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Financing Alternatives Lester Electronics

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Lester Electronics Financing Alternatives Benchmarking


University of Phoenix

R. Daniel Dague, CFP, MBA


Maximizing Shareholder Wealth

January 15, 2008

Financing Alternatives Benchmarking

Workshop 5 Assignment

Financing Alternatives Benchmarking

Corporate growth usually occurs internally when a firm grows its existing departments through normal capital budgeting activities. However, the most dramatic examples of growth sometimes results from mergers. Many reasons have been offered by financial managers to account for frequent merger activity. The primary motivation behind a merger is that it provides an opportunity to bring together and increase the value of the combined enterprise.

One commonly used researched tool available to organizations who are considering a merger in benchmarking. Benchmarking is the process of identifying, understanding, and adapting best practices from other industries and organizations. Benchmarking is an activity that gives businesses the ability to look onward to find the best practice that fits the organization, much like LEI must do as it decides on the best solution for merging with Shang-wa. This paper will review the concepts of the weighted average cost of capital (WACC), operating leverage, Beta, financial mix, dividend policy, and financial risks as they apply to Panasonic, TNT, Kimball Electronics, John Deere, RxElite, GoAmerica, Riverside, Peace Microsystems and MedPro Safety Products, Inc.

Weighted Average Cost of Capital

Whenever a company is looking to make a financial decision that will significantly affect the financial state of the company, whether in a positive or negative way, the company must evaluate and weigh the costs that will be affecting the project. One of the ways that someone can place a value on a project is to use the weighted-average-cost-of-capital method. The WACC formula helps a company as well as creditors and investors to see how much the finance activities are costing the company. This approach begins with the insight that projects of levered firms are simultaneously financed with both debt and equity, Ð'Ё (Ross, S.A., Westerfield, R.W., Jaffe, J., 2005, p. 13). Similarly, prudent companies want to see a low WACC; and generally a company can withstand a debt to equity mix up to about 50% without having a real problem. In fact, a company may even lower their WACC by the use of more debt. This presents one of the various ways that Lester Electronics can finance its upcoming project of merging with supplier Shang-Wa. The weighted average cost of capital method is useful because the cost of the business capital is a compared average of the cost of the debt and the cost of the equity involved with the financing of the project. This amount is the after tax cost of debt. Target ratios are generally expressed in terms of market values, not accounting values. (Recall that another phrase for accounting value is book value, Ð'Ё (Ross, et al., 2005, p.14).

Capital budgeting is a term used when discussing the process of determining whether or not a new project such as investing in a long-term venture, would be a worthwhile financial investment decision. In accordance to the definition of capital budgeting, this decision can be estimated by using the three methods of capital budgeting with leverage. The three methods include: the adjusted-present-value method which looks at the cash of a company at a specific date to the equity holders of an un-levered firm. It also reviews the cost of capital for the project of the un-levered firm as well, (Ross, et al., 2005, p. 25). The second type of capital budgeting method is the flow to equity method and the final method is the weighed average cost method.

However, different industries will have dissimilar WACC that are considered normal within that industry. This depends upon the level of debt acceptable for that industry. For example, airline companies have very high rates of debt even above 80% whereas software companies are generally around 30% (Block & Hurt, 2004). Different industries carry different mixes of debt and equity as stated previously. For the electronic capacitors and components industry the mix is right about 30% debts with 70% equity (Block & Hirt, 2004).

Determining the discount rate depends on company investments with leverage. A four step procedure is used to calculate all three discount rates. First determine the cost of equity using the security market line. Next determine the hypothetical all equity cost of capital. Thirdly determine the discount rate for levered equity, and finally use the weighed average cost of capital method.

Beta and leverage

“Since firms must pay corporate taxes in practice, it would be worthwhile to provide the relationship in a world with corporate taxes, Ð'Ё (Ross, et al., 2005, p. 46). Fortunately, for corporations, under taxes, leverage creates a risk less tax shield, thus lowering the risk of the entire firm. The beta of the equity of the firm is totally related to the influence of that firm.

Financing Mix that Optimizes Capital Structures

Financial difficulties influence firms’ ways to generate a profit. Buying and selling stocks is a viable solution. “An option is a contract giving its owner the right to buy of sell an asset at a fixed price on or before a given date, Ð'Ё (Ross, et al., 2005, p.1). LEI has the chance to use options with its stocks and Shang-wa stocks to recover from the money spent of the merger LEI is proposing.

When a company sees an acquisition in their future they are concerned with maintaining or improving their capital structure. For example, Home depot one of the largest building supply stores acquired Hughes supply of Florida which presented an opportunity for Home Depot to give their shareholders a call option. “A call option gives the owner the right to buy an asset at a fixed price during a particular period (Ross, et al., 2005, p.2).Ð'Ё This would allow Home Depot to put their stock on sell for a set value until a particular date giving



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