capital through debt financing at Symonds
Electronics Inc. can have several implications for shareholders.
The firm's earnings per share (EPS) can increase, particularly in
scenarios where sales growth exceeds expectations, such as the
30% increase scenario, where EPS rises to $1.725. Similarly,
 return on equity (ROE) shows improvement, rising from 9% to
14.5%, reflecting the positive effect of leveraging debt on
profitability metrics. However, the introduction of debt financing
also increases interest expenses, which in turn affects net profit
margins, though the overall effect on profitability ratios like ROE
and EPS is still favorable if sales growth meets or exceeds
expectations. In terms of the weighted average cost of capital
(WACC), introducing debt lowers the WACC from 12.88% to
11.59%, which reduces the firm's cost of capital and increases its
value, as long as the company does not rely excessively on debt.
A capital structure with a moderate debt-to-equity ratio, such as
the 33.33% D/E ratio in the case presented, appears optimal,
balancing the benefits of lower WACC and the risks associated
with increased leverage. Finally, if the firm were to finance
entirely through debt, profitability ratios like EPS, ROE, and
return on assets (ROA) would improve as long as sales growth
expectations are met. Therefore, debt financing, particularly when
managed carefully, provides Symonds Electronics with a
favorable way to boost shareholder value through enhanced
profitability, although risks such as increased interest costs must
be carefully managed.

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

The implications of additional capital by means of debt financing to

shareholders are changes in EPS and ROE. These changes are closely related to
the company's future performance expectations. The assumptions used are that
COGS and Selling and Administrative Expense are variable (marginal) costs,
while depreciation is a fixed cost. Several alternative scenarios can be seen in
the following table:

Symonds Electronic Inc.

Projected

Current Worst Case 10% Potential 30% Best Case 50%

Sales 15,000,000.00 16,500,000.00 19,500,000.00 22,500,000.00

Cost of Goods Sold 10,500,000.00 11,550,000.00 13,650,000.00 15,750,000.00

Gross Profit 4,500,000.00 4,950,000.00 5,850,000.00 6,750,000.00

Selling and Admin Exp 750,000.00 825,000.00 975,000.00 1,125,000.00

Depreciation 1,500,000.00 1,500,000.00 1,500,000.00 1,500,000.00

EBIT 2,250,000.00 2,625,000.00 3,375,000.00 4,125,000.00

Interest (10% of 5M) 0 500,000.00 500,000.00 500,000.00

EBT 2,250,000.00 2,125,000.00 2,875,000.00 3,625,000.00

Taxes 40% 900,000.00 850,000.00 1,150,000.00 1,450,000.00

Net Income 1,350,000.00 1,275,000.00 1,725,000.00 2,175,000.00

Shares Outstanding (5M/5) 1,000,000.00 1,000,000.00 1,000,000.00 1,000,000.00

Earnings Per Share 1.35 1.275 1.725 2.175

Common Equity 15,000,000.00 15,000,000.00 15,000,000.00 15,000,000.00

Return on Equity 9.00% 8.50% 11.50% 14.50%

From the calculation above, it can be seen that debt financing can
change the company's EPS from 1.35 to between 1.275 - 2.175 (depending on
the revenue growth scenario). If the company's expectation that sales will
increase by 30% is achieved, then EPS will increase by 0.375. On the other
hand, the company's ROE will be at 8.5% -14.5%, and the company's
expectation is at 11.5%, an increase of 2.5% from the current condition.

2. What does “homemade leverage” mean? Using the data in the case
explains how a shareholder might be able to use homemade
leverage to create the same payoffs as achieved by the firm.

Symonds Electronic Inc.

