Gentry Inc. is a mid-sized tech firm (200 employees and $300 million in revenue)

Question

Gentry Inc. is a mid-sized tech firm (200 employees and $300 million in revenue) and has been privately held since the firm’s inception ten years ago. The organization’s board of directors is keen on expanding the operations globally to take advantage of a growing market. Based on reports from the research and development team, the organization can increase its profitability metrics by 15 to 25% if it expands the operations to China, Japan, and Germany. Becoming a multinational organization will not be easy. To finance this expansion, the board of directors has decided to take the organization public and issue some bonds to raise an additional $50 million. The research team has already determined that the organization meets the financial requirements outlined by the Securities Exchange Commission. The goal is to maximize the Initial Public Offering (IPO), and the leadership must efficiently manage the capital, measure the risk of the investments, and ensure the financial metrics are robust relative to similarly sized organizations.

Based on the information that you learned about capital structure and budgeting, determine what the optimal capital structure should be for Gentry. You will need to determine how much equity (common stock) the company will offer in the IPO and how much debt the company should assume in their global expansion to meet the goal of $50 million.

Explanation / Answer

Optimal capital structure is the one that has lowest WACC. Lower the WACC, lower the discount rate and NPV would be higher.

There are several methods to find out WACC, namely; Net Income Approach, Net Operating Income Approach, Tradutional Approach. Each method has few assumptions.

I have used Traditional Appoach here:

Assumptions:

Formulae used:

1) Market value of debt = Interest / Cost of debt

2) Market value of equity = EAT / Cost of equity

3) Value of firm = Market value of debt + Market value of equity

4) WACC = EBIT / Value of firm

Outcomes of 4 scenarios are mentioned below in table:

Scenario 1

D/E = 1:9

Scenario 2

D/E = 1:4

Scenario 3

D/E =1:1

Scenario 4

D/E = 9:1

WACC (in %) for below scenarios:

Scenario 1: 19.96%

Scenario 2: 19.94%

Scenario 3: 24.73%

Scenario 4: 29.25%

Optimal Capital structure would be Scenario 2 i.e.; Debt/Equity = 1/4 since WACC is lowest.

Traditional Approach (in mil)

Scenario 1

D/E = 1:9

Scenario 2

D/E = 1:4

Scenario 3

D/E =1:1

Scenario 4

D/E = 9:1

Project Cost 50 50 50 50 Sources of Finance: Equity 45 40 25 5 Debt 5 10 25 45 Capitalization Rate: Debt (Rd) 10% 11% 12% 13% Equity (Re) 20% 20% 25% 30% EBIT 300 300 300 300 Interest (Debt*Rd) 0.5 1.1 3 5.85 EBT 299.5 298.9 297 294.15 Tax No tax No tax No tax No tax EAT 299.5 298.9 297 294.15 Market Value of debt (Interest/Rd) 5 10 25 45 Market Value of equity (EAT/Re) 1497.5 1494.5 1188 980.5 Value of firm 1502.5 1504.5 1213 1025.5 WACC 0.1996 0.1994 0.2473 0.2925

Related Questions

Navigate

• Browse (All)
• Browse G
• Subjects

---

---

Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.