Reference no: EM132943695
Question - The Drew Furniture Company is considering the introduction of a new product line. Plant & inventory expansion equal to 50% of present asset levels will be necessary to handle the anticipated volume of the new product line. New capital will have to be obtained to finance the asset expansion. Two proposals have been developed to provide the added capital.
1. Raise the $100,000 by issuing 10-year 12% bonds. This will change the capital structure from one with about 20% debt to one with almost 50% debt. The investment banking house estimates the P/E ratio, now 12 to 1, will be reduced to 10 to 1 if this method of financing is chosen.
2. Raise the $100,000 by issuing new common stock. The investment banker believes that the stock can be issued to yield $33.33. The P/E ratio would remain at 12 to 1 if the stock were issued. The present market price is $36.
The Company's most recent financial statements are as follows:
Assets
Current 65,000
Plant and equipment 135,000
Total Assets 200,000
Equities
Debt (5%) 40,000
Ordinary Shares 100,000
Retained Earnings 60,000
Total Equities 200,000
Sales 600,000
Less: Operating costs 538,000
Operating income 62,000
Less: Interest Charges 2,000
Net income before tax 60,000
Less: Income Tax 30,000
Net Income 30,000
(a) The Vice-President of finance asks you to calculate the earnings per share & the market value of the stock (assuming the P/E ratios given are valid estimates) for the two proposals assuming total sales (including the new product line) of: (1) $400,000; (2) $600,000; & (3) $800,000. Costs exclusive of interest & taxes are about 90% of sales.
(b) Which proposal would you recommend? Your answer should indicate: (1) the criteria used to judge the alternatives; (2) a brief defense of the criteria used; & (3) the proposals chosen in accordance with the criteria.
(c) Would your answer change if a sales level of $1,200,000 or more could be achieved? Explain.
(d) What reason(s) would the investment broker give to support the estimate of a lower P/E ratio if debt is issued?