In 2013, Natural Selection, a nationwide computer dating service, had $500 milli

Question

In 2013, Natural Selection, a nationwide computer dating service, had $500 million of assets and $200 million of liabilities. Earnings before interest and taxes were $120 million, interest expense was $28 million, the tax rate was 40%, principal repayment requirements were $24 million, and annual dividends were 30 cents per share on 20 million shares outstanding.

a) Calculate the following for Natural Selection:

1) Liabilities-to-equity ratio

2) Times-interest-earned ratio

3) Times burden covered

b) What percentage decline in earnings before interest and taxes could Natural Selection have sustained before failing to cover:

1) Interest payment requirements?

2) Principal and interest requirements?

3) Principal, interest, and common dividend payments?

Explanation / Answer

A)Equity = Assets-laibilities=$500 millions -$200 millions.i.e $ 300 millions.

1)Liabilities to equity ration =$200/$300=0.67timesor 0.67:1.

2)Times-interest-earned ratio=EBIT/interest expense=$120 million/$28 million=4.286times1)

3Times Burden Covered =

EBIT/ Interest + [principal payment / (1 – tax rate)]) i.e $120 million/($28+($24/0.6))=1.76 times

B)1)To fail to cover the existing interest payments, the times interest earned ratio has to fall below one. (4.29 - 1)/4.29 = 76.7%, or
(120 - 28)/120 = 76.7%

To fail to cover the interest and principal requirements, the times burden covered ratio has to fall to below one. (1.76-1)/1.76 = 43.2%, or
[120-(28+24/(1-0.40))]/120 = 43.3%

To fail to cover principal, interest, and common dividend payments we must further subtract the impact of dividends on the EBIT.
[120-(28 + ((24 +0.30*20)/(1-0.4))]/120 = (120 - 78)/120 = 35%

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