Question

The Verbrugge Publishing Company's 2019 balance sheet and income statement are as follows (in millions of dollars).

Balance Sheet

Current assets $300 Current Liabilities $40

Net fixed assets $200 Advance payments by customers $80

Noncallable Preferred Stock, $6 coupon, $110 par value (1,000,000 shares) 110

Callable preferred stick, $10 coupon, no par, $100 call price (2,000,000 shares) 200

Common stock, $2 par value (5,000,000 shares) $10

Retained earnings $60

Total Assets $500 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 of $2.50 preferred with a par value of $35 plus one 9% subordinated income debenture with a par value of $75. The callable preferred issue will 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 its par value. What is the value for total assets? For preferred stock? Enter your answers in millions. For example, an answer of $1 million should be entered as 1, not 1,000,000. Round your answers to the nearest whole number. The projected balance sheet (in millions of dollars) follows:

Current assets 100 Current Liabilities 40

Net fixed assets 200 Advance payments by customers 80

Noncallable Preferred Stock, $6 coupon, $110 par value (1,000,000 shares) 75

Callable preferred stick, $10 coupon, no par, $100 call price (2,000,000 shares) 35

Common stock, $2 par value (5,000,000 shares) 10

Retained earnings 60

Total Assets 300 Total liabilities and equity 300

What is the value for debt (i.e., liabilities)? Do not treat preferred stock as debt. Enter your answer in millions. For example, an answer of $1 million should be entered as 1, not 1,000,000. Round your answer to the nearest whole number.

$  ???? million

b. Construct the projected income statement. What is the income available to common shareholders in the proposed recapitalization? Do not round intermediate calculations. Enter your answers in millions. For example, an answer of $1.23 million should be entered as 1.23, not 1,230,000. Round your answers to two decimal places. The projected income statement (in millions of dollars) follows:

Net sales 540

Operating expense 516     

Net operating income 24     

Other income 4     

EBIT      28

Interest     6.75

EBT     21.25

Taxes (25%) 5.31

Net income 15.94

Dividends on $2.50 preferred 2.5    

Income available to common stockholders 13.44

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? Do not round intermediate calculations. Enter your answers in millions. For example, an answer of $1.23 million should be entered as 1.23, not 1,230,000. Round your answers to two decimal places.

Total cash flow to noncallable preferred stockholders before recapitalization: $   million

Total cash flow to noncallable preferred stockholders after recapitalization: $   million

What was the net income to common stockholders before the reorganization? After the reorganization. Do not round intermediate calculations. Enter your answers in millions. For example, an answer of $1.23 million should be entered as 1.23, not 1,230,000. Round your answers to two decimal places.

Net income to common stockholders before recapitalization: $   million

Net income to common stockholders after recapitalization: $   million

Required pre-tax earnings are defined as the amount that is just large enough to meet fixed charges (debenture interest and/or preferred dividends). What are the required pre-tax earnings before and after the recapitalization? Do not round intermediate calculations. Enter your answers in millions. For example, an answer of $1.23 million should be entered as 1.23, not 1,230,000. Round your answers to two decimal places.

Required pre-tax earnings before recapitalization: $   million

Required pre-tax earnings after recapitalization: $   million

How is the debt ratio (i.e., liabilities/total assets) affected by the reorganization? Round your answers to two decimal places.

1. Debt ratio before reorganization: %
2. Debt ratio after reorganization: %

Suppose you treated preferred stock as debt and calculated the resulting debt ratios. How are these ratios affected?

1. Debt ratio before reorganization: %
2. Debt ratio after reorganization: %

Answer 1

a) Projected balance sheet:

Current assets	$100	Current liabilities	$40
Net fixed assets	$200	Advance payments	$80
		9% Subordinated debentures,$75 par value (1,000000 no.s)	$75
		$2.5 preferred stock, $35 par value (1,000000 shares)	$35
		Common stock, $2 par value (5000000 shares)	$10
		Retained earnings	$60
Total assets	$300	Total claims	$300

1)When 10$ preferred stock redeemed with cash the adjustment has been done to current assets and reduced the same amount from current assets ( $300M - $200M)

2)6$ preferred stock redeemed with 9% subordinate debt of value $75M (1000000 * 75$) and 2.5 preferred stock of value $35M (1000000*$35)

Note: Adjustments made:

b) Projected income statement:

Net sales	$540
Operating expense	$516
Net operating income	$24
Other income	$4
EBIT	$28
Interest expense	$6.75
EBT	$21.25
Taxes (25%)	$5.31
Net income	$15.93
Dividends on $2.50 preferred	$2.5
Income available to common stockholders	$13.43

1) Interest on subordinate debt = $75M * 0.09 = $6.75M

2) Divided on preferred dividend = $2.5*1.0M = $2.5M

c) Required earnings:

The required pre-tax earnings before recapitalization ($6M + $2M)	$ 8million
The required pre-tax earnings after recapitalization ($6.75M * (1-0.25){tax effect})+ $2.5M	$ 7.56million

d) Debt equity ratio:

The debt ratio before reorganization = $120M/$380M = 0.315 or 31.57%

The debt ratio after reorganization = $195M/$105M = 1.857 or 185.71%

Explanation:

debt equity ratio formula is Total liabilities/Total equity

before reorganization total liabilities are sum of current liabilities and advances payment and the remaining sum of total claims is total equity.

after reorganization total liabilities are sum of current liabilities, advance payment and subordinate debt and the remaining sum of total claims will become total equity.