Projected

Current Worst Case 10% Potential 30% Best Case 50%

Sales 15,000,000.00 16,500,000.00 19,500,000.00 22,500,000.00

Cost of Goods Sold 10,500,000.00 11,550,000.00 13,650,000.00 15,750,000.00

Gross Profit 4,500,000.00 4,950,000.00 5,850,000.00 6,750,000.00

Selling and Admin Exp 750,000.00 825,000.00 975,000.00 1,125,000.00

Depreciation 1,500,000.00 1,500,000.00 1,500,000.00 1,500,000.00

EBIT 2,250,000.00 2,625,000.00 3,375,000.00 4,125,000.00

Interest (10% of 5M) 0 0 0 0

EBT 2,250,000.00 2,625,000.00 3,375,000.00 4,125,000.00

Taxes 40% 900,000.00 1,050,000.00 1,350,000.00 1,650,000.00

Net Income 1,350,000.00 1,575,000.00 2,025,000.00 2,475,000.00

Shares Outstanding 1,000,000.00 1,333,333.00 1,333,333.00 1,333,333.00

Earnings Per Share 1.35 1.18 1.52 1.86

Common Equity 15,000,000.00 20,000,000.00 20,000,000.00 20,000,000.00

Return on Equity 9.00% 7.88% 10.13% 12.38%

Eliminate the leverage effect of the company. They can borrow money
(to gain leverage) or lend money (eliminate the leverage effect). This can be
done by shareholders to obtain the desired effect or eliminate the effect that is
considered detrimental and risky from their investment. For example, if a
company leverages, but an investor feels that the effects that will come from this
decision are irrational, too optimistic or too pessimistic, they can eliminate or
obtain the effect desired by the investor, by borrowing money or lending their
money with the same interest rate as the rate issued by the company for their
debt financing until they have the same Debt to Equity ratio as the company if
they leverage, then these funds will be used to buy additional shares or reduce
shares if they want to lend money, this is to anticipate or payoff the effects of
the company's capital structuring decision. We can assume an investor in
Symonds Electronics has 200 shares, with a price per share of $ 15, so the total
investment is $ 3000. If the company expands by issuing debt of $ 5,000,000,
the EPS of the company becomes $ 1,185, $ 1,455, and $1,725 ​according to the
given scenario. Now if the expansion is done purely from equity alone, then the
EPS will be as shown in the table below.

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?

ß = 1.1
rf = 4%
rm = 12%
RE = 4% + 1.11*(12% - 4%) = 12.88%

Because at first the company in doing this expansion did not have a debt
portion in its funding (full equity), then the company did not have a cost of debt.
This causes the WACC of Symonds Electronics to be as large as their cost of
equity or the cost of an unlevered firm (RE) = Risk-free rate + Beta (Market
Rate – Risk-free rate)

RE = RU + (RU – RD) x (D/E) x (1-TC)

RE =R no debt + (R no debt – interest rate on 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)
13.45%
If the company turns out to be financing from debt, then their debt-equity ratio
will increase, which will change their cost of equity to be more expensive.
According to the case, the company will borrow $5,000,000 with an interest rate
of 10% per year and make the D/E Ratio to 33.33%

WACC = (E/V) x (RE) + (D/V) x RD x (1-TC)

$15,000,000/$20,000,000)*(13.45%) +5,000,000/20,000,000)*10%*0.60
11.59%

So, with the change in cost of equity and the emergence of new cost of debt due
to financing from debt, Symonds Electronics' WACC will change to:

The effect of the change in WACC which has decreased from 12.88% to 11.59%
is actually good for the company, because as we know WACC describes how
much cost we have to spend in collecting funding from equity or debt, so the
smaller the WACC, the smaller the cost related to this funding that must be paid

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 effect 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.

