Question

Early in the 2020, Baladna Co. prepared an expansion plan. The plan requires an increase in in both property, plant and equipment and inventory by $190,000,000 and $10,000,000 respectively. The following three alternative financing plans have been suggested by the firm’s investment bankers:

Plan I: issue preferred stock at par.

Plan II: issue common stock at $10 per share.

Plan III: issue a 16% long-term bonds, due in 20 years, at par ($1,000).

1. For the year ended December 31, 2020, compute the following ratios under each financing plan (assuming the same statement balances, except for the increased assets and financing; do not adjust retained earnings for the 2020 profits).

Plan A:

1. Times interest earned

Plan B:

1. Times interest earned

Plan C:

1. Times interest earned

Income Statement

For the Year Ended December 31, 2019

(in thousands except earnings per share)

Sales                                                                                              $936,000

Cost of sales                                                                                    671,000

Gross profit                                                                                   $265,000

Operating expenses:

Selling                                                                    $62,000

General                                                                     41,000          103,000

Operating income                                                                         $162,000

Other items:

Interest expense                                                                               20,000

Earnings before provision for income tax                                   $142,000

Provision for income tax                                                                 56,800

Net income                                                                                   $ 85,200

Earnings per share                                                                            $ 0.83

Answer 1

Answer :

Increase in property, plant and equipment = $190,000,000

Increase in and inventory =  $10,000,000

Total increase in assets = $190,000,000 + $10,000,000 = $200,000,000

So, Baladna Co. requires an $200,000,000 under expansion plan.

Under Plan A if Baladna Co.  issues preferred stock at par :

Operating income = $162,000

Interest expense = $20,000

Times interest earned ratio = Operating income / Interest expense

= 162,000 / $20,000

= 8.1 times

Under Plan B if Baladna Co. issue common stock at $10 per share :

Operating income = $162,000

Interest expense = $20,000

Times interest earned ratio = Operating income / Interest expense

= 162,000 / $20,000

= 8.1 times

Under Plan C if Baladna Co. issue a 16% long-term bonds, due in 20 years, at par :

Operating income = $162,000

Interest on 16% long term bonds = $200,000,000 x 16% = $32,000 thousand

Total Interest = $20,000 + 32,000 = $52,000

Times interest earned ratio = Operating income / Interest expense

= 162,000 / $52,000

= 3.115 times

So,

Plan A: Times interest earned = 8.1 times

Plan B: Times interest earned = 8.1 times

Plan C: Times interest earned = 3.115 times