The Severn Company plans to raise a net amount of $270 million to finance new equipment and working capital in early 2006. Two alternatives are being considered: Common stock may be sold to net $60 per share, or bonds yielding 12 percent may be issued. The balance sheet and income statement of the Severn Company prior to financing are as follows: 

Assuming that EBIT equals 10 percent of sales, calculate earnings per share (EPS) under both the debt financing and the stock financing alternatives at each possible level of sales. Then calculate expected EPS and EPS under both debt and stock financing alternatives. Also, calculate the debt 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?

Transcribed Image Text:

The Severn Company: Balance Sheet as of December 31, 2005 (Millions of Dollars) Current assets $ 900.00 Accounts payable $ 172.50 255.00 225.00 $ 652.50 Notes payable to bank Other current liabilities Total current liabilities Long-term debt (10%) Common stock, $3 par Retained earnings 300.00 60.00 337.50 Total liabilities and equity $1,350.00 Net fixed assets Total assets 450.00 $1,350.00 The Severn Company: Income Statement for Year Ended December 31, 2005 (Millions of Dollars) Sales Operating costs Earnings before interest and taxes (10%) Interest on short-term debt Interest on long-term debt Earnings before taxes Federal-plus-state taxes (40%) Net income The probability distribution for annual sales is as follows: Probability 0.30 0.40 0.30 $2,475.00 2,227.50 $ 247.50 15.00 30.00 $ 202.50 81.00 $121.50 Annual Sales (Millions of Dollars) $2,250 2,700 3,150