The B company’s December 31, 2012, balance sheet and income statement are presen
ID: 2424908 • Letter: T
Question
The B company’s December 31, 2012, balance sheet and income statement are presented in the following schedule, along with its interest coverage ratio:
Debt $12 million
Equity 20
Interest expense 1
Time interest earned 5.0X
B. company’s financial statement footnotes include the following:
(i) At the beginning of 2012, B. company’s entered into an operating lease with future payments of $40 million ($5 million /year) with a discounted present value of $20 million.
(ii)B. company’s has guaranteed a $5 million, 10% bond issue, due in 2014, issued by C’s, a nonconsolidated 30%-owned affiliated.
(iii)B. company’s has committed itself (starting in 2009)to purchase a total of $12 million of phosphorus from PE, inc.., its major supplier, over the next 5 years. The estimated present value of these payments is $7 million.(Assume the effective rate =18%)
a. Adjust B’s debt and equity and recomputed the debt-to-equity ratio, using the information in footnotes from (i)to (iii).
b. Adjust the time-interest-earned ratio for 2012 for these commitments.
c. Discuss the reasons (both financial and operating) why B’s may have entered into these arrangements.
d. Describe the additional information required to fully evaluate the impact of these commitments on B’s current financial condition and future operating trends.
Explanation / Answer
a. Adjust B’s debt and equity and recomputed the debt-to-equity ratio, using the information in footnotes from (i)to (iii).
Two adjustments have to be made.
1)Operating Lease .It will increased the long term liabilities and Fixed assets by present value $20 millions.
2) Payment agreement .It will increased the long term liabilities and Fixed assets by present value $7 millions
New Debt at the beginning of 2012 would be ($12 + $20 +7) millions = $39 millions
No impact on equity of any of these adjustments.
New Debt / Equity ratio = $39 millions/$20millions = 1.95 times
Old Debt /Equity ratio = $12/$20 millions = 0.6 times
This is more than thrice as high as the initial D/E ratio.
At end of 2012 Debt would be as we need to take out the 2012 payments in both Lease and Take or Pay
1)Operating Lease .It will increased the long term liabilities and Fixed assets by present value $20 millions.($20 - $5)million = $15 million
2) Payment agreement .It will increased the long term liabilities and Fixed assets by present value $7 millions ($7 - $12/5 ) = $4.6 million
Debt = ($12 + $15 + $4.6)/$20 million = 1.58 times
b. Times Interest Earned = EBIT/Interest = 5 = EBIT/1
EBIT = $5 million
1)Operating Lease = Interst rate calculated in ecxel Rate(nper,PMT, PV, FV) ; Rate(8,5,-20,0) =18.62%
Interest = $20 million x 18.62% = $3.72 million
2) Payment agreement .Interest 18%(given)
Interest = $7 million x 18% = 1.26 million
New EBIT = $5 + $3.72 +$1.26 million = $9.98 million
New Intest = $1 + $3.72 + $1.26 million = $5.98 million
New Times interest earened ratio = $9.98/$5.98 million = 1.67 x which is less than the old timest interest earned ratio.
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