(19-6) The Howland Carpet Company has grown rapidly during the past 5 years. Rec
ID: 2666126 • Letter: #
Question
(19-6)The Howland Carpet Company has grown rapidly during the past 5 years. Recently, its commercial bank urged the company to consider increasing its permanent financing. Its bank loan under a line of credit has risen to $250,000 carrying an 8% interest rate. Howland has been 30 to 60 days late in paying trade creditors.
Discussions with an investment banker have resulted in the decision to raise $500,000 at this time. Investment bankers have assured the firm that the following alternatives are feasible (flotation costs will be ignored).
* Alternative 1: Sell common stock at $8
* Alternative 2: Sell convertible bonds at an 8% coupon, convertible into 100 shares of common stock for each $1,000 bond (i.e., the conversion price is $10 per share).
* Alternative 3: Sell debentures at an 8% coupon, each $1,000 bond carrying 100 warrants to buy common stock at $10.
John L. Howland, the president, owns 80% of the common stock and wishes to maintain control of the company. There are 100,000 shares outstanding. The following are extracts of Howland’s latest financial statements:
Balance Sheet
Total Assets 550,000
Current Liabilities 400,000
Common Stock Par 1 100,000
Retaining Earning 50,000
Total Claims 550,000
Income Statement
Sales 1,100,000
All costs except interest 990,000
EBIT 110,000
Interest 20,000
EBT 90,000
Taxes (40%) 36,000
Net Income 54,000
Shares Outstanding 100,000
Earnings per share 0.54
Price/earnings ratio 15.83
Market price of stock 8.55
a.) Show the new balance sheet under each alternative. For Alternative 2 and 3 show the balance sheet after conversion of the bonds or exercise of the warrants. Assume that half of the funds raised will be used to pay off the bank loan and half to increase total assets.
b.) Show Mr. Howland's control position under each alternative, assuming that he does not purchase additional shares.
c.) What is the effect on earnings per share of each alternative, assuming that profits before interes and taxes will be 20% of total assets?
d.) What will be the debt ratio (TL/TA) under each alternative?
e.) Which of the three alternatives would you recommend to Holand, and why?
Explanation / Answer
a. Alternative 1: Sell Common Stock In $ Total Assets 1050000 Current liabilities 400000 Common Stock 600000 Retained Earnings 50000 Total Equity And Liabilities 1050000 Alternative 2: Convertble 8% bonds Total Assets 800000 Current liabilities 150000 Bonds 8% 500000 Common Stock 100000 Retained Earnings 50000 Total Equity And Liabilities 800000 Alternative 3: Sell Debentures at 8% Total Assets 800000 Current liabilities 150000 8% Debentures 500000 Common Stock 100000 Retained Earnings 50000 Total Equity And Liabilities 800000 b. Controling power: In $ Alternative 1: Shares 100000 New shares(500000/8) 62500 Total out standing shares 162500 He has 80000 Shares % is = 80000 / 162500 * 100 Controling power = 49.23% Alternative 2: Controling power = 80% Alternative 3: Controling power = 80% c. Profit is 20% of Assets: Alternative 1: Total Assets 1050000 Profit 20% 210000 Less: Interest on loan 250000*8% 20000 190000 Less: Tax (190000*40%) 76000 Net income 114000 Total Shares outstanding 162500 Earning Per Share = Net income / Total Shares = 114000 / 162500 = $0.70 Alternative 2: Assets 800000 Profit 20% 160000 Less: interest 500000*8% 40000 120000 Less: Tax(120000*40%) 48000 Net Income 72000 Total Shares Outstanding 100000 Earning Per Share = Net income / Total Shares = 72000 / 100000 = $0.72 Alternative 3: Assets 800000 Profit 20% 160000 Less: interest 500000*8% 40000 120000 Less: Tax(120000*40%) 48000 Net Income 72000 Total Shares Outstanding 100000 Earning Per Share = Net income / Total Shares = 72000 / 100000 = $0.72 d. Debt Ratio = Total liabilities / Total Assets Alternative 1: Debt Ratio = 400000 / 1050000 = 0.38 Alternative 2: Debt Ratio = 650000 / 800000 = 0.81 Alternative 3: Debt Ratio = 650000 / 800000 = 0.81 e. Debentures 8% is best alternative, because it is giving high earning per share and high debt ratio also. Note: I assumed in Alternative 2 bonds are not convert to shares in this year, i think it will be converted after one year. Thank you.... Alternative 1: Sell Common Stock In $ Total Assets 1050000 Current liabilities 400000 Common Stock 600000 Retained Earnings 50000 Total Equity And Liabilities 1050000 Alternative 2: Convertble 8% bonds Total Assets 800000 Current liabilities 150000 Bonds 8% 500000 Common Stock 100000 Retained Earnings 50000 Total Equity And Liabilities 800000 Alternative 3: Sell Debentures at 8% Total Assets 800000 Current liabilities 150000 8% Debentures 500000 Common Stock 100000 Retained Earnings 50000 Total Equity And Liabilities 800000Related Questions
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