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Gentry Inc. is a mid-sized tech firm (200 employees and $300 million in revenue) and has been privately held since the firm’s inception ten years ago. The organization’s board of directors is keen on expanding the operations globally to take advantage of a growing market. Based on reports from the research and development team, the organization can increase its profitability metrics by 15 to 25% if it expands the operations to China, Japan, and Germany. Becoming a multinational organization will not be easy. To finance this expansion, the board of directors has decided to take the organization public and issue some bonds to raise an additional $50 million. The research team has already determined that the organization meets the financial requirements outlined by the Securities Exchange Commission. The goal is to maximize the Initial Public Offering (IPO), and the leadership must efficiently manage the capital, measure the risk of the investments, and ensure the financial metrics are robust relative to similarly sized organizations.
Based on the information that you learned about capital structure and budgeting, determine what the optimal capital structure should be for Gentry. You will need to determine how much equity (common stock) the company will offer in the IPO and how much debt the company should assume in their global expansion to meet the goal of $50 million.
Expert Answer
Optimal capital structure is the one that has lowest WACC. Lower the WACC, lower the discount rate and NPV would be higher.
There are several methods to find out WACC, namely; Net Income Approach, Net Operating Income Approach, Tradutional Approach. Each method has few assumptions.
- In Net income approach, cost of equity (Re) and cost of debt (Rd) are assumed to be constant.
- In Net Operating Income approach, cost of equity rises to compensate reduced cost of debt and keeps overall rate constant.
- In Traditional approach, cost of debt increases gradually due to which overall cost of capital falls initially. After certain point of leverage, debt suppliers would raise cost of debt and shareholders experience threat of debt interest and would expect higher returns raising cost of equity.
- Since cost of capital falls initially and then starts rising, there would be a point where overall capital cost would be minimum. This point would be Optimal capital structure.
I have used Traditional Appoach here:
Assumptions:
- EBIT of $300m each year and 4 scenarios have been considered with debt-equity ratio of (Scenario 1)1:9, (Scenario 2) 1:4, (Scenario 3) 1:1, (Scenario 4) 9:1.
- Tax rate hasn’t been considered.
- Cost of debt and cost of equity have been assumed.
Formulae used:
1) Market value of debt = Interest / Cost of debt
2) Market value of equity = EAT / Cost of equity
3) Value of firm = Market value of debt + Market value of equity
4) WACC = EBIT / Value of firm
Outcomes of 4 scenarios are mentioned below in table:
| Scenario 1
D/E = 1:9 |
Scenario 2
D/E = 1:4 |
Scenario 3
D/E =1:1 |
Scenario 4
D/E = 9:1 |
|
| Project Cost | 50 | 50 | 50 | 50 |
| Sources of Finance: | ||||
| Equity | 45 | 40 | 25 | 5 |
| Debt | 5 | 10 | 25 | 45 |
| Capitalization Rate: | ||||
| Debt (Rd) | 10% | 11% | 12% | 13% |
| Equity (Re) | 20% | 20% | 25% | 30% |
| EBIT | 300 | 300 | 300 | 300 |
| Interest (Debt*Rd) | 0.5 | 1.1 | 3 | 5.85 |
| EBT | 299.5 | 298.9 | 297 | 294.15 |
| Tax | No tax | No tax | No tax | No tax |
| EAT | 299.5 | 298.9 | 297 | 294.15 |
| Market Value of debt (Interest/Rd) | 5 | 10 | 25 | 45 |
| Market Value of equity (EAT/Re) | 1497.5 | 1494.5 | 1188 | 980.5 |
| Value of firm | 1502.5 | 1504.5 | 1213 | 1025.5 |
| WACC | 0.1996 | 0.1994 | 0.2473 | 0.2925 |
WACC (in %) for below scenarios:
Scenario 1: 19.96%
Scenario 2: 19.94%
Scenario 3: 24.73%
Scenario 4: 29.25%
Optimal Capital structure would be Scenario 2 i.e.; Debt/Equity = 1/4 since WACC is lowest.
