Textbook Problem

FINANCING ALTERNATIVES The Severn Company plans to raise a net amount of $270 million to finance new equipment in early 2016. Two alternatives are being considered: Common stock may be sold to net $60 per share, or bonds yielding 12% may be issued. The balance sheet and income statement of the Severn Company prior to financing are as follows:

The Severn Company: Balance Sheet as of December 31, 2015

(Millions of Dollars)

Current assets	$ 900.00	Notes payable	$ 255.00
Net fixed assets	450.00	Long-term debt (10%)	697.50
		Common stock, $3 par	60.00
		Retained earnings	337.50
Total assets	$1,350.00	Total liabilities and equity	$1,350.00

The Severn Company: Income Statement for Year Ended December 31, 2015

(Millions of Dollars)

Sales	$2,475.00
Operating costs	2,227.50
Earnings before interest and taxes (10%)	$ 247.50
Interest on short-term debt	15.00
Interest on long-term debt	69.75
Earnings before taxes	$ 162.75
Federal-plus-state taxes (40%)	65.10
Net income	$ 97.65

The probability distribution for annual sales is as follows:

Probability	Annual Sales (Millions of Dollars)
0.30	$2,250
0.40	2,700
0.30	3,150

Assuming that EBIT equals 10% of sales, calculate earnings per share (EPS) under the debt financing and the stock financing alternatives at each possible sales level. Then calculate expected EPS and EPS under both debt and stock financing alternatives. Also calculate the debt-to-capital ratio and the times-interest-earned (TIE) ratio at the expected sales level under each alternative. The old debt will remain outstanding. Which financing method do you recommend? [Hint: Notes payable should be included in both the numerator and the denominator of the debt-to-capital ratio.]