TCO D Butler Corporation Produces Metal Buildings In The Pas

Tco D Butler Corporation Produces Metal Buildings In The Past Year

Tco D Butler Corporation produces metal buildings. In the past year, it earned a 10% return on its asset base of $10 million. Butler needs $10 million to expand its operations and has the option of obtaining none, some, or all of the proceeds from a bank loan. The company is currently financed entirely with equity and expects to maintain its return on assets after expansion. The bank has indicated that the interest rate on the loan will depend on the debt-to-equity ratio, with rates of 9%, 10%, and 12% for ratios less than or equal to 0.5, 1.0, and over 1.0, respectively. Butler’s tax rate is 40%. Calculate the company's return on equity if the expansion is financed with:

1. 50% debt and 50% equity

2. All debt

Paper For Above instruction

Introduction

The decision to finance an expansion through debt or equity significantly impacts a company's financial structure and return on equity (ROE). Butler Corporation, which produces metal buildings, faces a strategic choice: to finance its $10 million expansion either through a combination of debt and equity or entirely through debt. This paper aims to analyze the implications of both financing options on the company's ROE, considering the company's current financial standing, cost of debt, tax advantages, and the impact on leverage.

Background and Context

Butler Corporation has a current asset base of $10 million, generating a 10% return on assets (ROA). Its current equity financing implies no debt, and it aims to retain its ROA post-expansion. The company seeks to raise an additional $10 million, with the associated interest costs dependent on the debt-to-equity ratio, which influences the borrowing rate. The company's overall goal is to assess how different financing structures affect its ROE post-expansion to align with strategic financial management principles and maximize shareholder value.

Financial Analysis of the No-Leverage Scenario

Initially, understanding the company's current financial performance without leverage provides a baseline. With an ROA of 10% and an asset base of $10 million, Butler's net income before expansion is calculated as:

Net Income = ROA × Asset Base = 0.10 × $10 million = $1 million.

Since the company is all equity-financed, its equity equals its assets, i.e., $10 million. Therefore, current ROE is:

ROE = Net Income / Equity = $1 million / $10 million = 10%.

Post-expansion, assuming no leverage and same return on assets, the asset base would increase to $20 million, and net income would double to $2 million, maintaining the 10% ROA and ROE at 10%.

Scenario 1: Financing 50% Debt and 50% Equity

In this scenario, Butler raises $5 million through debt and $5 million through equity, totaling $10 million. The new asset base becomes $20 million, with debt totaling $5 million, representing a debt/equity ratio of 0.5.

Interest rate calculation:

Based on the bank’s tiered rates, for a debt/equity ratio of 0.5 or less, the interest rate is 9%.

Interest expense:

Interest = 9% × $5 million = $450,000

Tax shield advantage:

Interest expense is tax-deductible, reducing taxable income.

Tax savings = Tax rate × Interest expense = 0.40 × $450,000 = $180,000

Net income calculation:

Pre-tax income from operations (assuming same ROA):

Earnings before interest = ROA × Assets = 0.10 × $20 million = $2 million

Less interest expense:

Taxable income = $2 million - $450,000 = $1.55 million

Tax at 40%:

Taxes = 0.40 × $1.55 million = $620,000

Net income after tax:

$1.55 million - $620,000 = $930,000

Return on Equity (ROE):

Equity is $15 million ($10 million original + $5 million new equity).

ROE = Net income / Equity = $930,000 / $15 million ≈ 6.2%

Impact:

Introducing leverage reduces ROE in this case because the interest expense and the relatively low pre-expansion income mean the benefits of tax shields are offset by increased financial obligations and reduced net income.

Scenario 2: Financing Entirely with Debt

Here, Butler finances the entire $10 million expansion with debt. The debt/equity ratio becomes undefined (or approaches infinity if no equity remains). Correspondingly, according to the bank’s rate tiers, the rate would be 12% (for ratios over 1.0).

Interest expense:

Interest = 12% × $10 million = $1.2 million

Tax shield:

Tax savings = 0.40 × $1.2 million = $480,000

Pre-tax income:

Earnings before interest = 0.10 × $20 million = $2 million

Less interest expense:

Taxable income = $2 million - $1.2 million = $0.8 million

Taxes:

Taxes = 0.40 × $0.8 million = $320,000

Net income after tax:

$0.8 million - $320,000 = $480,000

Return on Equity:

In this case, equity is zero if financed solely by debt (risk of insolvency), but if we conceptualize an equity component, the ROE calculation becomes nonsensical because all profit accrues to debt holders unless the company retains earnings or issues equity. For the purpose of this analysis, the key insight is that debt financing amplifies financial risk but does not dilute the apparent ROE when viewed solely from net income and total capital, which is now entirely debt. Therefore, leveraging fully magnifies the financial risk, which can lead to higher potential ROE but also increased bankruptcy risk, inconsistent with the company's current stability.

Discussion of Results

The analysis indicates that financing with 50% debt and 50% equity results in a decrease in ROE compared to the company's current 10%. This drop stems from the interest expenses and taxation impacting net income despite the tax shield advantage. Conversely, entirely leveraging with debt amplifies risks dramatically, and while the apparent ROE can appear higher if profit margins are maintained, the financial stability of the company is compromised, and the debt servicing burden increases.

The critical consideration here is the trade-off between leverage benefits and financial stability. The moderate leverage scenario (50%) slightly reduces ROE but maintains debt levels within manageable ranges, especially given the company's stable ROA and industry practices. The full debt scenario, while potentially offering higher long-term returns, exposes the company to significant financial risk that could threaten its sustainability in adverse economic conditions.

Conclusion

In conclusion, expected ROEs depend critically on the chosen financial structure. A balanced approach with 50% debt and 50% equity slightly reduces the company's ROE post-expansion due to interest expenses and tax considerations but maintains a manageable risk level. Completely financing the expansion through debt, with higher interest rates, can theoretically increase ROE but at the expense of heightened financial vulnerability. Strategic financial management should weigh these factors carefully, favoring moderate leverage to optimize shareholder returns while safeguarding financial stability.

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