Please show work Question 5. (20 points) Kemper Company\'s balance sheet and inc
ID: 2600501 • Letter: P
Question
Please show work
Question 5. (20 points) Kemper Company's balance sheet and income statement are shown below (in millions of dollars). The company and its creditors have agreed upon a voluntary reorganization plan. In this plan, each share of the $5 preferred will be exchanged for one share of $1.00 preferred with a par value of $25 plus one 9% subordinated income debenture with a par value of $75. The $9 preferred issue will be retired with cash. The company's tax rate is 30 percent.
Balance Sheet prior to Reorganization (in millions
Current Assets
400
Current liabilities
350
Net fixed assets
450
Advance payments
20
$5 preferred stock, $100 par value (1,000,000) shares
100
$9 preferred stock, no par, callable at 100 (160,000 shares)
30
Common stock, $0.10 par value (10,000,000) shares
50
Retained earnings
300
Total assets
850
Total claims
850
a. Construct the pro forma balance sheet after reorganization takes place. Show the new preferred at its par value.
b. Construct the pro forma income statement after reorganization takes place. How does the recapitalization affect net income available to common stockholders?
Income Statement (in millions)
Prior to Reorganization
After Reorganization
Net sales
900.0
Operating expense
725.0
Net operating income
175.0
Other income
7.0
EBT
182.0
Taxes
54.6
30%
Net income
127.4
Dividends on $5 PS
5.0
Dividends on $9 PS
1.4
Income to Common SHs
121.0
Increased income available to common SHs with reorganization:
c. Calculate the required pre-tax earnings to cover debt and preferred stock obligations, before and after the recapitalization?
d. Calculate the debt ratio before and after the reorganization?
e. Would the common stockholders be in favor of the reorganization? Explain your answer, providing at least 2 reasons for it.
Balance Sheet prior to Reorganization (in millions
Current Assets
400
Current liabilities
350
Net fixed assets
450
Advance payments
20
$5 preferred stock, $100 par value (1,000,000) shares
100
$9 preferred stock, no par, callable at 100 (160,000 shares)
30
Common stock, $0.10 par value (10,000,000) shares
50
Retained earnings
300
Total assets
850
Total claims
850
Explanation / Answer
Solution:
c. The earnings required before the recapitalization is $6.4 million/(1 – 0.30) = $9.14 million. We divide the preferred dividends by 1 – T since $9.14 million should be earned to provide the $6.4 million needed after-tax. After capitalization, the firm requires $1 million/0.7 = $1.43 million to cover the preferred dividend payment, 9% x $75 = $6.75 million to cover the interest expense for a total of $8.18 million. Since interest expense is tax deductible and $6.75 million in pre-tax earnings to cover the interest expense. Hence, required earnings will decrease by $9.14 million - $8.18 million = $0.96 million.
d.
The debt ratio before reorganization is ($350 million + $20 million/$850 million = 0.4353 = 43.53%. After reorganization the debt ratio is ($350 million + $20 million + $75 million)/$820 million = 0.5427 = 54.27%.
e.
The reorganization would favor the common stockholders because:- 1) Earnings to shareholders increased. 2) Income debentures are less risky to the shareholders than preferred stock. 3) Earnings require to cover the fixed charges are decreased