Question

In: Accounting

Clayton Industries has the following account balances: Current assets $ 24,000 Current liabilities $ 6,000 Noncurrent...

Clayton Industries has the following account balances:

Current assets $ 24,000 Current liabilities $ 6,000
Noncurrent assets 82,000 Noncurrent liabilities 40,000
Stockholders’ equity 60,000


The company wishes to raise $37,000 in cash and is considering two financing options: Clayton can sell $37,000 of bonds payable, or it can issue additional common stock for $37,000. To help in the decision process, Clayton’s management wants to determine the effects of each alternative on its current ratio and debt-to-assets ratio.

Required
a-1. Compute the current ratio for Clayton’s management currently, if bonds are issued, if stock is issued.

a-2. Compute the debt-to-assets ratio for Clayton’s management currently, if bonds are issued, if stock is issued.

Assume that after the funds are invested, EBIT amounts to $13,100. Also assume the company pays $4,400 in dividends or $4,400 in interest depending on which source of financing is used. Based on a 30 percent tax rate, determine the amount of the increase in retained earnings that would result under each financing option.(bonds, stocks)

Solutions

Expert Solution

a-1)

Current assets after issue of bonds or stock will increase by $37,000. Hence, current ratio will remain same whether funds are raised by issue of bonds or stock

Hence, current assets = 24,000 + 37,000

= $61,000

Current ratio = Current assets/Current liabilities

= 61,000/6,000

= 10.17

a-2)

(i) When funds are raised by issuing bonds

Debt = Current liabilities + Non current liabilities

= 6,000 + (40,000 + 37,000)

= 6,000 + 77,000

= $83,000

Total assets = Current assets + Non current assets

= (24,000 + 37,000) + 82,000

= 61,000 + 82,000

= $143,000

Debt to assets ratio = Debt/Total assets

= 83,000/143,000

= 0.58

(ii) When funds are raised by issuing stock

Debt = Current liabilities + Non current liabilities

= 6,000 + 40,000

= $46,000

Total assets = Current assets + Non current assets

= (24,000 + 37,000) + 82,000

= 61,000 + 82,000

= $143,000

Debt to assets ratio = Debt/Total assets

= 46,000/143,000

= 0.32

Bonds option Stock option
EBIT 13,100 13,100
Less: Interest - 4,400 0
EBT 8,700 13,100
Tax - 2,610 - 3,930
Earnings after tax 6,090 9,170
Dividend 0 - 4,400
Increase in retained earnings $6,090 $4,770

ekkarill92 answered 10 months ago
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