Problem Solution: Lester Electronics

Problem Solution: Lester Electronics

Corporate growth usually occurs internally when a firm expands 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. Mergers also serve to increase market share, gain competitive advantage, and improve shareholder value.

Lester Electronics, Inc. has finally reached its decision: to merge with its long time supplier Shang-wa Electronics. What remains is to prepare a plan for that merger that addresses firm value and financing sources. Shareholders will want to know how this merger will impact them in the short term and how the combined company will look financially in the longer term. Company leadership will want thoughts on the combined capital structure post merger. The CFO will need to determine if the funds exist and how necessary funds can be raised. LEI will want to know how much it can afford and what the capital structure will look like. This paper will attempt to address these questions by reviewing the concepts of the weighted average cost of capital, operating leverage, financial mix, ratio analysis, dividend policy, and financial risks.

Situation Analysis

Issue and Opportunity Identification

Poor management is a prime cause of business failure, but another important consideration is lack of capital. If LEI does not have enough capital, it might find things very difficult. As well as having sufficient capital, the CFO will need to plan how that financing is going to be used and managed. The CFO will not want to make errors by obtaining the wrong type of financing or by overestimating or underestimating the amount of financing that will be needed. Ways of raising financing are self funding from existing cash flows, debt funding borrowed from others, and equity funding raised by selling to others an interest in the business.

The CFO will use financial planning models to determine the best course of action for this merger. Financial planning is comprised of the investment opportunities the firm elects to take advantage of, the amount of debt the firm chooses to employ, and the amount of cash the firm thinks is necessary and appropriate to pay shareholders, (Ross, et al., 2004). These are the financial policies that the CFO must decide on for its acquisition of Shang-wa and the new entity's profitability. LEI can choose among many alternative capital structures. Taxes and capital market imperfections further complicate this decision. The pie model is generally used to describe a firm's capital structure.

The CFO has to determine if the company has the financial capacity to complete a merger with SE. Lester's CFO should evaluate its cash flows to see if it has the money to either buy Shang-wa using the equity that it already has or to finance the purchase with debt. During this evaluation, the CFO should evaluate the timing of cash flows. If Lester decides to purchase Shang-wa using any debt, the financial managers will have to ensure that the timing of the cash flow is such that Lester is able to make the principal and interest payments on the debt (Ross, et al., 2004). Financial capacity, like other types of organizational capacity, represents available organizational resources and relationships - both internal and external - that enable individual organizations to pursue growth opportunities, (Scott, 2003). For LEI the problem is determining how much they can afford to pay. If this is not possible, the CFO has the added challenge of discovering how to raise the additional funds necessary to complete the merger. This will become a matter of using the equity that they already have or to finance the purchase with debt. Shang-wa should not necessarily be bought outright. Deciding on the capital structure will ultimately determine the acquisition's value to the firm since investment projects have complex accounting, tax, and legal effects.

Long-term financing is used to fund the purchase of assets from the merger. Three primary sources of capital available to LEI are shareholder's equity - i.e. money from investors, borrowed funds - e.g. from lending institutions or other sources, and reserves - i.e. profits that have been put back into the business. Though the firm can rely on internal sources, these are usually insufficient to meet investment needs, so the CFO may be compelled to look for external funding sources. These sources include retained earnings, equity capital, preference capital, debenture capital, and long-term loans.

Other long-term financing options include the issuance of common and preferred bonds. Preferred stock has some of the features of debt and some of the features of common equity. Holders of preferred stock have preference in liquidation and in dividend payments compared to holders of common equity. However, recent trends in capital structure show that this is a waning alternative. "In the 1980s and recently, U.S. firms retired massive amounts of equity. These share buy-backs have been financed with new debt," (Ross, et al., 2004, p. 400).

An additional challenge will be how to value the merger. Discounted cash flows would be one technique as would multiples of earnings, revenue, or free cash flows. A valuation of synergies expected from the merger might also prove useful. NPV analysis can be used to determine how much needs to be financed for this merger. However, the NPV of Shang-wa is more difficult to determine than that of a typical investment project because of complex accounting, tax, and legal effects. In addition, in a purchase, the acquired firm is generally bought at a premium; this is goodwill. Goodwill is the excess purchase price over the sum of the fair market values of the individual assets being acquired by LEI. The CFO will have the challenge of calculating the exchange rate for the shares as well as the financing for the shares. LEI shareholders will want to know how much will firm value be after the merger. Likewise, SE shareholders will want to know how much they will be given for their shares.

Stakeholder Perspectives/Ethical Dilemmas

All stakeholders (shareholders, management, employees, suppliers and distributors, and customers) have the right to expect benefits from this merger. Likewise, stakeholders may be concerned about a loss of revenue through poor investment choices and faulty capital budgeting. SE shareholders will expect a fair price to retire their shares. LEI shareholders will expect sufficient