Problem 6.6

Problem 6.6 - Debt 7,020,000/800,000=8.78 Equity...

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Problem 6.6 A. Calculate the debt ratio, time interest earned, earnings per share, and the financial leverage index under each alternative, assuming the expected increase in operating profit is realized. Loan Option (Debt)- Finance \$10 million with debt at an interest rate of 15% Operating profit 18,000,000 Interest expense 6,300,000 Earnings before tax 11,700,000 Income tax expense (40%) 4,680,000 Net income \$ 7,020,000 Earnings per share(800,000 shares) \$ 8.78 Equity option (financial leverage) - Finance \$10 million through the issuance of common stock 200,000 shares at \$50 per share. Operating profit 18,000,000 Interest expense 4,800,000 Earnings before tax 13,200,000 Income tax expense (40%) 5,280,000 Net income \$ 7,920,000 Earnings per share(1,000,000 shares) \$ 7.92 Debt ratio Total liabilities/Total assets Debt 40+10/90+10=50/100= 50% Equity 40/90+10=40/100=40% Times Interest earned Operating Profit/Interest expense Debt 18/4.8+1.5=18/6.3=2.86x Equity 18/4.8=3.75x Earnings per Share EPS=Net Income/Outstanding Shares

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Unformatted text preview: Debt 7,020,000/800,000=8.78 Equity 7,920,000/1,000,000=7.92 B. Discuss the factors the board should consider in making a decision. This question seems kind of tricky because one option is better in some ways and in other cases it’s not so great. For example, if the board were to take the loan option or “debt option” as I refer it to be then the company will look at having a 50% debt expectancy where as with the equity option would only give them a 40% debt expectancy. Then if you look at the times interest earned it is slightly less than it would be with the equity option. However if they chose this option their earnings per share would be almost a dollar higher in value than the other option. So like I said this is a tricky question, the board really needs to look into all three of these sections, and maybe look at the last couple years finance information and try to predict what would be the best option for their future. This is a tough choice....
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This note was uploaded on 06/13/2011 for the course ACC 320 taught by Professor Tittle during the Spring '10 term at Temple.

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Problem 6.6 - Debt 7,020,000/800,000=8.78 Equity...

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