Question

Sun Minerals, Inc., is considering issuing additional long-term debt to finance an expansion. Currently, the company has $52 million in 8 percent debt outstanding. Its after-tax net income is $12 million, and the company is in the 40 percent tax bracket. The company is required by the debt holders to maintain its times interest earned ratio at 3.8 or greater. Do not round intermediate calculations.

What is the present coverage (times interest earned) ratio? Round your answer to one decimal place. 5.8 times

How much additional 8 percent debt can the company issue now and maintain its times interest earned ratio at 3.8? (Assume for this calculation that earnings before interest and taxes remain at their present level.) Enter your answer in millions. For example, an answer of $1.2 million should be entered as 1.2, not 1,200,000. Round your answer to two decimal places. $ 13.79 million

If the interest rate on additional debt is 10 percent, how much unused “debt capacity” does the company have? Enter your answer in millions. For example, an answer of $1.2 million should be entered as 1.2, not 1,200,000. Round your answer to two decimal places. $ .63 million

Answer 1

After-tax net income of =$12,000,000

Rate of tax =40%

Debt outstanding=$52,000,000 in 8%

Maintenance of time interest earned ratio of 3.8 or better by its debt holders:

Times interest earned ratio:

= Earnings before Interest and taxes (EBIT) / Interest charges

Interest charges:

=Outstanding Debt * Interest rate of debt

=$52,000,000 * 8% =$4,160,000

Earnings before interest and taxes:

=After tax net income / (1-Tax rate) + Interest charges

=$12,000,000 / (1-.40) + $4,160,000

=$12,000,000 / .60 + $4,160,000

=$20,000,000 + $4,160,000

Earnings before interest and taxes =$24,160,000

Time interest earned ratio:

= Earnings before Interest and taxes (EBIT) / Interest charges

=$24,160,000 / $4,160,000

=5.8 times

Issuance of additional 8 percent debt and maintenance of times interest earned ratio at 3.5:

It was assumed for this calculation that the earnings before interest and taxes remain at their present level. Maximum amount of interest can be calculated by altering the original times interest earned ratio.

3.8 times =$24,160,000 / Interest charges

Maximum amount of interest =Earnings before Interest and taxes (EBIT) / Time interest earned ratio

=$24,160,000 / 3.8 times

=$6,357,894

Interest amount= $4,160,000

=$6,357,894 - $4,160,000 = $2,197,894

Additional Debt can be issued = Additional Interest Expenses which can be incurred /Additional cost of debt

=$2,197,894 / 8%

=$27,473,675

=$27.47 million

Interest rate on additional debt is 12 percent, calculation of “debt capacity”:

=Earnings before Interest and taxes (EBIT) / Time interest earned ratio

=$24,160,000 / 3.8 times

=$6,357,894

Interest amount= $4,160,000

=$6,357,894 - $4,160,000 = $2,197,894

Additional Debt can be issued = Additional Interest Expenses which can be incurred /Additional cost of debt

=$2,197,894 / 10%

=$21,978,940

=$21.98 million