The Severn Company: Balance Sheet as of December 31, 2018 (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 33750 Total assets $1350.00 Total liabilities and equity $1350.00 The Severn Company: Income Statement for Year Ended December 31, 2018 (millons 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: Annual Sales (millions of Probability dollars) 0.30 $2,250 0.40 2,700 0.30 3,150
Cost of Capital
Shareholders and investors who invest into the capital of the firm desire to have a suitable return on their investment funding. The cost of capital reflects what shareholders expect. It is a discount rate for converting expected cash flow into present cash flow.
Capital Structure
Capital structure is the combination of debt and equity employed by an organization in order to take care of its operations. It is an important concept in corporate finance and is expressed in the form of a debt-equity ratio.
Weighted Average Cost of Capital
The Weighted Average Cost of Capital is a tool used for calculating the cost of capital for a firm wherein proportional weightage is assigned to each category of capital. It can also be defined as the average amount that a firm needs to pay its stakeholders and for its security to finance the assets. The most commonly used sources of capital include common stocks, bonds, long-term debts, etc. The increase in weighted average cost of capital is an indicator of a decrease in the valuation of a firm and an increase in its risk.
The Severn Company plans to raise a net amount of
$270 million to finance new equipment in early 2019. 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:
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 σEPS 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.)
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