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Fundamentals of Financial Manageme...

14th Edition
Eugene F. Brigham + 1 other
ISBN: 9781285867977

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BuyFindarrow_forward

Fundamentals of Financial Manageme...

14th Edition
Eugene F. Brigham + 1 other
ISBN: 9781285867977
Textbook Problem

EXTERNAL EQUITY FINANCING Northern Pacific Heating and Cooling Inc. has a 6-month  backlog of orders for its patented solar heating system. To meet this demand, management  plans to expand production capacity by 40% with a $10 million investment in plant and  machinery. The firm wants to maintain a 40% debt level in its capital structure. It also  wants to maintain its past dividend policy of distributing 45% of last year’s net income. In  2015, net income was $5 million. How much external equity must Northern Pacific seek at  the beginning of 2016 to expand capacity as desired? Assume that the firm uses only debt  and common equity in its capital structure.

Summary Introduction

To calculate: Amount of external equity NP seeks at the beginning to expand its capacity as desire.

External Equity Financing:

When a firm requires funds and it obtains them externally, then it is termed as external equity financing. It is also termed as selling of ownership interest to acquire funds for business.

Explanation

Calculate total value equity required.

Given,

Cost of project is $10,000,000.

Percentage of debt in capital is 40%.

Formula to calculate equity required,

Equityrequired=Costofproject×(1%debtincapital)

Substitute $10,000,000 for project cost and 40% for % debt in capital.

Equityrequired=$10,000,000×(140%)=$10,000,000×0.6=$6,000,000

Hence, total value of equity required for new project is $6,000,000.

Calculate total earnings retained.

Given,

Net income is $5,000,000.

Payout ratio is 45%.

Formula to calculate total earnings retained,

Totalearningsretained=NetIncome×(1Payoutratio)

Substitute $5,000,000 for net income and 45% for payout ratio

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