Question

Coastal Carolina Heating and Cooling Inc. has a 6-month backlog of orders for its patented solar heating system. To meet this demand, management plans to expand production capacity by 50% with a $10 million investment in plant and machinery. The firm wants to maintain a 35% debt level in its capital structure. It also wants to maintain its past dividend policy of distributing 50% of last year's net income. In 2016, net income was $5 million. How much external equity must Coastal Carolina seek at the beginning of 2017 to expand capacity as desired? Assume that the firm uses only debt and common equity in its capital structure. Write out your answer completely. For example, 25 million should be entered as 25,000,000. Round your answer to the nearest cent.

Answer 1

Net income for 2016 = $5 million = $5000000

Since company wants to distribute 50% of its net income

Dividends distributed in 2016 = 50% of net income = 50% of 5000000 = 2500000

Earnings retained in 2016 = net income for 2016 - dividends distributed in 2016 = 5000000 - 2500000 = 2500000

Total investment = $10 million = $10000000
Since the company wants to maintain 35% debt level in its capital structure, therefore 35% of the total investment will be financed by debt

Investment financed by debt = 35% x 10000000 = 3500000

The total investment of Coastal Carolina will financed by debt, earnings retained in 2016 and external equity raised at beginning of 2017

Total investment = Investment financed by debt + earnings retained in 2016 + External equity raised at beginning of 2017

10000000 = 3500000 + 2500000 + External equity raised at beginning of 2017

External equity raised at beginning of 2017 = 10000000 - 3500000 - 2500000 = 4000000

Hence External equity required by Coastal Carolina at beginning of 2017 = 4000000