(Choosing financial targets) Simplicity Company is evaluating their capital stru
ID: 2672159 • Letter: #
Question
(Choosing financial targets) Simplicity Company is evaluating their capital structure. The CFO is concerned that the firm might be underleveraged, even though the firm has larger-than-average research and development and foreign tax credits when compared to other firms in its industry. The finance staff prepared the industry comparison shown here.a. Simplicity’s objective is to achieve a credit standing that falls, in the words of the chief financial officer, “comfortably within the ‘A’ range.” What target range would you recommend or each of the three credit measures?
b. Before settling on these target ranges, what other factors should Simplicity’s chief financial officer consider?
c. Before deciding whether the target ranges are really appropriate for Symplicity in its current financial situation, what key issues specific to Symplicity must the chief financial officer resolve?
FUNDS FROM
RATING FIXED CHARGE OPERATIONS/ LONG-TERM DEBT/
CATEGORY COVERAG E TOTAL DEBT CAPITALIZATION
Aa 4.00–5.25x 60–80% 17–23%
A 3.00–4.30 45–65 22–32
Baa 1.95–3.40 35–55 30–41
Explanation / Answer
(Choosing financial targets) Simplicity Company is evaluating their capital structure. The CFO is concerned that the firm might be underleveraged, even though the firm has larger-than-average research and development and foreign tax credits when compared to other firms in its industry. The finance staff prepared the industry comparison shown here.
a. Simplicity’s objective is to achieve a credit standing that falls, in the words of the chief financial officer, “comfortably within the ‘A’ range.” What target range would you recommend or each of the three credit measures?
Fixed Charge Coverage 3.00–4.30
Funds From Operations/Total Debt 45%–65%
Long-Term Debt/Capitalization 22%-32%
So to be comfortably within the range A the company should try to maintain higher fixed coverage ratio (near to 4.3), higher Fund from operation/total debt ratio (near to 65%) and maintain a lower long-term debt to capitalization ratio (near to 22%).
b. Before settling on these target ranges, what other factors should Simplicity’s chief financial officer consider?
1.Company ability to fully use non-interest tax credits (foreign tax credits)
2.Issuance cost related to Debt and future fixed expense in form of interest payment irrespective of the level of income
3.Company ability to raise debt from the market.
4.Effect on Brand image or goodwill of the company on raising debt
c. Before deciding whether the target ranges are really appropriate for Symplicity in its current financial situation, what key issues specific to Symplicity must the chief financial officer resolve?
FUNDS FROM
RATING FIXED CHARGE OPERATIONS/ LONG-TERM DEBT/
CATEGORY COVERAG E TOTAL DEBT CAPITALIZATION
Aa 4.00–5.25x 60–80% 17–23%
A 3.00–4.30 45–65 22–32
Baa 1.95–3.40 35–55 30–41
the CFO of Simplicity’s Corporation should consider the existing amount of R&D expenditure and foreign Tax credit. It is possible company may not be able to fully utilize the additional tax saving generated by taking additional debt when R&D expenditure and foreign tax credit is taken into consideration.
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