Question

Problem 24-02
Reorganization

The Verbrugge Publishing Company's 2016 balance sheet and income statement are as follows (in millions of dollars).

Balance Sheet
Current assets	$168		Current liabilities	$42
Net fixed assets	153		Advance payments	78
Goodwill	15		Reserves	6
			$6 preferred stock, $112.50 par value (1,200,000 shares)	135
			$10.50 preferred stock, no par, callable at $150 (60,000 shares)	9
			Common stock, $1.50 par value (6,000,000 shares)	9
			Retained earnings	57
Total assets	$336		Total claims	$336

Income
Net sales	$540.0
Operating expense	516.0
Net operating income	$ 24.0
Other income	3.0
EBT	$ 27.0
Taxes (50%)	13.5
Net income	$ 13.5
Dividends on $6 preferred	7.2
Dividends on $10.50 preferred	0.6
Income available to common stockholders	$ 5.7

Verbrugge and its creditors have agreed upon a voluntary reorganization plan. In this plan, each share of the $6 preferred will be exchanged for one share of $2.40 preferred with a par value of $38.50 plus one 8% subordinated income debenture with a par value of $74. The $10.50 preferred issue will be retired with cash.

Construct the projected balance sheet while assuming that reorganization takes place. Show the new preferred stock at its par value. Enter your answers in millions. For example, an answer of $1.2 million should be entered as 1.2, not 1,200,000. Round your answers to two decimal places.
The projected balance sheet (in millions of dollars) follows:

Current assets	$		Current liabilities	$
Net fixed assets	$		Advance payments	$
Goodwill	$		Reserves	$
			Subordinated debentures	$
			$2.4 preferred stock, $38.5 par value (1,200,000 shares)	$
			Common stock, $1.50 par value (6,000,000 shares)	$
			Retained earnings	$
Total assets	$		Total claims	$

Construct the projected income statement. What is the income available to common shareholders in the proposed recapitalization? Enter your answers in millions. For example, an answer of $1.2 million should be entered as 1.2, not 1,200,000. Round your answers to two decimal places.
The projected income statement (in millions of dollars) follows:

Net sales	$
Operating expense	$
Net operating income	$
Other income	$
EBIT	$
Interest expense	$
EBT	$
Taxes (50%)	$
Net income	$
Dividends on $2.40 preferred	$
Income available to common stockholders	$

Required earnings is defined as the amount that is just enough to meet fixed charges (debenture interest and/or preferred dividends). What are the required pre-tax earnings before and after the recapitalization? Enter your answers in millions. For example, an answer of $1.2 million should be entered as 1.2, not 1,200,000. Round your answers to two decimal places.

The required pre-tax earnings before recapitalization	$  million
The required pre-tax earnings after recapitalization	$  million

How is the debt ratio affected by the reorganization? Round your answers to two decimal places.

The debt ratio before reorganization	%
The debt ratio after reorganization	%

Answer 1

Solution :-

a) Projected Balance sheet after reorganization ( amounts in million )   

Assets	Amount	Liabilities	Amount
Current assets (168-9)	159	Current liabilities	42
Net fixed assets	153	Advance payables	78
Goodwill	15	Reserves	6
		8% Subordinated debentures	88.80
		$2.4 preferred stock	46.20
		Common stock, $1.50 par value (6,000,000 shares)	9
		Retained earnings	57
Total assets	327	Total claims	327

Working notes:-

1) The preferred shares of $10.50 valued $9 million will retire with cash. Hence , current asset will decrease by $9 million.

2)One subordinated debenture will be given to one preferred share.The par value of sub ordinate debenture is $75.

          i) The par value of sub ordinate debenture after reorganization is

                   Value of subordinate debenture=(Number of preferred shares)× (Par value of                                                                         subordinate debenture)

                   =1,200.000×$74

                   =$88.80million

          ii) Calculation of par value of preferred stock after reorganization

                   Value of preferred stock =(Number of preferred stock (Par value of                                                                     preferred stock)

                                                =1,200.000×$38.50

                                                =$46.20 million

b) Projected income statement

Particulars	Amount
Net Sales	540.00
(-) Operating expenses	516.00
Net operating income	24.00
Other income	3.00
EBIT	27.00
Interest expense on 8% suordinate debenture ($88.80 million×8%)	7.10
EBT	19.90
Taxes (50%)	9.95
Net income	9.95
Dividends on $2.40 preferred	2.88
Income available to common stockholders	7.07

Note:- In the above statement we have adjusted interest expenses and preference dividend.

c)

i) Calculation of required pre-tax earnings before recapitalization

        Required pre-tax earnings ={(dividend for $6 preferred shareholder)/(1-tax rate)}                                                +{(dividend for $10.50 preferred shareholder)/(1-tax rate)}

                                 =($7.20million/0.50)+($0.63million/0.50)

                                =$14.40 mil+$1.26 mil

                                =$15.66 million

ii) Calculation of required pre-tax earnings after recapitalization

      Required pre-tax earnings =Interest on 8% sub ordinate debentures+{(dividend for $2.40 preferred                                                 shareholder)/(1-tax rate)}

                                      =$7.10+(2.88/0.50)

                                      =12.96 million

d) Calculation of Debt ratio before recapitalization

                   Debt ratio=All liablities/Total assets

                             =(current liablities+Advance payments)/Total assets

                             =(42+78)/336

                             =0.357 ie 35.70%

Calculation of Debt ratio after recapitalization

                                Debt ratio=All liablities/Total assets

                                                     = (current liablities+Advance payments+debenture)/Total asset

                                                =(42+78+88.80)/327

                                                =0.638 ie 63.80%

Change in debt ratio= Debt ratio after recapitalization- Debt ratio before recapitalization

                                        =63.80%-35.70%

                                         =28.10%