Gentry Company (GC) needs advice regarding their capital structure. They want to issue bonds with a 5-year maturity and maintain an S&P bond rating of BBB. Treasury bonds with a 5-year maturity currently yield 4.0%. Data on yield spreads, along with key financial ratios used by S&P, are provided below.
QUESTION: What is the maximum amount GC can borrow to achieve their goal, using the median financial ratios as a guide? Support your answer with calculations.
Gentry Co. 2010 Partial Income Statement ($000)
Sales
5,000
COGS
3,500
Gross profit
1,500
SG&A expense
500
Operating income
1,000
Gentry Co. 2010 Partial Balance Sheet ($000)
Cash
550
A/P
300
A/R
950
Total current liabilities
300
Inventory
1,800
Total current assets
3,300
Long-term debt
?
Common stock
?
Fixed assets
9,100
Retained earnings
4,800
Total equity
Total
12,400
Total
12,400
Total external financing needs (long-term debt + common stock) = 7,300
Corporate Bond Yield Spreads over Treasurys (in basis points)
Rating
1 yr
2 yr
3 yr
5 yr
7 yr
10 yr
30 yr
AAA
5
10
15
20
25
30
50
AA
15
25
30
35
42
49
60
A
40
49
55
63
67
70
77
BBB
65
80
90
100
112
116
129
BB
200
285
310
270
235
240
265
Key Median Financial Ratios, Long-Term Debt
AAA
AA
A
BBB
BB
B
CCC
EBIT interest coverage (x)
23.8
13.6
8.5
4.2
2.3
0.9
0.4
Debt/capital (%)
6.2
34.8
40.4
45.6
57.2
74.2
101.2
Key Financial Ratios used in Bond Ratings
EBIT interest coverage
Earnings before interest and taxes / interest expense
Debt/capital
Debt / [Debt + shareholders' equity]
Gentry Company (GC) needs advice regarding their capital structure. They want to issue bonds with a 5-year maturity and maintain an S&P bond rating of BBB. Treasury bonds with a 5-year maturity currently yield 4.0%. Data on yield spreads, along with key financial ratios used by S&P, are provided below.
QUESTION: What is the maximum amount GC can borrow to achieve their goal, using the median financial ratios as a guide? Support your answer with calculations.
| Gentry Co. 2010 Partial Income Statement ($000) | |
| Sales | 5,000 |
| COGS | 3,500 |
| Gross profit | 1,500 |
| SG&A expense | 500 |
| Operating income | 1,000 |
| Gentry Co. 2010 Partial Balance Sheet ($000) | |||||
| Cash | 550 | A/P | 300 | ||
| A/R | 950 | Total current liabilities | 300 | ||
| Inventory | 1,800 | ||||
| Total current assets | 3,300 | Long-term debt | ? | ||
| Common stock | ? | ||||
| Fixed assets | 9,100 | Retained earnings | 4,800 | ||
| Total equity | |||||
| Total | 12,400 | Total | 12,400 | ||
Total external financing needs (long-term debt + common stock) = 7,300
| Corporate Bond Yield Spreads over Treasurys (in basis points) | ||||||||
| Rating | 1 yr | 2 yr | 3 yr | 5 yr | 7 yr | 10 yr | 30 yr | |
| AAA | 5 | 10 | 15 | 20 | 25 | 30 | 50 | |
| AA | 15 | 25 | 30 | 35 | 42 | 49 | 60 | |
| A | 40 | 49 | 55 | 63 | 67 | 70 | 77 | |
| BBB | 65 | 80 | 90 | 100 | 112 | 116 | 129 | |
| BB | 200 | 285 | 310 | 270 | 235 | 240 | 265 | |
| Key Median Financial Ratios, Long-Term Debt | |||||||
| AAA | AA | A | BBB | BB | B | CCC | |
| EBIT interest coverage (x) | 23.8 | 13.6 | 8.5 | 4.2 | 2.3 | 0.9 | 0.4 |
| Debt/capital (%) | 6.2 | 34.8 | 40.4 | 45.6 | 57.2 | 74.2 | 101.2 |
| Key Financial Ratios used in Bond Ratings | |
| EBIT interest coverage | Earnings before interest and taxes / interest expense |
| Debt/capital | Debt / [Debt + shareholders' equity] |
Related questions
need some help filling out my balance and income statement using the following information given.
Using a Percentage of Sales method from 2017 results and the Given Information below, derive the 2018 Pro Forma (forecast) Income Statement and Balance Sheet (i.e. fill in the 2018 cells with the appropriate amounts).
Is there a âplugâ needed? If so, how much is it? What does it tell you about Scarletâs forecasted 2018 financial projections and what could Scarlet do to remedy the situation?
