Intergrative problem Early next year, the Strasburg Company plans to raise a net amount of $270 million to finance new equipment and working capital. Two alternatives are being considered: common stock can be sold to net $54 per share (market price is $60) or bonds yielding 12 percent can be issued. The balance sheet and income statement of the Strasburg Company prior to financing are as follows:
The Strasburg Company
Balance Sheet as of December 31 ($ millions)
Current assets $ 900.00 Accounts payable $ 172.50
Net fixed assets 450.00 Notes payable to bank 255.00
Other current liabilities 225.00
Total current liabilities $ 652.50
Long-term debt (10%) 300.00
Common stock, $3 par 60.00
Retained earnings 337.50
Total assets $1,350.00 Total liabilities and equity $1,350.00
Income Statement for Year Ended December 31 ($ millions)
Sales $2,475.00
Operating costs (2,227.50)
Earnings before interest and taxes (EBIT) (10%) $ 247.50
Interest on short-term debt ( 15.00)
Interest on long-term debt ( 30.00)
Earnings before taxes (EBT) $ 202.50
Taxes (40%) ( 81.00)
Net income $ $ 121.50
The probability distribution for annual sales is as follows:
Annual Sales
Probability ($ millions)
0.20 $2,250
0.60 2,700
0.20 3,150
a. Assuming that EBIT is equal to 10 percent of sales, calculate earnings per share under both the debt financing and the stock financing alternatives at each possible level of sales. Then calculate expected earnings per share (EPS) and ?EPS under both debt and stock financing. Also, calculate the debt-to-total-assets ratio and the times-interest-earned (TIE) ratio at the expected sales level under each alternative. The old debt will remain outstanding. Which financing method do you recommend?
b. Now assume that if new debt is sold, the old long-term debt will not remain outstanding; rather both the old debt and the new debt will be refinanced at the new long-term interest rate of 12 percent. If stock is issued, the old debt will remain outstanding at the existing interest rate. What effect does this change have on the decision to refinance?
c. What would be the effect on the refinancing decision if the rate long-term debt fell to 5 percent or rose to 20 percent, assuming that all long-term debt must be refinanced if new debt is issued? If stock is issued, the old debt will remain outstanding at the existing interest rate.
d. Which financing method would you recommend if the net stock price (1) rose to $105 or (2) fell to $30? Assume that all long-term debt is refinanced at 12 percent if new debt is issued. If stock is issued, the old debt will remain outstanding at the existing interest rate.