Gentry Company (GC) needs advice regarding their capital structure. They want to
ID: 2708082 • Letter: G
Question
Gentry Company (GC) needs advice regarding their capital structure. They want to issue bonds with a 5-year maturity and maintain an S&P bond rating of BBB. Treasury bonds with a 5-year maturity currently yield 4.0%. Data on yield spreads, along with key financial ratios used by S&P, are provided below.
QUESTION: What is the maximum amount GC can borrow to achieve their goal, using the median financial ratios as a guide? Support your answer with calculations.
Gentry Co. 2010 Partial Income Statement ($000)
Sales
5,000
COGS
3,500
Gross profit
1,500
SG&A expense
500
Operating income
1,000
Gentry Co. 2010 Partial Balance Sheet ($000)
Cash
550
A/P
300
A/R
950
Total current liabilities
300
Inventory
1,800
Total current assets
3,300
Long-term debt
?
Common stock
?
Fixed assets
9,100
Retained earnings
4,800
Total equity
Total
12,400
Total
12,400
Total external financing needs (long-term debt + common stock) = 7,300
Corporate Bond Yield Spreads over Treasurys (in basis points)
Rating
1 yr
2 yr
3 yr
5 yr
7 yr
10 yr
30 yr
AAA
5
10
15
20
25
30
50
AA
15
25
30
35
42
49
60
A
40
49
55
63
67
70
77
BBB
65
80
90
100
112
116
129
BB
200
285
310
270
235
240
265
Key Median Financial Ratios, Long-Term Debt
AAA
AA
A
BBB
BB
B
CCC
EBIT interest coverage (x)
23.8
13.6
8.5
4.2
2.3
0.9
0.4
Debt/capital (%)
6.2
34.8
40.4
45.6
57.2
74.2
101.2
Key Financial Ratios used in Bond Ratings
EBIT interest coverage
Earnings before interest and taxes / interest expense
Debt/capital
Debt / [Debt + shareholders' equity]
Gentry Co. 2010 Partial Income Statement ($000)
Sales
5,000
COGS
3,500
Gross profit
1,500
SG&A expense
500
Operating income
1,000
Explanation / Answer
The maximum amount the GC can borrow to achieve their goal is as below
Given , from Key Median Financial Ratios, Long-Term Debt for BBB rating is as follows
Debt/capital (%) = 45.6
EBIT interest coverage (x) = 4.2
Given total external financing needs (long-term debt + common stock) = 7,300000
Hence, Debt required = 7300 x 45.6% = 3328.8 x 1000 = $3328800
Common stock required = 7,300000 x 54.4% = $3971200
Given EBIT = 1000000
and
EBIT interest coverage (x) =Earnings before interest and taxes / interest expense = 4.2
= 1000000 /interest expense = 4.2
Hence, Interest Expense = 1000000 /4.2 = 238095.24
Hence, Rate of Interest = 238095.24 / $3328800 = 0.071526 = 7.15%
the maximum amount GC can borrow to achieve their goal, using the median financial ratios as a guide is
$3328800 with 7.15% as Coupon rate.
Related Questions
drjack9650@gmail.com
Navigate
Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.