Based on Scarletâs 2017 & 2016 financials, what is her businessâs Sustainable Growth Rate (SGR)?
Given Information:
Scarlet believes that her 2018 Revenue figure will be 12% higher than her 2017 Revenue.
She estimates that her SG&A will go up by $1,000 from 2016-2017 since she plans on getting a part-time employee.
She doesnât intend to pay any dividends for 2018.
For her Balance Sheet forecasted items she uses only 2017 results, rather than taking an average of the results (average of the % of sales) from 2016 and 2017.
Scarlet assumes Interest Expense, Curr Portion of LT Debt, and Bank Loan Payable will remain the same in 2018 as they were in 2017.
Scarlet plans on issuing $1,000 of (new) Common Stock in 2018.
Scarlet determines that she will need to spend $3,700 for a new Lemon Press machine, which will be her entire CAPEX for 2018. We will assume depreciation will be $200 for this item for 2018, and the yearly depreciation/amortization expense for the rest of Scarletâs PPE will remain the same as it was in 2017 (and assume no asset sales were made in 2017).
Intangibles and Goodwill will remain unchanged in 2018.
She is not planning on disposing of any of her assets (i.e. no asset sales).
| Income Statement | ||
| 2018 | 2017 | |
| Sales / Revenue | 46,592 | 41,600 |
| Cost of Goods Sold (COGS) | ? | 24,960 |
| Gross Profit | ? | 16,640 |
| Selling, General & Administrative (SG&A) | 13,940 | 12,940 |
| Operating Profit | ? | 3,700 |
| Interest Expense | ? | 2,000 |
| Income Before Taxes | ? | 1,700 |
| Income Tax Expense | ? | 595 |
| Net Income | ? | 1,105 |
| Assume No Dividends Paid |
| Balance Sheet | |||||||||||
| Assets | Liabilities and Stockholders' Equity | ||||||||||
| Current Assets: | 2018 | 2017 | 2016 | Current Liabilities: | 2018 | 2017 | 2016 | ||||
| Cash | ? | 2,500 | 5,495 | A/P | ? | 1,100 | 300 | ||||
| A/R | ? | 800 | 1,300 | Deferred Revenue | ? | 700 | 1,000 | ||||
| Inventory | ? | 2,900 | 1,600 | Curr Portion of LT Debt | ? | 2,200 | 5,300 | ||||
| Prepaid Rent | ? | 2,200 | 1,800 | Wages Payable | ? | 2,600 | 4,600 | ||||
| Prepaid Insurance | ? | 1,400 | 1,900 | Tot Curr Liab | ? | 6,600 | 11,200 | ||||
| Tot Curr Assets | ? | 9,800 | 12,095 | ||||||||
| LT Liab | |||||||||||
| LT Assets | Bank Loan Payable | ? | 5,500 | 3,300 | |||||||
| PPE, Gross | ? | 9,500 | 5,500 | Tot Liab | ? | 12,100 | 14,500 | ||||
| Accumul Depr | ? | 2,800 | 2,000 | ||||||||
| PPE, Net | ? | 6,700 | 3,500 | Stockholders' Equity | |||||||
| Common Stock | 4,300 | 3,300 | 1,100 | ||||||||
| Intangibles | ? | 3,000 | 3,000 | Retained Earnings | ? | 5,100 | 3,995 | ||||
| Goodwill | ? | 1,000 | 1,000 | Total Stockholders' Equity | ? | 8,400 | 5,095 | ||||
| Total Assets | ? | 20,500 | 19,595 | Total Liab + Stockholders' Equity | ? | 20,500 | 19,595 | ||||
| 2a. | PLUG (if necessary): | ? | |||||||||
| What it tells you: | ? | ||||||||||
| 2b. | Sustainable Growth Rate (SGR): | ? | |||||||||
You recently graduated from Suffolk University, and your job search led you to J&J Bagel, Inc. As you are finishing your employment paperwork, Jerry Chen, one of the co-owners of J&J Bagel, informs you about the companyâs new 401(k) plan. A 401(k) is a type of retirement plan, offered by many companies.
A 401(k) is tax deferred, which means that any deposits you make into the plan are deducted from your current income, so no current taxes are paid on these deposits. For example, if your annual salary is $30,000 and you contribute $1,500 to the 401(k) plan, you will pay taxes only on the $28,500 in income. No taxes will be due on any capital gains or plan income while you are invested in the plan, but you will pay taxes when you withdraw the money at retirement. You can contribute up to 15 percent of your salary to the plan. As is common, J&J Bagel has a 5 percent match program. This means that the company will match your contribution dollar-for-dollar up to 5 percent of your salary, but you must contribute to get the match. In other words, if you contribute 5 percent of your $30,000 salary (which is $1,500) towards the 401(k) plan, J&J Bagel will match your contribution by adding another $1,500 to your plan, so that $3,000 in total will be contributed to your 401(k) plan.
