Question

Riley-Rocky Roof!Ing, Inc. is a new company that replaces shingled roofs with metal roofs in the Kansas City area. The product is superior, and as a result, sales are going crazy. The company is only two years old and it's return on assets will easily exceed 20% for at least the next four years. The cost of borrowing funds--which are needed to purchase the equipment needed to meet the growing demand--is 10% before taxes. The company's tax rate is 35 percent. The company's current capital structure is 90% equity, 10% debt, and the total assets are $4 million.

With this information, should the company borrow more money? If so, how much should it borrow, in your opinion? Support your view. There are no right or wrong answers here--there is only the logic you present to support your view.

Answer 1

Answer (a):

Yes, It should borrow and invest.

Explanation:

Given that:

Expected return on assets will easily exceed 20% for at least the next four years.

The cost of borrowing funds = 10% before taxes

After tax cost of fund = 10% * (1 - 35%) = 6.5%

Further current capital structure is: 90% equity, 10% debt.

As such the company is using very low %age of debt and it has debt capacity which it can use.

As return on assets is higher than after tax cost of fund, it should borrow more money and invest.

Answer (b):

The amount it should borrow would depend on following factors:

1. Amount of investment required for project which will provide 20% return on assets.

2. Amount of loan it can avail at 10% rate.

If investment requirement is more, higher amount of loan requirement may increase the leverage to a point where the investors may demand higher rate of interest.

So, the amount borrowed should be such that it results in a capital structure (debt: equity ratio) which minimizes WACC and maximizes shareholder value.

Current capital structure:

Equity = 4 * 90% = $3.60 million

Debt = 4 * 10% = $0.40 million

If we assume:

Investment required = 3.20 million

Then assuming it borrows the entire investment required and gets the loan at 10% rate; then:

Post borrowing:

Debt = 0.40 + 3.20 = $3.60 million

Equity = $3.60 million.

This will result in debt equity ratio of 1:1.

Total assets = 4 + 3.20 = $7.20 milion

Expected net income = 7.20 * 20% = $1.44 million

Current net income = 4 * 20% = $0.80 million (assuming same return on asset ratio)

Hence the decision to borrow $3.2 million and invest will increase annual net income by (1.44 - 0.80) = $0.64 millon without any increase in equity (from new equity).

This will result in significant increase in Return on equity and shareholder value.