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%) 695.00 Common stock, $3 par 60.00 Retained earnings 340.00 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 15.00 Interest on long-term debt 69.50 Earnings before taxes $163.00 Federal-plus-state taxes (40%) 65.20 Net income $97.80 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 . ___________ Which financing method do you recommend? select one Debt or Equity

Answer 1

1. Calculation of EPS

Debt Financing
Prob	0.3	0.4	0.3
Sales	2250	2700	3150
Ebit@10% of sales	225	270	315
Intt. Cost on short term	15	15	15
Intt. Cost on long term	69.5	69.5	69.5
Intt Cost on debt Finance	27	27	27
EBT	113.5	158.5	203.5
Tax@40%	45.4	63.4	81.4
EAT	68.1	95.1	122.1
Equity Shares	100	100	100
EPS on Debt Financing	0.681	0.951	1.221
Equity Financing
Prob	0.3	0.4	0.3
Sales	2250	2700	3150
EBIT@10% of sales	225	270	315
Intt. Cost on short term	15	15	15
Intt. Cost on long term	69.5	69.5	69.5
EBT	140.5	185.5	230.5
Tax@40%	56.2	74.2	92.2
EAT	84.3	111.3	138.3
Equity Shares	95.5	95.5	95.5
EPS on Debt Financing	0.883	1.165	1.448

2.Calculation of Standard deviation

Sales	EPS
	Debt	Equity	Prob	P.Debt	P Equity	(Debt-Debt mean)^2	(Eq.-Eq Mean)^2	P(Debt-Debt mean)^2	P(Eq.-Eq Mean)^2
2250	0.681	0.883	0.3	0.204	0.180	0.073	0.074	0.02187	0.054102063
2700	0.951	1.165	0.4	0.380	0.443	0.000	0.000	0	0.177334115
3150	1.221	1.448	0.3	0.366	0.530	0.073	0.086	0.02187	0.159139131
Total				0.951	1.154			0.04374	0.390575309
				Debt Mean	Equity Mean			Variance Debt	Variance Equity
							Standard Deviation
							Debt	0.209141101	Square root of variance debt
							Equity	0.624960246	Square root of variance equity

3. Debt to capital ratio calculation

Debt to capital Ratio =	Debt/Debt+Shareholder Equity
Calcuation of debt to capital ratio(Debt Finance)
Sales	2250	2700	3150
Debt
Long term debt	695	695	695
Notes Payable	255	255	255
Addition Require in next yr.	270	270	270
Total debt	1220	1220	1220
Shareholders Equity
Common Shares	60	60	60
Retained Earrning	340	340	340
Total Shareholders Equity	400	400	400
Debt to capital ratio	0.753086	0.753086	0.753086
Debt to capital Ratio =	Debt/Debt+Shareholder Equity
Calcuation of debt to capital ratio(Equity Finance)
Sales	2250	2700	3150
Debt
Long term debt	695	695	695
Notes Payable	255	255	255
Total debt	950	950	950
Shareholders Equity
Common Shares	55.5	55.5	55.5
Retained Earrning	340	340	340
Total Shareholders Equity	395.5	395.5	395.5
Debt to capital ratio	0.706057	0.706057	0.706057

4.Time Interest Earn Ratio

TIE Ratio =	EBIT/Interest Expense
Calcuation of Time interest Earning ratio(Debt Finance)
Sales	2250	2700	3150
EBIT@10% of sales	225	270	315
Interest Expenses
Intt. Cost on short term	15	15	15
Intt. Cost on long term	69.5	69.5	69.5
Intt Cost on debt Finance	27	27	27
Total Interest Exp.	111.5	111.5	111.5
TIE	2.018	2.422	2.825
TIE Ratio =	EBIT/Interest Expense
Calcuation of Time interest Earning ratio(Equity Finance)
Sales	2250	2700	3150
EBIT@10% of sales	225	270	315
Interest Expenses
Intt. Cost on short term	15	15	15
Intt. Cost on long term	69.5	69.5	69.5
Total Interest Exp.	84.5	84.5	84.5
TIE	2.663	3.195	3.728