Suppose that you are an experienced entrepreneur. At the end of 2019, you consider to acquire a struggling business, SUFE One, who does not have any liability. Its 2019 revenues and expenses are shown in the provided spread sheet. The 2019 depreciation of $100 is associated with the firms historical long-term investments. The same amount will incur each year throughout the analysis. The fair market value of SUFE Ones assets, which is also the acquiring price, is estimated to be $2000. But you only have $600 available to invest. Fortunately, the University Board is convinced to lend you the rest of funds needed at the annual interest rate of 8%. Clearly, this acquisition will result in a highly levered company. And we typically call such transaction leveraged buyout or LBO. Please answer the questions in the following scenarios, given the income tax rate for is always 33%.

1) After the LBO, what are the amounts of debt and equity shown on the balance sheet of the new company?

2) Suppose that you plan to expand the business in 2020 by investing $100 in PPE. This investment depreciates over a 12-year period. As a result, the gross margin and operating expenses will both increase by 8%. What is the net income of 2020? (Hint: the total depreciation is the sum of the $100 from historical investments and the depreciation from the new investment. The interest expense is the charge based on the debt balance at the end of 2019.) Compared with 2019, does the change of net income reflect that of the operational profitability?

You will understand if you look at the problem and the last picture.

Capitalization 45% 25% 70% 30% 100% December 31, 2010 Senior debt 900 Subordinated debt 500 Total debt 1.400 Common equity 600 Total capital S2,000 Projected Income Statement 2010 (Act.) Sales $1,429 Cost of sales 800 Depreciation 100 Selling, general, and 286 administrative expense Operating income 243 Interest expense 45 Income before income taxes 198 Provision (credit) for income Taxes 65 Net Income S 133) Projected Cash Flow 2011 $1,543 864 108 309 2012 $1,667 933 117 333 2013 $1,800 1,008 126 360 2014 $1,944 1,089 136 389 2015 $2,100 1,176 147 420 1.08 1.083333 1.076923 1.079365 306 357 262 108 154 283 100 183 91 331 80 250 68 215 289 83 51 S 1031 60 S 1231 71 S 144 95 $ 194 S 168 0.194175 0.170732 0.166667 177.984 2011 $ 103 108 $ 211 100 2012 $123 117 S 239 108 2013 S 144 126 S 270 117 2014 S 168 136 S 304 126 2015 $ 194 147 S 341 136 Net income Depreciation Cash from operations Less: Property and equipment additions Cash available for debt reduction Projected Capitalization $ 111 S131 S 153 S178 $ 205 | 2010 (Act. $ 900 500 2011 S 789 500 2012 S 657 500 2013 2014 S 5041 S 326 500 500 2015 S121 500 Senior debt Subordinated debt Total debt Common equity Total capital 1,400 600 1,289 $ 703 1,157 S 826 1,004 S 970 826 $1,138 621 $1,332 $2,000 $1,992 $1,983 $1,974 $1,964 $1,953 8.230453 2156.379 2329.218 867 1,172 2019 2020 2021 | 108 2023 126 100 2024 136 PPE Investment 117 $679 $734 $792 $856 $924 286 $309 $334 $360 $389 629 100 2861 243 45 198 S420 Gross margin Depreciation Operating expenses EBIT Interest expense Income before income taxes Taxes Net Income 65 $ 133 Cash from operations Cash available to reduce debt Debt Equity Return on equity Average return on equity Market value/EBIT Selling price Pre-tax LBO income Capital gain Income tax After-tax LBO income 5-year return Yearly return Capitalization 45% 25% 70% 30% 100% December 31, 2010 Senior debt 900 Subordinated debt 500 Total debt 1.400 Common equity 600 Total capital S2,000 Projected Income Statement 2010 (Act.) Sales $1,429 Cost of sales 800 Depreciation 100 Selling, general, and 286 administrative expense Operating income 243 Interest expense 45 Income before income taxes 198 Provision (credit) for income Taxes 65 Net Income S 133) Projected Cash Flow 2011 $1,543 864 108 309 2012 $1,667 933 117 333 2013 $1,800 1,008 126 360 2014 $1,944 1,089 136 389 2015 $2,100 1,176 147 420 1.08 1.083333 1.076923 1.079365 306 357 262 108 154 283 100 183 91 331 80 250 68 215 289 83 51 S 1031 60 S 1231 71 S 144 95 $ 194 S 168 0.194175 0.170732 0.166667 177.984 2011 $ 103 108 $ 211 100 2012 $123 117 S 239 108 2013 S 144 126 S 270 117 2014 S 168 136 S 304 126 2015 $ 194 147 S 341 136 Net income Depreciation Cash from operations Less: Property and equipment additions Cash available for debt reduction Projected Capitalization $ 111 S131 S 153 S178 $ 205 | 2010 (Act. $ 900 500 2011 S 789 500 2012 S 657 500 2013 2014 S 5041 S 326 500 500 2015 S121 500 Senior debt Subordinated debt Total debt Common equity Total capital 1,400 600 1,289 $ 703 1,157 S 826 1,004 S 970 826 $1,138 621 $1,332 $2,000 $1,992 $1,983 $1,974 $1,964 $1,953 8.230453 2156.379 2329.218 867 1,172 2019 2020 2021 | 108 2023 126 100 2024 136 PPE Investment 117 $679 $734 $792 $856 $924 286 $309 $334 $360 $389 629 100 2861 243 45 198 S420 Gross margin Depreciation Operating expenses EBIT Interest expense Income before income taxes Taxes Net Income 65 $ 133 Cash from operations Cash available to reduce debt Debt Equity Return on equity Average return on equity Market value/EBIT Selling price Pre-tax LBO income Capital gain Income tax After-tax LBO income 5-year return Yearly return