Lester Electronics Financing Alternative Benchmarking

Lester Electronics Financing Alternative 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 research tool available to organizations who are considering a merger is 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 outward 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 Apple Computers, Ford Motor Company, Oracle Corporation, AT&T, Delphi, General Motors, Home Depot, and Proctor & Gamble.

Overall Analysis

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. ÐŽ§This approach begins with the insight that projects of levered firms are simultaneously financed with both debt and equity,ЎЁ (Ross, et al., 2005, p. 13). 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 companyÐŽ¦s 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. ÐŽ§Target ratios are generally expressed in terms of market values, not accounting values. (Recall that another phrase for accounting value is book value,ЎЁ (Ross, et al., 2005, p.14).

Capital budgeting is a term that is used when discussing the process of determining whether or not a new project such as investing in a long-term venture or building an additional plant, would be a worthwhile financial investment decision, according to the definition of capital budgeting. Thus this decision can be estimated by using the three methods of capital budgeting with leverage. These 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.

Determining the discount rate depends on a companyÐŽ¦s investments with leverage. Leverage does play a significant role in the cost of capital and must be taken into an account before any potential investment. A simple four step procedure can be 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 discuss, ÐŽ§the formula for the relationship between the beta of the common stock and leverage of the firm in a world without taxes,ЎЁ ÐŽ§Since firms must pay corporate taxes in practice, it is worthwhile to provide the relationship in a world with corporate taxes,ЎЁ (Ross, et al., 2005, p. 46). Fortunately, for corporations, under taxes, leverage creates a riskless tax shield, thereby lowering the risk of the entire firm. The beta of the equity of the firm is absolutely related to the influence of that firm.

Financing Mix that Optimizes Capital Structures

As companies go through financial difficulties they must find ways to generate profit. A major way to do this is through buying and selling stocks. ÐŽ§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,ЎЁ (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. Home depot one of the largest building supply stores acquired Home Depot, which would have opened up an opportunity for Home Depot to give their shareholders a call option. ÐŽ§A call option gives the owner the right to buy an asset at a fixed price during a particular time period (Ross, et al., 2005, p.2).ЎЁ This would allow Home Depot to put their stock on sell for a set value until a particular date giving the shareholders the opportunity to buy the stock before the acquisition generating additional revenue to show on the balance sheet in the acquisition with Hughes Supply. LEI has the same opportunity and needs to take advantage of this kind of financial investment if they are going to generate the cash flow they need to convince Mr. Lin of accepting their proposal for Shang-wa.

Another option for companies to consider is the put option. ÐŽ§A put option can be viewed as the opposite of a call option. Just as a call gives the holder the right to buy the stock at a fixed price, a put gives the holder the right to sell the stock for a fixed exercise price (Ross, et al., 2005, p.4).ЎЁ This option gives the acquired companies shareholders to sell off their stock giving the additional profits to protect their finances during the merger. Shang-wa has to make this one of the priorities in its financial plan in order to give their shareholders the financial stability to make it through the merger with LEI positively. When companies merge with other companies maintaining the capital structure is controlled by the financial decisions the company makes during the crucial transition period.

Risks Associated with Investment Decisions

ÐŽ§Risk is a concept that denotes a potential negative impact to an asset or some characteristic of value that may arise from some present