Consider the financial statements for New England Corporation provided below. Th

Question

Consider the financial statements for New England Corporation provided below.  The company expects sales to increase by 25% in 2019. Its applicable tax rate in 2019 is expected to be 21% (note that this is significantly less than the rate implied by the Income Statement for 2018).  Its dividend payout ratio in 2019 will be exactly the same as what it is in 2018. Accounts payable are the only “spontaneous liability” for this firm.  New England’s management plans to raise any funding needed for growth through long-term debt only.  Its current interest rate on its existing short-term and long-term debt will remain the same for 2019, and it does not propose to pay down any of its existing short-term or long-term debt (so, effectively, it will be able to “roll over” its existing short-term debt at the same rate as it is paying currently).  On any new long-term borrowings in 2019, New England’s creditors have indicated that they will charge 7.25%.

New England Corporation

Income Statement ($ thousands)

2018

Sales

$95,023

Cost of goods sold

63,186

SG&A expense

8,241

Depreciation expense

6,106

EBIT

17,490

Interest expense

6,724

EBT

10,766

Taxes

5,092

Net income

5,674

Allocation of net income:

Dividends

$2,921

Addition to retained earnings

$2,753

Balance Sheet ($ thousands)

31-Dec-18

ASSETS

Current assets

   Cash and marketable securities

$7,916

   Accounts receivable

$22,854

   Inventory

$30,991

Total current assets

$61,761

Net PPE

331,083

Total assets

$392,844

LIABILITIES AND EQUITY

Current liabilities

   Accounts payable

$63,250

   Short-term debt

$53,258

Total current liabilities

$116,508

Long-term debt

$58,757

Total liabilities

$175,265

Shareholders' equity

   Common Stock & Paid-In Capital

$147,400

   Retained earnings

$70,179

Total shareholders' equity

$217,579

Total liabilities and shareholders' equity

$392,844

Make an adjustment to your EFN estimate (Direct Method estimate) if New England Corporation was operating at 90% capacity in 2018.  What is the adjusted EFN once the presence of excess capacity is accounted for?

New England Corporation

Income Statement ($ thousands)

2018

Sales

$95,023

Cost of goods sold

63,186

SG&A expense

8,241

Depreciation expense

6,106

EBIT

17,490

Interest expense

6,724

EBT

10,766

Taxes

5,092

Net income

5,674

Allocation of net income:

Dividends

$2,921

Addition to retained earnings

$2,753

Explanation / Answer

Current sales is $95,023. A 25% increase entails $118,779 of sales. New england is currently operating at 90% capacity. Therefore, 90% of fixed assets are employed.

The formula for full capacity sales :

Full capacity sales x Percentage of capacity used = current sales

Or, X x 0.90 = 95,023

Or, X = $105,581

Therefore, $331,083 of PPE is capable of generating $105,581 of sales. How much PPE will be required for generating $118,779 of sales?

331083/105,581 = X/118779

Or, X = $372,470

Assuming for 2019, the Current assets remain the same, The asset side total becomes = 61,761 + 372,470 = $434,231.

Let the amount of new long term debt needed be Y.

Proforma income statement for 2019:

5,791 + 0.0144Y

Accounts payable = $63,250

Since it is a spontaneous liability, it will increase in proportion with COGS. 2018 COGS is 99.9% of 2018 AP. Therefore, 2019 AP = 78,970 / 0.999 = $79,049

Balancesheet total for 2019:

434,231 = 79,049 + 53,258 + (58,757 + Y) + 147,400 + 70,179 + (5,791 + 0.0144Y)

Or, 434,231 = 414,434 + 1.0144Y

Or, Y = 19,797 / 1.0144 = $19,516

Therefore, EFN for 2019 at 90% capacity is $19,516

If presence of excess capacity is accounted for:

Full capacity sales x Percentage of capacity used = current sales

Or, X x 0.90 = 118,779

Or, X = $131,977

Therefore, $372,470 of PPE is capable of generating $118,779 of sales. How much PPE will be required for generating $131,977 of sales?

372,470/118,779 = X/131,977

Or, X = $413,857

Asset side total at full capacity = 61,761 + 413,857 = $475,618

Now,

$475,618 = 414,434 + 1.0144Y

Or, Y = $60,315

Sales 118,779 -COGS (66.48% of sales) 78,970 -S&A expense (8.67%) 10,301 -Depreciation (18.44% of PPE) 6,869 EBIT 22,639 - Interest 6,724 + 0.0725Y EBT 15,915 + 0.0725Y -tax @21% 3,978.75 + 0.018125Y Net income 11,936 + 0.0544Y Dividend (51.5% of NI) 6,145 + 0.028Y Retained earnings

5,791 + 0.0144Y

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