The following is ABC Inc.’s balance sheet (in thousands):

(LG 21-5)

Assets Liabilities and Equity Cash $ 20 Accounts payable $ 30 Accounts receivable 90 Notes payable 90 Inventory 90 Accruals 30 Long-term debt 150 Plant and equipment 500 Equity 400 Total $700 Total $700 Also, sales equal $500, cost of goods sold equals $360, interest payments equal $62, taxes equal $56, and net income equals $22. The beginning retained earnings is $0, the market value of equity is equal to its book value, and the company pays no dividends.

a. Calculate Altman’s Z score for ABC, Inc. if ABC has a 50 percent dividend payout ratio and the market value of equity is equal to its book value. Recall the following:

EBIT

=

Revenues − Cost of goods sold − Depreciation Net inT caoxmees == (EEBBIITT − − I nIntetereresst t−)( TTaaxx ersa te)

Retained earnings

=

Net income(1 − Dividend payout ratio)

Net working capital

=

Current assets − Current liabilities C urrent assets = Cash + Accounts receivable + Inve ntories Current liabilities

=

Accounts payable + Accruals + Notes payable

b. Should you approve ABC Inc.’s application to your bank for $500,000 for a capital expansion loan?

c. If ABC’s sales were $450,000, taxes were $16,000, and the market value of equity fell to one-quarter of its book value (assume cost of goods sold and interest are unchanged), how would that change ABC’s income statement? With the new data, does your credit decision change?

d. What are some of the shortcomings of using a discriminant function model to evaluate credit risk?AppendixLO1