This problem asks you to evaluate a major increase in financial leverage on the part of Nova Products, Inc. The company’s financial statements for 2015–2017 and specific questions are available for download through McGraw-Hill’s Connect or your course instructor.

Using the financial statements provided below to answer the following questions:

 

NOVA PRODUCTS
INCOME STATEMENT ($ millions)
	2015	2016	2017
Sales	5,957.8	6,228.3	6,876.0
Cost of Goods Sold	2,156.9	2,217.6	2,481.8
Gross Profit	3,800.9	4,010.7	4,394.2
Selling, General, & Administrative Expense	2,889.5	2,979.6	3,213.6
Operating Income Before Depreciation	911.4	1,031.1	1,180.6
Depreciation, Depletion, & Amortization	109.0	124.8	123.5
Operating Profit	802.4	906.3	1,057.1
Interest Expense	71.1	59.7	49.0
Non-Operating Income/Expense	36.3	25.3	(0.3)
Special Items	(77.9)	(36.3)	(14.3)
Pretax Income	689.7	835.6	993.5
Total Income Taxes	240.3	292.3	318.9
Minority Interest	4.5	8.7	9.8
Income Before Extraordinary Items & Discontinued Operations	444.9	534.6	664.8
Extraordinary Items	(0.3)	0.0	0.0
Discontinued Operations	0.0	0.0	0.0
Adjusted Net Income	444.6	534.6	664.8
BALANCE SHEET ($ millions)
	2015	2016	2017
ASSETS
Cash & Short-Term Investments	508.5	606.8	694.0
Net Receivables	519.5	555.4	599.8
Inventories	612.5	614.7	653.4
Other Current Assets	248.6	271.3	278.9
Total Current Assets	1,889.1	2,048.2	2,226.1
Gross Plant, Property & Equipment	1,552.4	1,548.4	1,728.9
Accumulated Depreciation	779.7	779.3	873.3
Net Plant, Property & Equipment	772.7	769.1	855.6
Intangibles	0.0	20.6	46.2
Deferred Charges	0.0	0.0	0.0
Other Assets	530.8	489.6	434.4
TOTAL ASSETS	3,192.6	3,327.5	3,562.3
LIABILITIES
Long Term Debt Due In One Year	1.2	3.1	4.4
Notes Payable	87.6	602.1	239.7
Accounts Payable	404.1	379.9	400.1
Taxes Payable	375.9	353.0	321.9
Other Current Liabilities	592.2	637.4	621.6
Total Current Liabilities	1,461.0	1,975.5	1,587.7
Long Term Debt	1,236.3	767.0	877.7
Deferred Taxes	30.6	35.4	50.6
Investment Tax Credit	0.0	0.0	0.0
Minority Interest	29.0	37.0	46.0
Other Liabilities	510.8	640.3	629.0
TOTAL LIABILITIES	3,267.7	3,455.2	3,191.0
EQUITY
Common Stock	89.1	89.6	90.3
Capital Surplus	938.0	1,019.5	1,188.4
Retained Earnings	899.9	943.9	1,473.0
Less: Treasury Stock	2,002.1	2,180.7	2,380.4
TOTAL EQUITY	(75.1)	(127.7)	371.3
TOTAL LIABILITIES & EQUITY	3,192.6	3,327.5	3,562.3

a. What was the book value of Nova’s shareholders’ equity from 2015 to 2017? What were Nova’s debt-to-assets and times-interest-earned ratios in these years? (Use pretax income plus interest expense as EBIT.) What do these figures suggest about Nova’s use of financial leverage? Consulting Table 6-5 in the text, what bond rating would Nova have in 2016 if the rating were based solely on the firm’s coverage ratio?

b. What percentage decline in EBIT could Nova have suffered in each year before Nova would have been unable to make its interest payments out of operating income?                                      

c. Assuming a 35 percent corporate tax rate, and 2016 earnings before interest and taxes of $895 million, by how much did Nova’s $60 million interest expense reduce taxes?                                         

d. Answer question (a) and (b) again for 2016 assuming the company had borrowed an additional $3 billion in debt at 8 percent interest at the start of the year and distributed the proceeds to shareholders as a special dividend. You may ignore the effect of added interest expense on Nova’s balance sheet. Might shareholders benefit from such an increase in financial leverage? Explain.                                         

e. Based on your analysis, is Nova heavily or modestly indebted? Should the company acquire more debt, or shed existing debt? Why?