Question

The Severn Company plans to raise a net amount of $270 million to finance new equipment in early 2017. Two alternatives are being considered: Common stock may be sold to net $60 per share, or bonds yielding 10% may be issued. The balance sheet and income statement of the Severn Company prior to financing are as follows:

The Severn Company: Balance Sheet as of December 31, 2016 (Millions of Dollars)
Current assets	$ 900.00		Notes payable	$ 255.00
Net fixed assets	450.00		Long-term debt (10%)	697.50
			Common stock, $3 par	60.00
			Retained earnings	337.50
Total assets	$1,350.00		Total liabilities and equity	$1,350.00

The Severn Company: Income Statement for Year Ended December 31, 2016 (Millions of Dollars)

Sales	$2,475.00
Operating costs	2,227.50
Earnings before interest and taxes (10%)	$247.50
Interest on short-term debt	16.00
Interest on long-term debt	69.75
Earnings before taxes	$161.75
Federal-plus-state taxes (40%)	64.70
Net income	$97.05

The probability distribution for annual sales is as follows:

Probability		Annual Sales (Millions of Dollars)
0.30		$2,250
0.40		2,700
0.30		3,150

Assuming that EBIT equals 10% of sales, calculate earnings per share (EPS) under the debt financing and the stock financing alternatives at each possible sales level. Do not round intermediate calculations. Round your answers to two decimal places. Write out your answer completely. For example, 0.00013 million should be entered as 130.

Annual Sales (Millions of Dollars)		EPS under the debt financing		EPS under the stock financing
$2,250		$___		$___
2,700		___		___
3,150		___		___

Calculate expected EPS under both debt and stock financing alternatives. Do not round intermediate calculations. Round your answers to two decimal places. Write out your answer completely. For example, 0.00013 million should be entered as 130.
Under the debt financing expected EPS is $___ .
Under the stock financing expected EPS is $____ .

Calculate σEPS under both debt and stock financing alternatives. Do not round intermediate calculations. Round your answers to two decimal places. Write out your answer completely. For example, 0.00013 million should be entered as 130.
Under the dept financing σEPS is $____ .
Under the stock financing σEPS is $____ .

Calculate the debt-to-capital ratio and the times-interest-earned (TIE) ratio at the expected sales level under each alternative. The old debt will remain outstanding. [Hint: Notes payable should be included in both the numerator and the denominator of the debt-to-capital ratio.] Do not round intermediate calculations. Round your answers to two decimal places.

Under the debt financing:

The debt ratio is	____ %.
Times-interest-earned ratio is	____ .

Under the stock financing:

The debt ratio is	___ %.
Times-interest-earned ratio is	___ .

Answer 1

1
Annual sales	EBIT	No. of	EPS	EPS under
(million dollars)	-10%	Shares	under debt financing	Stock financing
2250	225	20 million	(225-0.10*225)/20 M= $10.125	225/20 M= $11.25
2700	270	20 million	(270-0.10*270)/20 M=$12.15	270/20 M= $13.50
3150	315	20 million	(315-0.10*315)/20 M=$14.175	315/20M= $15.75
(No. of shares= 60 million/$3= 20 Million shares)

2. Under Debt Financing:

Debt ratio= Total debt/Total Capital

= (Notes payable+long term debt+bonds issued)/Total debt+Equity

= ($255M+$697.5+$270M)/$1620= 75.46%

Times interest earned ratio= EBIT/total interest= $270 M/(0.10*$270 M+69.75+16)= 2.39 times

(EBIT at expected sales= 10%(0.30*2250+0.40*2700+0.30*3150)= $270 M)

3. Under Stock financing:

Debt ratio=( 255+697.5)/1350= 70.55%

Times interest earned ratio= 270/(69.75+16)= 3.15 times

Remark: Stock financing is the better option in terms of EPS and Leverage ratios. The company should focus on enhancing its equity base rather than incre.