The Severn Company plans to raise a net amount of $270 million to finance new eq

Question

The Severn Company plans to raise a net amount of $270 million to finance new equipment in early 2012. 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:

The Severn Company: Income Statement for Year Ended December 31, 2012 (Millions of Dollars)

The probability distribution for annual sales is 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 level of sales. Round your answers to two decimal places. Write out your answer completely. For example, 0.00013 million should be entered as 130.

Calculate expected EPS under both debt and stock financing alternatives. Round your answers to two decimal places. Write out your answer completely. For example, 0.00013 million should be entered as 130.
Under the debt financing expected EPS is $  
Under the stock financing expected EPS is $  

Calculate ?EPS under both debt and stock financing alternatives. Round your answers to two decimal places. Write out your answer completely. For example, 0.00013 million should be entered as 130.
Under the dept financing ?EPS is $  
Under the stock financing ?EPS is $  

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. [Hint: Notes payable should be included in both the numerator and the denominator of the debt-to-capital ratio.] Round your answers to two decimal places.

Under the debt financing.

Under the stock financing.

The Severn Company: Balance Sheet as of December 31, 2012
(Millions of Dollars) Current assets $ 900.00 Notes payable $ 255.00 Net fixed assets 450.00 Long-term debt (10%) 695.00 Common stock, $3 par 60.00 Retained earnings 340.00 Total assets $1,350.00 Total liabilities and equity $1,350.00

Explanation / Answer

When new debt is issued, interest on new debt = 270 million *12% = 32.4 million

When new stock is issued, number of new shares = 270 / 60 = 4.5 million shares

Number of old shares outstanding = 60 / 3 = 20 million shares

So total number of shares after stock issue = 20+4.5 = 24.5 million shares

Under the 2 scenarios, the EPS is calculated below for the 3 different levels of sales:

Explanation:

EBIT is calculated as 10% of sales.

Interest on short term and long term debt is taken from the question.

Interest on new debt is 32.4 as calculated earlier.

Earnings before taxes = EBIT - the 3 interest items.

Tax = 40%*earnings before taxes.

Net income = earnings before taxes - tax.

EPS = net income / number of shares

So the table in the question would be populated as under:

Under debt financing, expected EPS = 0.3*3.27 + 0.4*4.62 + 0.3*5.97 = 4.62

Under stock financing, expected EPS = 0.3*3.47 + 0.4*4.57 + 0.3*5.67 = 4.57

Expected EBIT = 0.3*225 + 0.4*270 + 0.3*315 = 270 million

Under debt financing, debt ratio = (notes payable + long term debt + new debt) / (total assets) = (255+695+270) / (1350+270) = 75.31%

Under debt financing, times interest earned ratio = EBIT / total interest = 270 / (14+69.5+32.4) = 2.33

Under stock financing, debt ratio = (notes payable + long term debt) / (total assets) = (255+695) / 1350 = 70.37%

Under stock financing, times interest earned ratio = EBIT / total interest = 270 / (14+69.5) = 3.23

Debt financing Stock financing Case 1 Case 2 Case 3 Case 1 Case 2 Case 3 Sales 2,250 2,700 3,150 2,250 2,700 3,150 EBIT @ 10% of sales 225 270 315 225 270 315 Interest on short term debt 14 14 14 14 14 14 Interest on long term debt 69.5 69.5 69.5 69.5 69.5 69.5 Interest on new debt 32.4 32.4 32.4 0.0 0.0 0.0 Earnings before taxes 109.1 154.1 199.1 141.5 186.5 231.5 Tax @ 40% 43.64 61.64 79.64 56.6 74.6 92.6 Net income 65.46 92.46 119.46 84.9 111.9 138.9 No of shares (mn) 20 20 20 24.5 24.5 24.5 EPS 3.27 4.62 5.97 3.47 4.57 5.67

Related Questions

Navigate

• Browse (All)
• Browse T
• Subjects

---

---

Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.