The company wishes to raise $40,000 in cash and is considering two financing opt
ID: 2592667 • Letter: T
Question
The company wishes to raise $40,000 in cash and is considering two financing options: CSC can sell $40,000 of bonds payable, or it can issue additional common stock for $40,000. To help in the decision process, CSC’s management wants to determine the effects of each alternative on its current ratio and debt to assets ratio.
Compute the current ratio for CSC’s management.
Compute the debt to assets ratio for CSC’s management.
Assume that after the funds are invested, EBIT amounts to $12,900. Also assume the company pays $4,100 in dividends or $4,100 in interest depending on which source of financing is used. Based on a 40 percent tax rate, determine the amount of the increase iretained earnings that would result under each financing option.
Composite Solutions Company (CSC) has the following account balances:Explanation / Answer
1.
Current Assets = $29,000
Current Liabilities = 7,000
Current Ratio = Current Assets / Current Liabilities
If the company issues bonds
Cash will Increase by $40,000 and long term liability will increase by 40,000. So in current ratio only current assets will increase.
Current ratio = (29,000 + 40,000) / 7,000
Current ratio = 9.86:1
If the company issues Common Stock
Cash will Increase by $40,000 and Stockholder’s equity will increase by 40,000. So in current ratio only current assets will increase.
Current ratio = (29,000 + 40,000) / 7,000
Current ratio = 9.86:1
Current Ratio will remain same in both options of Financing.
2.
Total Debt = (41,000 + 7,000) = 48,000
Stockholder’s equity = 68,000
Debt equity ratio = Total Debt / Stockholder’s equity
If the company issues Bonds
Cash will Increase by $40,000 and Debt will increase by 40,000. So in Debt equity ratio only Debt will increase.
Debt equity ratio = (48,000 + 40,000) / 68,000
Debt equity ratio = 129.41%
If the company issues Common Stocks
Cash will Increase by $40,000 and Stockholder’s equity will increase by 40,000. So in Debt equity ratio only Stockholder’s equity will increase.
Debt equity ratio = 48,000 / (68,000 + 40,000)
Debt equity ratio = 44.44%
3.
Retain earnings = EBIT – Interest – Tax * (EBIT – Interest) - Dividend
If the company issues Bonds
= 12900 - 4100- 40% * (12,900 – 4100)
Increase In retain earnings= 5,250
If the company issues Common Stocks
= 12,900 – 40% * (12,900) – 4,100
Increase In retain earnings = 3,640