Financing alternatives: Using Debt financing:

Stock - Price per share $100 Expected EPS $18.12

Existing L-T debt interest rate 8.00% Standard Deviation $4.31

New L-T debt interest rate 10.00% Expected TIE 10.15

Debt ratio 75.46%

Annual Sales Prob.

$5,000 0.40 Using Equity financing:

$7,500 0.40 Expected EPS $16.52

$8,500 0.20 Standard Deviation $3.79

1.0 Expected TIE 14.89

Debt ratio 58.80%

Amount financed $270

Tax rate 40%

Initial balance sheet data:

Current assets: 900.00

Net fixed assets: 450.00

Accounts payable: 172.50

Notes payable: 255.00

Other current liabilities: 225.00

Long-term debt: 300.00

Common stock: 60.00

Retained earnings: 337.50

Common stock par value: 3.00

Total Assets 1,350.00

Total Liabilities & Equity 1,350.00

Initial income statement data:

Sales 2,475.00

EBIT (10% of sales) 247.50

Interest on S-T debt 15.00

Interest on L-T debt 30.00

Taxes 81.00

Net income 121.5

MODEL-GENERATED DATA:

Analysis if debt financing is used:

Probability 0.4 0.4 0.2

Sales 5,000 7,500 8,500

EBIT 500 750 850

Interest on S-T debt (15) (15) (15)

Interest on L-T debt (51) (51) (51)

EBT 434 684 784

Taxes (174) (274) (314)

Net income 260 410 470

EPS 13.02 20.52 23.52

Expected EPS using debt 18.12

Std Deviation of EPS: 4.31

TIE 7.58 11.36 12.88

Expected TIE: 10.15

Analysis if stock financing is used:

Sales 5,000 7,500 8,500

EBIT 500 750 850

Interest on S-T debt (15) (15) (15)

Interest on L-T debt (30) (30) (30)

EBT 455 705 805

Taxes 182 282 322

Net income 273 423 483

EPS 12.03 18.63 21.28

Expected EPS using stock 16.52

Std Deviation of EPS: 3.79

TIE 11.11 16.67 18.89

Expected TIE 14.89

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.