Debt/V Equity/
D/E RE WACC Debt Vu VI
alue Value

0 1 0.010 12.88% 12.88% 0 13625776 13625776

0.01 0.99 0.010 12.90% 12.83% 136257.8 13625776 13680280

0.02 0.98 0.020 12.92% 12.78% 272515.5 13625776 13734783

0.03 0.97 0.031 12.93% 12.73% 408773.3 13625776 13789286

0.04 0.96 0.042 12.95% 12.67% 545031.1 13625776 13843789

0.05 0.95 0.053 12.97% 12.62% 681288.8 13625776 13898292

 0.06 0.94 0.064 12.99% 12.57% 817546.6 13625776 13952795

0.07 0.93 0.075 13.01% 12.52% 953804.3 13625776 14007298

0.08 0.92 0.087 13.03% 12.47% 1090062 13625776 14061801

0.09 0.91 0.099 13.05% 12.42% 1226320 13625776 14116304

0.1 0.9 0.111 13.07% 12.36% 1362578 13625776 14170807

0.11 0.89 0.124 13.09% 12.31% 1498835 13625776 14225311

0.12 0.88 0.136 13.12% 12.26% 1635093 13625776 14279814

0.13 0.87 0.149 13.14% 12.21% 1771351 13625776 14334317

0.14 0.86 0.163 13.16% 12.16% 1907609 13625776 14388820

0.15 0.85 0.176 13.18% 12.11% 2043866 13625776 14443323

0.16 0.84 0.190 13.21% 12.06% 2180124 13625776 14497826

0.17 0.83 0.205 13.23% 12.00% 2316382 13625776 14552329

0.18 0.82 0.220 13.26% 11.95% 2452640 13625776 14606832

0.19 0.81 0.235 13.29% 11.90% 2588898 13625776 14661335

0.2 0.8 0.250 13.31% 11.85% 2725155 13625776 14715839

0.21 0.79 0.266 13.34% 11.80% 2861413 13625776 14770342

0.22 0.78 0.282 13.37% 11.75% 2997671 13625776 14824845

0.23 0.77 0.299 13.40% 11.70% 3133929 13625776 14879348

0.24 0.76 0.316 13.43% 11.64% 3270186 13625776 14933851

0.25 0.75 0.333 13.46% 11.59% 3406444 13625776 14988354

0.26 0.74 0.351 13.49% 11.54% 3542702 13625776 15042857

0.27 0.73 0.370 13.52% 11.49% 3678960 13625776 15097360

The partial table above shows that as the debt-equity ratio increases the WACC
of the firm decreases and approaches the after-tax cost of debt. As can be seen
from the graph above, with 100% debt the value will be maximized. But we
must realize that this is quite impossible considering that no company can run
with 100% debt.

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?
Symonds Electronics profitability ratio if the company finances by issuing
5-year notes is as follows: (in various scenarios)

Symonds Electronic Inc.

Projected

Current Worst 10% Bad 20% Expected 30% Good 40% Best 50%

Sales 15,000,000.00 16,500,000.00 18,000,000.00 19,500,000.00 21,000,000.00 22,500,000.00

Cost of Goods
Sold 10,500,000.00 11,550,000.00 12,600,000.00 13,650,000.00 14,700,000.00 15,750,000.00

Gross Profit 4,500,000.00 4,950,000.00 5,400,000.00 5,850,000.00 6,300,000.00 6,750,000.00

Selling and
Admin Exp 750,000.00 825,000.00 900,000.00 975,000.00 1,050,000.00 1,125,000.00

Depreciation 1,500,000.00 1,500,000.00 1,500,000.00 1,500,000.00 1,500,000.00 1,500,000.00

EBIT 2,250,000.00 2,625,000.00 3,000,000.00 3,375,000.00 3,750,000.00 4,125,000.00

Interest (10%
of 5M) 0 500,000.00 500,000.00 500,000.00 500,000.00 500,000.00

EBT 2,250,000.00 2,125,000.00 2,500,000.00 2,875,000.00 3,250,000.00 3,625,000.00

Taxes 40% 900,000.00 850,000.00 1,000,000.00 1,150,000.00 1,300,000.00 1,450,000.00

Net Income 1,350,000.00 1,275,000.00 1,500,000.00 1,725,000.00 1,950,000.00 2,175,000.00

Shares
Outstanding
(5M/5) 1,000,000.00 1,000,000.00 1,000,000.00 1,000,000.00 1,000,000.00 1,000,000.00
Earnings Per
Share 1.35 1.275 1.5 1.725 1.95 2.175

Current
Liabilities 5,000,000.00 5,000,000.00 5,000,000.00 5,000,000.00 5,000,000.00 5,000,000.00
Additional
Debt 5,000,000.00 5,000,000.00 5,000,000.00 5,000,000.00 5,000,000.00

Equity 15,000,000.00 15,000,000.00 15,000,000.00 15,000,000.00 15,000,000.00 15,000,000.00

Total Assets 20,000,000.00 25,000,000.00 25,000,000.00 25,000,000.00 25,000,000.00 25,000,000.00

Debt Equity
Ratio 0.00% 33.33% 33.33% 33.33% 33.33% 33.33%
Net Profit
Margin 9.00% 7.73% 8.33% 8.85% 9.29% 9.67%
Return on
Equity 9.00% 8.50% 10.00% 11.50% 13.00% 14.50%
Return on
Assets 6.75% 5.10% 6.00% 6.90% 7.80% 8.70%

The assumptions used are that COGS and Selling and Administrative Expense
are variable (marginal) costs, while depreciation is a fixed cost. The table above
shows that through debt financing, the company can increase its EPS, ROA, and
ROE if the expected increase in sales growth of 30% is achieved. The decrease
in the company's net profit margin in the scenario according to expectations is
mainly due to interest costs. In general, it can be said that the choice of
expansion with debt financing is the right choice for Symonds Electronic.

