Question

Leverage Benefits: You have finished your MBA and taken job at a small manufacturing company that specializes in restoring old fj-40 Land Cruisers and the Series II and III Land rovers (the classic safari vehicles you see in movies). With baby boomers retiring and fulfilling pent up dreams the business cannot keep up with demand for these classic rugged 4-wheel drive vehicles. The owners would like to expand but tell you they only have about half cash to pay for the expansion, which would cost about $600,000. You ask them why they don’t just borrow the other half. They say it is too expensive, especially compared to the cost of retained earnings. Current loans from the bank would cost 7% to 8%. The company is every profitable and the expansion would have a positive NPV at discounts up to 18% or 20%. The company’s tax rate is 30%.

A. Do you agree with the owners that debt is expensive compared to retained earnings?

B. Make a brief argument for why the owners should borrow and pursue this opportunity.

Answer 1

A. In this case , there is no cost of utilization of retained earning ( as cost of retained earning is the opportunity cost of the funds ), and the new debt will cost $21000-$24000(7%-8% of 300,000). thus it can be clearly seen that borrowed debt will be more expensive as compared to retained earnings.

B.The expansion gives a positive NPV At discount rates upto 18% or 20% this means that at required rate of return of 18%-20% the expansion has positive NPV. this means that the expansion projects is in the money(surplus/positive cash flows). at such high rates of discounts.

if the manufacturer borrowed the funds and pursues the expansion opportunity the cashflows ( which were earlier discounted at 18%-20% will now be discounted at 7%-8%(cost of debt) and the magnitude of the npv will increase (as the denominator will get smaller the npv will increase). thus borrowing the funds and pursuing this opportunity will be benifitial for the manufacturer .