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Fundamentals of Financial Manageme...

15th Edition
Eugene F. Brigham + 1 other
ISBN: 9781337395250

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BuyFindarrow_forward

Fundamentals of Financial Manageme...

15th Edition
Eugene F. Brigham + 1 other
ISBN: 9781337395250
Textbook Problem

FINANCING ALTERNATIVES 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 not $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, 2018

(millions of dollars)

images

The Severn Company: Income Statement for Year Ended

December 31,2018 (millions of dollars)

Sales $2,475.00
Operating costs 2227.50
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 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.)

Summary Introduction

To Determine: The EPS under debt financing and stock financing alternatives for each sales level, the expected EPS and standard deviation of EPS under debt financing and stock financing alternatives, the debt-to capital ratio, the times interest earned at the expected sales level and the suitable financing method that is recommended.

Introduction: Earnings per share or EPS is considered as financial ratio, which separates net profit accessible to common shareholders by the aggregate outstanding shares over a specific timeframe. The EPS formula shows an organization's capacity to create net profits for common shareholders.

Explanation

Determine the EPS for each sales alternative under the debt financing method

Using an excel spreadsheet, the EPS for sales level $2,250 is determined as $3.24, sales level $2,700 is determined as $4.59 and sales level $3,150 is determined as $5.94.

Excel Spreadsheet:

Excel Workings:

Therefore the EPS for sales level $2,250 is $3.24, sales level $2,700 is $4.59 and sales level $3,150 is $5.94.

Determine the expected EPS under the debt financing method

ExpectedEPS=[EPS×Probability]=[($3.24×30%)+($4.59×40%)+($5.94×30%)]=[$0.97+$1.83+$1.78]=$4.59

Therefore the expected EPS under the debt financing method is $4.59.

Determine the standard deviation of EPS under the debt financing method

Using an excel spreadsheet and excel function =SQRT, the standard deviation of EPS under the debt financing method is determined as $1.05.

Excel Spreadsheet:

Excel Workings:

Therefore the standard deviation of EPS under the debt financing method is determined as $1.05.

Determine the times interest earned (TIE) ratio under the debt financing method

TIERatio=[EBITInterestEarned]=[$270million$117.15million]=2.3047or2.30times

Therefore the times interest earned (TIE) ratio under the debt financing method is 2.30 times.

Determine the debt to capital ratio under the debt financing method

DebttoCapitalRatio=[(NotesPayable+LongTermDebt+CostofEquipment)(NotesPayable+LongTermDebt+CostofEquipment+CommonStock+RetainedEarnings)]=[($255+$697.50+$270)($255+$697.50+$270+$60+$337.50)]=[$1,222.50$1,620]=0.75462or75.46%

Therefore the debt to capital ratio under the debt financing method is 75.46%.

Determine the coefficient of variation for each sales alternative under the debt financing method

CoefficientofVariation=[StandardDeviationExpectedEPS]=[$1.05$4.59]=0.2287or0.23

Therefore the coefficient of variation for each sales alternative under the debt financing method is 0.23.

Determine the EPS for each sales alternative under the stock financing method

Using an excel spreadsheet, the EPS for sales level $2,250 is determined as $3

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