The 401(k) plan has several options for investments, most of which are mutual funds. As you know, a mutual fund is a portfolio of assets. When you purchase shares in a mutual fund, you are actually purchasing partial ownership of the fundâs assets, similar to purchasing shares of stock in a company. The return of the fund is the weighted average of the return of the assets owned by the fund, minus expenses. The largest expense is typically the management fee paid to the fund managers, who make all of the investment decisions for the fund. J&J Bagel uses Imperium Financial Services as its 401(k) plan administrator.
Jerry Chen then explains the following retirement investment options available for employees:
Company Stock. One option is stock in J&J Bagel. The company is currently privately held. The price you would pay for the stock is based on an annual appraisal, less a 20 percent discount. When you are interviewed by the owners, John Benson and Jerry Chen, they informed you that the company stock was expected to be publically sold in three to five years. If you needed to sell the stock before it became publicly traded, the company would buy it back at the then-current appraised value.
Imperium S&P 500 Index Fund. This mutual fund tracks the S&P 500 Index. Stocks in the fund are weighted exactly the same as they are in the S&P 500 Index. This means that the fundâs return is approximately the return of the S&P 500 Index, minus expenses. With an index fund, the manager is not required to research stocks and make investment decisions, so fund expenses are usually low. The Imperium S&P 500 Index Fund charges expenses of 0.20 percent of assets per year.1
Imperium Small-Cap Fund. This fund primarily invests in small capitalization stocks. As such, the returns of the fund are more volatile. The fund can also invest 10 percent of its assets in companies based outside of the U.S. This fund charges 1.7 percent of assets in expenses per year.
Imperium Large-Cap Fund. This fund invests primarily in large capitalization stocks of companies based in the U.S. The fund is managed by Jenna King and has outperformed the market in six out of the last eight years. The fund charges 1.5 percent in expenses.
Imperium Bond Fund. This fund invests in long-term corporate bonds issued by U.S. companies. The fund is restricted to investments in bonds with investment grade credit rating. This fund charges 1.4 percent in expenses.
Imperium Money Market Fund. This fund invests in short-term, high credit quality debt instruments, which include Treasury Bills. As such, the return on money market funds is only slightly higher than the return on Treasury Bills. Because of the credit quality and short-term nature of the investments, there is only a very slight risk of negative return. The fund charges 0.60 percent in expenses.
*1 The return on a mutual fund after accounting for management expenses is calculated as follows. If a fund charges 2 percent in expenses and it is expected to yield a 10 percent return before expenses, then the return on this fund after expenses will be (1 + 0.10)Ã(1 â 0.02) â 1 = 0.078 or 7.8 percent*
QUESTIONS
1. advantages/disadvantages do the mutual funds offer compared to company stock for your retirement investing?
2. One can assess investment risk by looking forward to how assets are expected to react to a particular set of circumstances or âstates of economyâ. Use the following set of assumptions for the coming year to compute the expected rates of return (before expenses) and the standard deviations for the mutual funds described above.
| Probability | S&P 500 index fund | Small-cap fund | large-cap fund | Bondfund | moneymarketfund | |
|---|---|---|---|---|---|---|
| Recession | 20% | -12% | -30% | -10% | 18% | 2% |
| Near Recession | 10% | -8% | -20% | -6% | 14% | 3% |
| Normal | 30% | 12% | 22% | 12% | 8% | 4% |
| Near Boom | 20% | 22% | 38% | 15% | -1% | 5% |
| Boom | 20% | 26% | 54% | 20% | -6% | 6% |
3. Given the expected returns calculated for each of the mutual funds above, estimate the betas of these funds. Assume a risk-free rate of 4 percent and the expected market return equal to the expected return on the S&P 500 Index.
4. If you decide to invest your money equally in the Small-Cap and Bond funds, what would your portfolioâs expected return and risk level (standard deviation and beta) be? (Hint: Adjust mutual fund returns for management expenses as explained in footnote 1.
5. What would happen if you were to put 70 percent of your portfolio in the Small-Cap fund and 30 percent in the S&P 500 Index fund? Would this combination be better for you?
6. The returns of the Imperium Small-Cap Fund are the most volatile of all the mutual funds offered in the 401(k) plan. Why would you ever want to invest in this fund? When you examine the expenses of the mutual funds, you will notice that this fund also has the highest expenses. Will this affect your decision to invest in this fund?
