Lester Electronics Financing Alternative Benchmarking

Running head:  LESTER ELECTRONICS FINANCING ALTERNATIVE BENCHMARKING

Lester Electronics Financing Alternative Benchmarking

University of Phoenix


Overall Analysis

Lester Electronics Inc. (Lester) has the opportunity to merge with Shang-Wa Electronics (Shang-Wa). Lester believes that combining the efforts of these two, well established companies, it will bring financial success to all. (Scenario, 2008)  In order to increase future profits, Lester’s senior management team has developed new organizational strategies to move Lester through this merger with Shang-Wa but various steps must be researched before implemented. One of those steps is benchmarking that identify potential or existing issues of an organization and finding best practices to solve them. Key findings from six other companies that have faced similar issues that Lester is facing have been researched in regards to “weighted-average-cost-of-capital,” “recommended financing mix to optimize capital structure,” “analyzing the risks associated with investment decisions,” and “recommended offers” for Lester to think about. This paper will cover key concepts in communication as well as compare and contrast best practices taken from selected companies like financial institutions CitiGroup and Wells Fargo as well industry giants like United Health Group, Kmart, Verizon and InBev, which will lead to new discoveries and solutions for Lester’s future.

Weighted Average Cost of Capital

        One can determine the value of a project using the weighted-average-cost-of-capital (WACC) method. The cost of capital is a weighted average of the cost of debt and the cost of equity. The cost of equity is rS. Ignoring taxes, the cost of debt if simply the borrowing rate, rB. However with corporate taxes, the appropriate cost of debit is (1-Tc) rB, the after tax cost of debt (Ross, 2005 p. 480). WACC is another way to adjust for presence of leverage. Suppose that a firm was to use both debt and equity to finance their investments. If the company borrowing rate is rB and the expected return on equity is rS, what is the overall cost of its capital? For this example, let B & S be the market values of debt and equity. An easy way to compute the overall cost of capital is to take the weighted average of cost of equity and cost of debt by using this formula:         

One also needs to take into account tax. To modify this formula we will suppose the expected return on equity is rS and the rB be the borrowing rate. Since the interest is tax deductable at the corporate rate, after tax return to the debt holder is rb (1_Tc) where Tc is the corporate tax rate. In other words, rB (1-Tc) is the after cost of debt (Ross, 2005 p. 491). Therefore, the appropriate discount rate in the presence of corporate tax is given by the following WACC:

 The S is the market value of equity and the B is the market value of the debt. Lester can use this formula to determine their WACC. When computing the WACC for Shang-Wa, we will need to combine the following taken from the 2004 Balance Sheet of Shang-Wa, will be Long-Term Debts $83,941 and Equity $36,415 to come up with a total Capital Structure of $120,356 (Scenario, 2008) Lester’s consists of Long –Term Debt of 41.688mm, Other debt (minority interest) $3.908mm plus total Shareholders’ Equity $161.7mm for a total Capital Structure $167.296mm (Scenario, 2008).

        The WACC technique calculates the projects after-tax cash flows assuming all-equity financing (UCF). The UCF is placed in the numerator of the capital-budgeting equation. The denominator, rWACC, is the weighted average of the cost of equity capital and the cost of debt capital. The tax advantage of debt is reflected in the denominator because the cost of debt capital is determined net of corporate tax. The numerator does not reflect debt at all (Ross, 2005 p. 482).

        CitiGroup has used this method to determine risk in capital as well. Banks like CitiGroup are required to put different risk weightings on assets ranging from government notes to mortgage securities to corporate bonds and cash. All corporate bonds have a risk weighting of 100 percent no matter what their rating while cash and government securities carry no weight (CitiGroup, 2008).

Recommended Financing Mix to Optimize Capital Structures

        The ability of an organization to perform well in the market depends on the efficiency of its capital structure. Total capital is the net funds available to the company after it fulfills its current liabilities. The basic aim of optimizing capital structure is to select that proportion of debts and equities that maximizes the firm’s value while minimizing the average cost of capital. There is no single formula or theory that conclusively provides the optimal capital structure for all firms but there are some theories that are more favorable than others. Here are three approaches that are recommended to optimize capital structure.

         The Net Income Approach (NI) states the total value of the firm changes with a change in the financial leverage. For example: The NI approach assumes that the cost of debt is lower than the cost of equity. The NI approach can be used to determine a firm’s optimum capital structure where the value of the firm is highest and the cost of the capital is lowest. (Accenture, 2006)

        The Net Operating Income Approach (NOC) states that the proportion of debt and equity in the firm’s structure does not have any impact on the firms value or its cost of capital. The NOI approach assumes that while the cost of debt is constant for all levels of leverage, the cost of equity increases because the shareholders expect a higher rate of return to cover the risk of increase in leverage. (Accenture, 2006)

        The Modigliani & Merton Miller theory (M&M) is the most widely accepted capital structure theory. The first theory states that the value of a firm is unaffected by its capital structure. The second states that the required rate of return on equity increases as the firms debt equity ratio increases. (Ross, 2005)

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        Lester has determined that merging with Shang-Wa will be a strong capital venture. Knowing the proper financing mix to optimize Lester’s capital structure will be key to their success. United Health Group has a wise Chief Financial Officer, who understands maximizing capital structure very well. Pat Erlandson, CFO for United Health Group stated, “successful capital management requires trade-offs and tough decisions.  Always make connections between value creation and capital stewardship by the following: balance the requirements of delivering both current and future value, identify the key capabilities required, assess gaps existing and prioritize strategy clearly. (United Health Group, 2008)

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