Suppose that you have generated the estimates listed below from a pro forma anal

Question

Suppose that you have generated the estimates listed below from a pro forma analysis for a manufacturing company that had requested a threeyear term loan. The loan is a $1.5 million term loan with equal annual principal payments. Principal and interest are payable at the end of each year with interest calculated against outstanding principal at a rate of prime plus 2 percent.

a. The prime rate averages 8 percent each year. Will the firm’s cash flow from operations before interest be sufficient to meet debt service requirements and other mandatory expenditures?

b. If prime averages 8 percent, 9 percent, and 10 percent over the three years, respectively, will cash flow be sufficient?

Year 1Year 2 Year 3 Capital expendituresS250,000 125,000 75,000 140,000$140,000 $140,000 $750,000 $780,000 $800,000 Cash dividends Cash flow from operations before interest expense

Explanation / Answer

a. The firm's cash flow from operations before interest will not be sufficient to meet its debt service obligation and other mandatory expenses. The workings are provided below:

b. The cash flow will not be sufficient if the interest rates are increased as higher interest rates will increase the interest cost and the firm's cash flow are not sufficient to serve all expenses with an interest cost of 8% (calclation provided in part a), so the cash flow will be sufficient in case of higher interest cost of 9% and 10%.  

Year 1 Year 2 Year 3 Cash flow from operations before interest 750000 780000 800000 Mandatory Expenses Capital expenditure 250000 125000 75000 Dividends 140000 140000 140000 Total Mandatory Expenses 390000 265000 215000 Debt Service Requirement Interest 100000 60000 20000 Loan Repayment 500000 500000 500000 Total Debt Service Requirement 600000 560000 520000 Total debt service requirements and other mandatory expenditures 990000 825000 735000

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