Lester Electronics Financing Problem

Lester Electronics Financing Problem

“Corporations are very adept at creating hybrid securities that look like equity but are called debt. Obviously, the distinction between debt and equity is important for tax purposes. When corporations try to create a debt security that is really equity, they are trying to obtain the tax benefits of debt while eliminating its bankruptcy costs” (Ross, Westerfield & Laffe, 2004). Since CEO and board of Lester Electronics have decided to acquire Shang-Wa of South Korea, there are many challenges and opportunities facing Lester Electronics. It is critical for Lester Electronics to identify and overcome all challenges and capitalize on all opportunities related to the Shang-Wa acquisition to ensure future success of the combine company.

The next step for Lester Electronics is to identify and select the best financing solution for the acquisition. Lester Electronics’ executives should choose the capital structure that will yield the highest firm value and most beneficial to firm’s shareholders. In the capital market, the cost of debt financing is much lower than cost of equity. However, should Lester Electronics finance the acquisition solely with debt to reduce cost or should the company consider a combination of debt and equity finance? It is not an easy decision to determine the best debt and equity financing mix, optimal debt and equity ratio, and most appropriate balance between risk, leverage and control. Capital structure decisions affect firm’s earning per share (EPS), financial risks and long-term financial health of acquiring firm. The proper use of debt financing can increase Lester Electronics’ leverage, reduce cost and improve cash flow. On the other hand, using debt financing will increases overall financial risk of Lester Electronics. Even when debt financing is determined to benefit the company in its acquisition activity, how much debt and types of debt (short-term or long-term) need to be considered. If the equity is chosen to finance the acquisition, then how much of equity and what types (common or preferred stocks) need to be evaluated and considered. All these decisions impact Lester Electronics’ tax liabilities, balance sheet, and income and cash-flow statements. In addition to the challenge of making the appropriate financing decision, Lester Electronics must consider the appropriate purchase price as well. There may be significant differences between market and book values of Shang-Wa. Lester Electronics must take into consideration of its joint venture activities, supplier and vendor relationship, cost savings, cost of doing business in foreign country, expanded market shares in international markets, cultural differences, South Korea and United States financial regulations and tax structures for the proposed capital market for the acquisition. Some of the Shang-Wa’s existing financial conditions also present challenges for Lester Electronics. Shang-Wa has relatively low cash reserves, high account receivable and leverage ratio. By acquiring Shang-Wa, Lester Electronics will have to inherit all Shang-Wa’s existing financial conditions. Although there are many challenges facing Lester Electronics, there are many opportunities in the Shang-Wa acquisition as well.

Shang-Wa supplies forty five percent of Lester Electronics products. Instead of losing

Shang-Wa to Lester Electronics’ competitor and stand to lose forty five percent of revenues over the next five years, the acquisition of Shang-Wa can ensure the uninterrupted supply of Lester Electronics’ products at a reduced product costs. By owning Shang-Wa, Lester Electronics gain control over product manufacturing, supply chain, cost reduction, and profit from Shang-Wa’s existing sales and international markets. Furthermore, Lester Electronics and Shang-Wa has existing joint-venture plan in place to dramatically increase the product manufacturing capabilities with increased markets and sales channels. The long-term partnership between both companies and strong loyalty from Shang-Wa’s CEO are great advantages for Lester Electronics in the acquisition. Since Lester Electronics has predominance in United States market, the acquisition of Shang-Wa increases Lester Electronics diversity and gain access to additional international markets without having to start from scratch. Shang-Wa has large fixed assets with relatively new equipments (derived from low Accumulated depreciation figures). Lester Electronics and Shang-Wa are both very profitable companies over the years. One of the differences is Lester Electronics pays