6. If you were Andrew Lamb, what would you recommend to the

board and why?

We would recommend to Bob Symonds to continue with the expansion project,

because the estimated sales that will emerge from this project will add revenue
with a fairly good amount, although in the worst case scenario, because of
overtime, the initial outlay of this project will be covered by the additional sales
due to this expansion. For the funding of this project, we recommend to Bob
Symonds to fund it through the issuance of $5,000,000 debt for this expansion
project. We can say this because currently there is no debt that can cause the
company to experience potential distress that can lead to bankruptcy. The EBIT
expected to emerge from this expansion project can also be seen as positive and
on the other hand the value of the company (value of the firm) will increase
with the addition of debt in the company's capital structure due to the effect of
leverage that is carried out, mostly because of the tax-shield for interest which
causes the company's after tax cost of debt to decrease.

7. What are some issues to be concerned about when increasing

leverage?

Things to consider in increasing leverage in a company are revenue, taxes and

financial distress costs. Revenue must be considered because revenue describes
the total income earned by the company, some of which will be used to pay for
costs related to this leverage, so the company's revenue must be considered in
order to pay for leverage costs and be able to make a profit afterwards. Taxes
can be an advantage in leveraging, namely getting a tax shield or tax credit from
interest payments. Next is the financial distress cost.

The high debt ratio in a company will gradually cause the company to
experience financial distress when they get a period of low profitability.
Financial distress costs are divided into two categories, namely ex ante (before
the event) and ex post (after the event), which is meant by the event here is
bankruptcy. Financial distress costs included in ex ante are increased borrowing
costs, because usually companies that are already having financial difficulties
will have difficulty getting a good loan "deal". While for financial distress costs
included in ex-post are the costs of filing for bankruptcy, lawyers and
accountants to resolve this bankruptcy dispute.

By considering the three important points related to increasing the leverage

level, it can be concluded that companies that have a large potential to
experience financial distress and whose revenue is quite unstable, should
borrow less funds and be more careful in building the company's capital
structure compared to companies that have stable revenue.

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.

Stock prices depend on several factors including EPS and risk. In the case of
positive profitability in the short term, stock prices can increase if analysts and
investors do not take into account increased risk. However, if the market expects
increased risk, the Price-Earnings ratio can fall and stock prices will follow.

Debt ratio is a comparison between the level of debt and the amount of assets
that describes the proportion of debt in supporting the company's assets. So the
higher the debt ratio, it can be said that the company's need for debt in
generating company assets is also higher. Meanwhile, debt will not be free from
the element of risk. Ceteris paribus, the level of risk will be higher if the
company's debt level is higher. Therefore, even though the company's
profitability increases, if it is accompanied by a higher increase in risk
compared to the increase in the company's profitability, then the stock price
level is not impossible to actually decrease. However, if it is felt that there is no
significant increase in the company's risk, then the assumption that the stock
price will increase is reasonable.

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)

Using Modigliani and Miller proportions with taxes, the value of a levered firm
(VL) is equal to the value of an unlevered firm (VU) plus the value of the tax
shield:

VL = VU + TcD

Where Tc is the corporate tax rate and D is the amount of debt.

VU = EBIT (1-Tc)
RU
Using proportion II with taxes: Cost of equity (RE):

RE = RU + (RU – RD) X (D/E) x (1-TC)

In this case then:

Vu = $1,755,000/0.1288 = $13,625,776.4

The amount of debt increases the value of the firm so that the value of the firm
at 99% debt is $19,021,584.

The (WACC) decreases from 12.88% to 7.78% and the cost of equity (RE)
increases from 12.88% to 183.95% as the firm relies on debt financing.

WACC = (E/V) x (RE) + (D/V) X RD x (1-TC)