Question

The verbrugge publishing company's 2019 balance sheet and income statement are as follows

Balance Sheet

Current assets $300

Net Fixed Assets 200

Total assets 500

Current Liabilities $40

Advance Payments by customers $80

Noncallable preferred stock $6 coupon

$110 par value (1,000,000 shares) $110

Callable preferred stock, $10 coupon

no par, $100 call price (200,00) shares $200

Common stock, $2 par value

(5,000,000 shares) $10

Retained Earnings $60

Total liabilities and equity $500

Income Statement

Net Sales $540

Operating Expense $516

Net Operating income $24

Other income $4

EBT $28

Taxes(25%) $7

Net Income $21

Dividends on $6 preferred $6

Dividends on $10 preferred $2

Income available to common stockholders $13

Verbrugge and its creditors have agreed upon a voluntary reorganization plan. In this plan, each share of the noncallable preferred will be exchanged for 1 share or $2.40 preferred with a par value of $35 plus on 8% subordinated income debenture with a par value of $75. The callable preferred issue with be retired with cash generated by reducing current assets.

a) Assume that the reorganization takes place and construct the projected balance. Show the new preferred stock at is par value. What is the total assets? For debt? For preferred stock?

b) Construct the projected income statement. What is the income available to common shareholders in the proposed recapitalization.

c) What were the total cash flows received by the noncallable preferred stockholders prior to the reorganization? What were the total cash flows to the original noncallable preferred stockholders after the reorganization? What was the new income to common stockholders before and after reorganization

d)Required pre-tax earnings are defined as the amount that is just large enough to meet fixed charges. What are the required pre-tax earnings before and after recapitalization?

e) How is the debt ration affected by reorganization? Suppose you treated preferred stock as debt and calculated the resulting debt ratios, How are these ratios affected? If you were a holder of Verbrugge's common stock, would you vote in favor or the reorganization? Why or Why not?

Answer 1

Solution (a)

Let’s consider the reorganization

Present situation = Non callable preferred stock $6 coupon

$110 par value (1,000,000 shares) $110

Proposed situation = 1 share or $2.40 preferred with a par value of $35 and 8% subordinated income debenture with a par value of $75.

So that becomes = $35*1000000 = $35 Million preferred stock & $75*1000000= $75 Million debentures

We also have to consider the following.

The callable preferred issue with be retired. So that will show the following impact.

Current asset will be reduced by $200 million and callable preferred stocks will be written off from the balance sheet.

So finally the Balance sheet will look like this.

Total asset = $300 million

Total Debt = $75 million

Total Preferred Stock = $35

Solution(b)

Now let’s see the projected income statement.

We have to consider the interest which the company will now pay e debenture holders. We have to consider the new preferred stock’s dividend. So the projected income statement will look like this.

Interest will be = $75 * 8%= $6

So the income available to common share holders is $14.1 million.

Solution (C)

Total cash flows received by the noncallable preferred stockholders prior to the reorganization=

Preferred dividend= 6$*1000000= $ 6 million

Total cash flows to the original noncallable preferred stockholders after the reorganization

Preferred dividend = $2.4*1000000= $2.4 million

Interest income = $6 * 1000000 = $6 million

Total = 6+2.4= $8.4 million

Income to common stockholders

before reorganization = $13 million

after reorganization = $14.1million

Solution(d)

Required pre-tax earnings before recapitalization

We have to consider two things. First is dividend and second in interest.

So pretax earnings = Dividend /(1-tax rate)+interest income

                             = ($6+$2)/(1-0.25)+0

                             =$8/0.75=$10.67million

Required pre-tax earnings after recapitalization

pretax earnings = Dividend /(1-tax rate)+interest income

                             = $2.4/(1-0.25)+$6

                             =$2.4/0.75+$6

                             =$3.2+$6=$9.2 million

Solution(e)

How is the debt ratio affected by reorganization? Suppose you treated preferred stock as debt and calculated the resulting debt ratios, How are these ratios affected? If you were a holder of Verbrugge's common stock, would you vote in favor or the reorganization? Why or Why not?

Debt ratio before reorganization

=Total liabilities/Total assets

=(40+80)/500 = 0.24

Debt ratio after reorganization

=Total liabilities/Total assets

= (80+40+75)/300=0.65

Debt ratio is increasing and it is above 0.6. It is not a good sign for the company.

If we consider preferred stock as debt then-

Debt ratio before reorganization

=Total liabilities/Total assets

=(40+80+110+200)/500= 0.86

Debt ratio after reorganization

=Total liabilities/Total assets

= (80+40+75+35)/300=0.76

In this case after reorganization debt ratio is improving and it is a good sign for the company.

If I am a share holder of the organization, then I will definitely vote in favor of this reorganization because the income for common share holder is increasing. By using interest company can use tax shield against profits. And also debt ratio is increasing if we take preferred stocks as liability.