Mba 540

Introduction

LEI, Inc. a public company, has decided to acquire Shang-wa, a Korean based company that manufactures capacitors in a vertical integration. The CEO of LEI has convinced the shareholders that this move is a necessary one to avoid the takeover of Shang-wa by one of LEI's competitors, Transnational Electronics Corporation (TEC). Shang-wa has historically represented 43% of LEI's revenue stream. As result of the Board's approval to move forward with the acquisition, LEI must determine which financing alternatives they wish to use to complete the acquisition. The benchmark studies included in this document illustrate several pertinent alternatives to be considered. They include reviewing the financing mix that will optimize the capital structure of the new firm; the weighted average cost of capital considerations in financing; evaluating a dividend policy; and analyzing the risks associated with various financing considerations such as executive stock options and conducting an IPO.

Recommend a Financing Mix that Optimizes Capital Structures

There are many methods for a business to raise needed funds. Typically a firm is not financed 100% by debt. The balance of debt and equity is one of the most basic and important financing questions to be addressed by any business. Use of stocks and bonds as financing options can play an integral part of any organization. These programs become a significant part of a company's capital structure and an important part of business valuation from future investors. As companies expand business capital needs increase for some period to cover costs. The need for any increase in capital can place pressure on a company's overall capital structure. Lester Electronics is now facing these same issues as they attempt to secure financing alternatives. LEI must find a financing mix that allows for optimization of capital structure. One of the included case studies, Domino's, highlights how the use of stock options in a repurchase option, reclaimed 13.9 million shares of common stock which eventually led to a share price increase of 11% for Dominos. The use of bonds, another option within a financing mix optimization, is illustrated in the case study related to Cingular. This study illustrates how the use of a combination of issuing bonds along with other financial strategies accomplished the funding that Cingular required to complete a merger successfully. Flowserve, in their acquisition of Ingersoll Dresser Pumps, demonstrates the importance of balancing debt and equity. In this example, a heavy debt load stressed the company's ability to meet payments when the market contracted unexpectedly

Evaluate Dividend Policy on Wealth Maximization

Research conducted in 2005 speaks to the fact the firms have historically paid out about 40% of their net income as cash dividends or have chosen the route of stock repurchase programs which also has accounted for about 40% of their net income (Ross, et. al, 2005). LEI (pre-merger) was in the group of firms that paid out large dividends to shareholders. With the merger, however; the lack of cash is going to potentially put a damper on continued dividend payment without external financing. Ross, et al (2005) indicates that a firm should never use financing just to pay a dividend. The signaling effect of not issuing a dividend when they have been issued historically may cause a share price drop in the market. The case studies show various approaches to address dividends. First State Investments had success with a high dividend policy; Hitachi illustrates a decision to switch from a dividend payout to a stock repurchase program and finally, Colonial Properties Trust/Conversion Realty Income Trust, Inc. which prioritized continuing the existing dividend payout rate post merger.

Determine the Weighted Average Cost of Capital

According to Ross et al. (2005), certain situations require different project valuation methods. The benchmark case to address the valuation of a project based on the weighted average cost of capital is illustrated in the merger between Exxon and Mobil. In this case the weighted average cost of capital was preferable to the adjusted present value or flow-to-equity methods. The WACC method is based on the assumption that a levered firm will finance a project with both debt and equity, and is preferred "if the firm's target debt-to-value ratio applies to the project over its life" (Ross et al., 2005, p. 483). LEI can use this same methodology in determining how best to fund this acquisition.

In order to determine a firm's ability to absorb the risk of a new venture or project, the firm must analyze its beta and leverage status. The case study on Citigroup (the company created by the merger of Travelers Group and Citibank) provides an example of a low-leverage company's ability to assume risk, thereby allowing greater potential for the firm's projects to maximize shareholder wealth. As LEI is also a low leverage company pre-merger they should also consider the affect of this merger considering their beta in relation to their debt to equity ratio.

Analyze Risks Associated with Investment Decisions

All financial decisions typically imply some kind of risk. Decisions surrounding capital structure are no different. Whether LEI decides to use debt or equity to finance the acquisition should be evaluated with due diligence. Some risks with equity include the lack of tax shields; dilution; costs of issuing securities; and not maximizing the net present value of potential projects. The risks of debt include costs of financial distress such as bankruptcy, agent risk; increased return expectations of shareholders; and increased discount rates of lenders if too much debt is incurred. As a result, LEI along with other firms will want to optimize risk regardless of which investment security they choose. One option to minimize the equity risk of dilution and project maximization is to choose executive stock options as an internal means