Northern Pacific Heating and Cooling Inc. has a 6-month backlog of orders for it

Question

Northern Pacific Heating and Cooling Inc. has a 6-month backlog of orders for its patented solar heating system. To meet this demand, management plans to expand production capacity by 45% with a $10 million investment in plant and machinery. The firm wants to maintain a 35% debt-to-total-assets ratio in its capital structure. It also wants to maintain its past dividend policy of distributing 40% of last year's net income. In 2012, net income was $5 million. How much external equity must Northern Pacific seek at the beginning of 2013 to expand capacity as desired? Assume the firm uses only debt and common equity in its capital structure. Write out your answer completely. For example, 25 million should be entered as 25,000,000.

Explanation / Answer

Retained earnings        = Net income (1 – Payout ratio)

                           = $5,000,000(0.6) = $3,000,000.

External equity needed:

Total equity required            = (New investment)(1 – Debt ratio)

                                = $10,000,000(0.65) = $6,500,000.

New external equity needed = $6,500,000 – $3,000,000 = $3,500,000.

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