Question

As the chief financial officer of ADM Designs, you are considering to raise $50 million in new debt financing. You are provided with the following information:

Next year’s expected net income after tax but before new financing: $49 million

Sinking-fund payments due next year on the existing debt $15 million

Interest due next year on the existing debt $10 million

Interest rate on new debt 5%

Common stock price, per share $25.00

Common shares outstanding 10 million

Company tax rate 30%

Assume that the annual sinking-fund payments on the new debt will equal $5 million next year. Calculate ADM's % EBIT can fall before the firm struggles to service its interest and principal payments. Show your work by providing the answers for the following ratios:

EBIT = ?

TBC= EBIT / (IE + PP/(1-t)) = ? %

EBIT can fall = ?

Calculate next year’s earnings per share assuming ADM raises $50 million in new debt financing. Show your work by providing the answers to the following questions:

Net income after new financing = ?

EPS = Net income / No. of shares outstanding = ?

Answer 1

Next year’s expected net income after tax but before new financing = NI = $49 million

Earnings before taxes, EBT = NI / (1 - T) = 49 / (1 - 30%) = $ 70 million

Interest due next year on the existing debt = I = $10 million

Hence, EBIT = EBT + I = 70 + 10 = $ 80 milion

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IE = I + I* = 10 + 5% x 50 = $ 12.50 million

PP = Sinking-fund payments due next year on the existing debt + Sinking-fund payments due next year on the new debt = 15 + 5 = $ 20 million

TBC = EBIT / (IE + PP/(1 - T)) = 80 / [12.5 + 20 / (1 - 30%)] = 1.9478 (If you have to input the answer as a number, please round the figure of 1.9478 as per your requirement; if you have to enter this number as %, please enter 194.78%)

Minm EBIT to service the debt burden = IE + PP/(1 - T) = 12.5 + 20 / (1 - 30%) = 41.07

Hence, EBIT can fall by 1- Minm EBIT / EBIT = 1 - 41.07 / 80 = 48.66%

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Net income = NI* = (EBIT - IE) x (1 - T) = (80 - 12.5) x (1 - 30%) = $ 47.25 million

EPS =  Net income / No. of shares outstanding = 47.25 / 10 = $ 4.725 per share