Question 19.1: Informed Judgment about Risk SITUATION: You are given some a...
Informed Judgment about Risk
SITUATION: You are given some additional information about Sleepy Hollow Corporation’s use of financial leverage, as shown:
\begin{matrix} Debt \ to \ total \ assets \ before \ capital \ project &=& \$400/\$600 &=& 66.7\% \\ Debt \ to \ total \ assets \ after \ capital \ project &=& \$660/\$890 &=& 74.2\% \\ Industry \ average \ debt \ to \ total \ assets &=& 40.0\% \end{matrix}
What should management do in light of this information?
DECISION: Sleepy Hollow’s current leverage ratio of 66.7 percent is already high compared with the industry average of 40 percent. If the firm goes ahead with the project, the leverage ratio will increase to 74.2 percent, which is even higher. The high debt ratio makes the firm more risky and could negatively affect its stock price, its borrowing cost, and even its ability to borrow money. A more prudent alternative would be to fund at least part of the $290 million of new assets ($90 million + $200 million = $290 million) with internally generated funds by reducing dividends or with externally-raised equity by selling new stock, or both.
The important point here is that financial planning models do not think for management. Even though the balance sheet balances and results are consistent with the firm’s financing plan, management must apply informed judgment.