Using financial leverage in practice.

Epsilon, an LCD monitor assembly company, wants to raise 525 million PLN in next two years. You find out that Epsilon would be able to rise 225 million of this total out of operating cash flows and excess cash, leaving 300 million to be financed externally.

Historically, the company had sought to limit capital expenditures to an amount that could be financed out internally generated funds and modest new borrowings. However, the board of directors deemed the current investments to important to postpone.

Several members of senior management want to use financial leverage to increase earnings per share, a key determinant of Epsilon executive's bonuses. These executives saw the current situation as an ideal opportunity to right the balance by financing by debt.

Investment bankers indicated that the company could raise the needed money in either two ways:

1. Sell 15 million new shares of common stock at a net price of 20 PLN per share.

2. Sell 300 million, par value bonds at an interest rate of 12%. The maturity would be 20 years, and the bonds would carry an annual sinking fund of 15 million.

Looking in the future, you could expect that EBIT would increase to about 300 million in next year. Epsilon's EBIT performance was rather volatile (look at the table 1). You further anticipated that a need for outside capital in the coming years would rise, probably to 50-100 million range annually. The company had paid annual dividends of 0,5 PLN per share in recent years and you may assume management intended to do so. Table 2 presents selected information about the two financing options in 2007.

Leverage and Risk

Your first task is to estimate if the Epsilon can safely carry the financial burden imposed by debt. After the “Corporate Finance” classes you know that you may do this in two ways: build pro forma financial statements and improve you estimation with sensitivity analysis and simulations, or more simply to analyze the coverage ratios.

The before- and after-tax burdens of Epsilon financial obligation under two financing options appear in the top portion of Table 3. (Note! The Epsilon's effective tax rate is 25%) Three coverage ratios, corresponding to the progressive addition of each financial obligation are listed in the table 3 as well.

Of course, you should compare your calculations with industry averages, which are reported in Table 4.

Leverage and earnings

After formulating the propositions for risk exposure in each financial proposition, you wonder what will be an impact of each financial scenario on reported earnings. We can safely assume, that these two financial plans will not affect the way of future cash flows will be generated. Of course, these plans will influence the way the future cash flows will be divided among owners, creditors and tax collectors. For that reason, we may start our analysis of reported earnings with EBIT.

You decided to analyze the pro forma profit and loss statement under bust and boom scenario. Bust corresponds to recessionary EBIT of 100 million PLN, while boom represents a very healthy EBIT of 500 million PLN.

Questions

1. Calculate the change in selected financial information presented in Table 2 in two financing options in 2007.

Table 2 Selected information about Epsilon financing options (millions)

	Before new financing	Stock financing	Bond Financing
Interest bearing debt	160	160	460
Interest expense	16	16	52
Principal payments	40	40	55
Shareholders equity (book value)	820	1120	820
Common shares outstanding	50	65	50
Dividends paid at 0,5 PLN per share	25	33	25
Debt ratio

Comment……………………………………………………………………………………………………………………………………………………………………………………………………………………………………………………………………………………………

2. Calculate coverage ratios in table 3. Note that

1. 
   

2. 
   

3. 
   

Table 3

	Stock		Bonds
	After tax	Before tax	After tax	Before tax
Financial obligations
Interest expense		16		52
Principal payment	40	67	55	92
Common dividends	33	55	25	42
	Stock		Bonds
	Coverage	%EBIT Can Fall	Coverage	%EBIT Can Fall
Coverage ratios
Times interest earned	18,8	95%	5,8	83%
Times burden coveraged	3,6	72%	2,1	52%
Times common coveraged	2,2	54%	1,6	38%

Do you think that figures in table 3 confirm greater risk inherent in debt financing?

Comment………………………………………………………………………………………………………………………………………………………………………………………………………………………………………………………………………………………………………………………………………………………………………………………………

3. Compare your results with industry indicators? What is your opinion on firm's financial risk? Do you think that debt financing is feasible?

Table 4

	2003	2004	2005	3^rd Q of 2006
WIG
Debt ratio	20	20	19	19
TIE	5,5	5,6	5,8	6,2
Electrical Equipment and Computer Devices
Debt ratio	21	16	17	19
TIE	16,2	10,6	17,0	17,2

Comment……………………………………………………………………………………………………………………………………………………………………………………………………………………………………………………………………………………………

4. Estimate the impact of financial leverage on company's performance using the table 5.

Table 5

Scenario	Break-down		Realistic		Boom
		Stocks	Bonds	Stocks	Bonds	Stocks	Bonds
EBIT	100	100	300	300	500	500
Interest	16	52	16	52	16	52
EBT	84	48	284	248	484	448
Tax (25%)	33,6	19,2	113,6	99,2	193,6	179,2
Net income	50,4	28,8	170,4	148,8	290,4	268,8
Number of shares outstanding	65	50	65	50	65	50
EPS	0,78	0,58	2,62	2,98	4,47	5,38
Effect of financial leverage
ROIC
net cost of debt
ROE

5. Calculate the break-even for debt financing using the EPS. Draw the EBIT-EPS relationship for two financing scenarios.

6. Play the role of the consultant. What is your advice for managers? Use all available information from the case. List all missing information.

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You know that if `real' money would be involved the detailed pro forma would be the order of the day.

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