Read the case first and answer the question according to the text and exhibit.

QUESTION: Project the 1996 income statement assuming the firm uses debt. (Assume sales will increase by 10 percent, and show your calculations in your answer)

Palmetto Soups is a household name in much of the Southeast and Southwest. It wasnt always so.

Thirty years ago Robert Rivera founded Palmetto Soups when numerous informal and unscientific taste tests convinced him that his recipes generated soups that were different and flavorful. Only six years out of college, Rivera literally had to pester grocery stores to sell his soups. The first three years were difficult as few stores were willing to give shelf space to the products of a firm owned by someone not quite thirty years of age. Yet the soups were good and grocers who did carry Palmetto products quickly noticed that customers began asking for Palmetto by name. Sales and profits grew rapidly and, in fact, in the last few years earnings per share have increased at a rate well above companies of similar size. And the future looks bright also. The companys market area is experiencing an economic boom, and sales are projected to increase in real terms (i.e.,adjusted for inflation) for at least the next three years.

COST REDUCTION

Earlier this year (1995), Palmettos board of directors approved a switch to a highly capital-intensive method of production. This change will be made in part to accommodate the anticipated sales growth but mainly to lower unit costs. At present raw materials and direct labor are 77 percent of sales, which is the industry average. By 1997, these inputs are expected to be roughly 45 percent of salesprimarily due to substantial labor savingsand the gross margin should be 52 percent, which would be the highest in the industry. The year 1996, however, will be a transition year. That is, it will make time to fully implement the new production techniques. Management believes that raw materials and direct labor will be 60 percent of sales. Since variable selling expense is predicted to be 3 percent of sales, in 1996 gross margin is estimated to be 37 percent. Of course, the change will increase the firms overhead costs. Administrative and other fixed expenses are predicted to reach $3 million and $1 million. respectively, in 1996 due in part to necessity of hiring a number of experienced technicians. Depreciation in 1996 will be $3.75 million. Production is confident that these cost of sales will not strain in the firms capacity. For example, in 1996 the company will operate at roughly 57 percent of its production capability.

Everyone in the company believes the change will be very profitable in the long run, but there is a heated debate over the financing of the Project. The companys investment banking firm, Smith, Peabody and Associates, believes that all Money could easly be borrowed considering Palmettos extremly strong net working capital position, very competitive debt ratio, and low business risk.

FINANCING CONTROVERSY

Rivera, the company president, wants to use this debt alternative. First, he feels the risk is minimal since the demand for the company's product is quite stable. "After all," he argues, "we've never been more than 10 percent off in any of our sales forecasts." Second, sales and profits are both expected to increase for at least the next three years. Next year's (1996) sales, for example, are predicted to increase 10 percent, though half of this is pure inflation. Rivera simply finds it hard to believe that the money to pay the debt won't be there. Third, equity financing will bring in outsiders to the business, and he is very proud of the fact that all the firm's stock is owned by the Rivera family. Finally, since he strongly believes that the company's profits will "take off," Rivera is loathe to "divide up the pie into more slices," which could be the result if additional stock were issued. As he puts it, "The possibility of sharing what I've worked so hard to develop bothers me a great deal."Theodore Tlpps, a financial officer, has a very different view. He worries that the huge interest expense associated with the debt may embarrass the company. Specifically, his concern is that net operating income in 1996, the transition year, will be insufficient to pay the firm's interest, which he estimates would increase by $1.4 million if debt is used. Tlpps agrees with Rivera about Palmetto's future prospects but cautiously points out that "too much debt could mean we won't be around to enjoy the fruits of our investments. And there is another problem: the threat of bankruptcy needs to be considered. Adverse rumors could cause key employees to leave, make it difficult to deal with our suppliers, and might even cost us sales. It is, therefore, not just a question of whether we can pay the debt, but whether we can do so without disrupting the operation of the firm." Tipps also suggests lengthening the term of the loan in order to lower the yearly payment, assuming the firm decides to borrow. Rivera is reluctant to do this because (1) it would raise the interest rate; and (2) he wants to repay any debt as soon as possible.Though Tipps feels strongly that the firm's borrowing should be completely financed from Palmetto's yearly operations, he admits that in a pinch assets could be liquidated. But he initially told Rivera that he would be reluctant to do this because "we need all our assets to adequately support our future sales projections." When pressed by Rivera, though, Tipps conceded that Palmetto's working capital position is too conservative; also, if sales were below projection, less working capital would be needed.

As they part, Rivera feels that Tipps has made a number of good points but wonders if he isn't overreacting and thinking too conservatively. However, Rivera has a great deal of respect for Tipps's financial savvy and is taking to objections very seriously.

EXHIBIT 1

Income Statement (000s)

1995 (Present) 1996

Sales $25,500

Cost of goods sold 20,400

Gross profit 5,100

Administrative 1,275

Depreciation 850

Other fixed 425

EBIT 2,550

Interest 400

Earnings before taxes 2,150

Taxes (%40) 860

Net income 1,290