1. The Severn Company plans to raise a net amount of $270 million to finance new equipment in early 2022. Two alternatives are being considered: Common stock may be sold to net $60 per share, or bonds yielding 12% may be issued. The balance sheet and income statement of the Severn Company prior to financing are as follows:

The Severn Company

Balance Sheet as of October 31, 2021

(Millions of Dollars)

Current assets $ 900.00 Notes payable $ 255.00

Net fixed assets 450.00 Long-term debt (10%) 697.50

Common stock, $3 par 60.00

Retained earnings 337.50

Total assets $1,350.00 Total liabilities and equity $1,350.00

The Severn Company

Income Statement for Year Ended

October 31, 2021

(Millions of Dollars)

Sales $2,475.00

Operating costs 2,227.50

Earnings before interest and taxes (10%) $ 247.50

Interest on short-term debt 15.00

Interest on long-term debt 69.75

Earnings before taxes $ 162.75

Federal-plus-state taxes (40%) 65.10

Net income $ 97.65

The probability distribution for annual sales is as follows:

Probability Annual Sales (Millions of Dollars)

0.30 $2,250

0.40 2,700

0.30 3,150

Assuming that EBIT equals 10% of sales, calculate earnings per share (EPS) under the debt financing and the stock financing alternatives at each possible sales level. Then calculate expected EPS and _EPS under both debt and stock financing alternatives. Also calculate the debt-to-capital ratio and the times-interest-earned (TIE) ratio at the expected sales level under each alternative. The old debt will remain outstanding. Which financing method do you recommend? [Hint: Notes payable should be included in both the numerator and the denominator of the debt-to-capital ratio.