Cooper Electronics, Inc.

Cooper Electronics embarked upon an expansion project that has the potential to increase sales by about 30% per year over the next 5 years. The additional capital needed to finance the project had been estimated at $5 million. Bob Cooper, President and CEO, was wondering about whether he should burden the firm with fixed rate debt or issue common stock (through a private placement) to raise the needed funds. Bob needed input from a finance team to shed some light on the matter.

Bob Cooper established the company 10 years ago in his hometown of Salt Lake City. After taking early retirement at age 55 from a large electronics firm in California, Bob felt that he could really capitalize on his engineering background and contacts within the industry. Bob remembered vividly how easily he had managed to get the company up and running by using $3 million of his own saving and a five-year bank loan worth $2 million. He recollected how uneasy he had felt about the debt burden and the 9% per year rate of interest that the bank had been charging him. He also recalled how relieved he felt after paying off the debt one year ahead of schedule and the surprised look on the bank manager’s face.

Business had been good over the years and sales had doubled about every 4 years. As Sales began to escalate with the booming economy and thriving stock market (before 2008), the firm needed additional capital. Previously, Bob had been able to finance growth with internally generated funds. However, about 5 years ago when the need for financing was overwhelming, Bob decided to raise additional equity financing from a private equity fund. He sold a million shares at $5 per share. According to a recent valuation study that Bob purchased from Bluerock Consulting, the current market value of the stock equaled the book value of $15 per share.

When the expansion proposal was presented at last week’s board meeting, the directors were unanimous about the decision to accept the proposal. Based upon estimates provided by the marketing department, the project had the potential of increasing revenues by expected 30% with an increase of 10% (worst case) and 50% (best case) per year.

The internal rate of return of the expansion was expected to far outperform the company’s hurdle rate. But the firm had already invested all its internally generated funds into the existing business. Thus Bob and his colleagues were hard pressed to make a decision as to whether to use long-term debt or equity for the additional financing.

Upon contacting their investment bankers, Bob learned that they could issue 5-year notes, at par, at a rate of 6% per year. Conversely, the company could issue common stock to the same consortium of private equity firms at the current price of $15 per share. Not knowing which way to go, Bob put the question to the Board of Directors for a vote. Unfortunately, the directors were evenly divided in their opinion of which financing route should be chosen. Some of the directors felt that the debt option offered an interest tax shelter that would reduce the tax burden of the firm and lower the weighted average cost of capital. However, other directors spoke