Donatello Industries wishes to sell its sewer pipe division for $10 million. Management of the division wishes to buy it and has arranged a leveraged buyout. Management will put up $1 million in cash. A senior lender will advance $7 million secured by all the assets of the company. The rate on the loan is 2 percent above the prime rate, which is currently 12 percent. The loan is payable in equal annual principal installments over five years, with interest for the year payable at the end of each year. A junior subordinated loan of $2 million also has been arranged, and this loan is due at the end of six years. The interest rate is fixed at 15 percent, and interest payments only are due at the end of each of the first five years. Interest and the entire principal are due at the end of the sixth year. In addition, the lender has received warrants exercisable for 50 percent of the stock.
The sewer pipe division expects earnings before interest and taxes of $3.4 million in each of the first three years and $3.7 million in the last three years. The tax rate is 33 V) percent, and the company expects capital expenditures and investments in receivables and inventories to equal depreciation charges in each year. All debt servicing must come from profits. (Assume also that the warrants are not exercised and that there is no cash infusion as a result.)
If the prime rate stays at 12 percent on average throughout the six years, will the enterprise be able to service the debt properly? If the prime rate were to rise to 20 percent in the second year and average that for the second year through the sixth year, would the situation change?