Why do things have to be so complicated? said Barry to Daniel, as he sat at his

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“Why do things have to be so complicated?” said Barry to Daniel, as he sat at his desk shuffling papers around. “I need you to come up with a convincing argument.” Barry’s company, Okay Facebooks, 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 $10,000,000. What Barry was wondering about was whether he should burden the firm with fixed rate debt or issue common shares/stock to raise the needed funds. Having had no luck with getting the board of directors to vote on a decision, Barry decided to call on Daniel, his CFO to shed some light on the matter. Barry, the CEO of Okay Facebooks, established the company about 10 years ago in his hometown, Canberra. After taking early retirement at the age of 43, Barry felt he could really capitalise on his psychology knowledge and contacts within the industry. Barry remembered vividly how easily he 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 didn’t realise just how much the Facebook services were needed. People needed counselling from traumatic Facebook experiences and were prepared to pay. Some were seriously traumatised from planking images and paid well to be brainwashed or re-assigned as he liked to call it. 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 revenues had doubled about every 4 years. As revenues began to escalate with the booming economy and thriving stock market, the firm had needed additional capital. Initially, Barry 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, Barry decided to take the company public via and initial public offering (IPO) on the Australian Securities Exchange. The issue was very successful and oversubscribed, mainly due to the superb publicity and marketing efforts of the investment underwriting company that Barry had excellent relations with. 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 $30 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 on 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 hurdle rate. Ordinarily, the project would have started using internal and spontaneous funds. However, at this juncture, the firm had already invested all its internal equity into the business. Thus, Barry 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, Barry learned that they could issue 5-year notes, at par, at a rate of 10% per year. Conversely, the company could issue common stock/shares at their current price of $30 per share. Being unclear about what decision to make, Barry 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, who were based in the US, felt that the tax shelter offered by debt would help reduce the firms overall cost of capital and prevent the firm’s earning 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 investor leverage 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 confused and frustrated, Barry decided to call upon his CFO, Daniel, to resolve this dilemma. Daniel had joined the firm about two years ago. He held an MBA from the University of Wollongong and had recently completed his Chartered Financial Analysts’ certification. Prior to joining Okay Facebooks, Daniel had worked at two other publicly traded firms and had been successful in helping them raise capital at attractive rates, thereby lowering their cost of capital considerably. Daniel knew he was in for a challenging task. He felt however that this was a good opportunity to prove his worth. He had just received a salary increase and was given a new Porsche as part of his package. Barry asked him to prepare a presentation. In preparation of his presentation, he got the latest income statement and balance sheet of the firm (see Tables 1 and 2) and started to crunch the numbers. The title of his presentation is “Leverage is a lever, and look before you lever”.

Table 1 Okay Facebooks Pty Ltd Latest balance sheet 2,000,000 Accounts payable 6,000,000 Accruals 8,000,000 16,000,000 Total

Questions:

1. If Okay Facebooks Pty Ltd were to raise all of the required capital by issuing debt, what would the impact be on the firm’s shareholders?

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

3. The firm’s asset beta was estimated to be 1.2. Commonwealth Treasury bills were yielding 4% p.a. and the expected rate of return on the market index was expected to be 12%. Using various combinations of debt and equity, show the effect of increasing leverage on the weighted average cost of capital of the firm.

4. 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. Is there a particular capital structure that maximises the value of the firm? Explain.

6. How would key profitability ratios of the firm be affected if the firm were to raise all the capital by issuing 5-year notes?

7. If you were Daniel, what would you recommend to the board and why?

8. What are some of the issues to be concerned about when increasing leverage?

9. Is it fair to assume that if profitability is positively affected in the short run, due to higher debt ratio, the stock price would increase? Explain.