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Chapter 15: Problem 5

Northern Pacific Heating and Cooling Inc. has a 6 -month backlog of orders for its patented solar heating system. To meet this demand, management plans to expand production capacity by \(40 \%\) with a \(\$ 10\) million investment in plant and machinery. The firm wants to maintain a \(40 \%\) debt-to-total-assets ratio in its capital structure, It also wants to maintain its past dividend policy of distributing \(45 \%\) of last year's net income. In 2008 , net income was \(\$ 5\) million. How much external equity must Northern Pacific seek at the beginning of 2009 to expand capacity as desired? Assume that the firm uses only debt and common equity in its capital structure.

Short Answer

Expert verified
Northern Pacific must seek $3.25 million in external equity.

Step by step solution

01

Determine Total Investment Required

The company plans to expand its production capacity by 40%, which requires a $10 million investment in plant and machinery.
02

Calculate the Debt Portion of the Investment

The firm wants to maintain a 40% debt-to-total-assets ratio. Therefore, the portion financed by debt is 40% of the total investment, which can be calculated as: \(0.40 \times \\(10\ million = \\)4\ million.\)
03

Calculate the Equity Portion of the Investment

The remaining 60% of the \(10 million investment needs to be financed by equity. Calculate this as follows: \(0.60 \times \\)10\ million = \$6\ million.\)
04

Calculate Dividends Paid

The firm plans to distribute 45% of last year's net income as dividends. Given that the net income for 2008 was \(5 million, calculate the dividends: \(0.45 \times \\)5\ million = \$2.25\ million.\)
05

Determine Retained Earnings

The retained earnings are the portion of net income not paid out as dividends, which can be calculated by subtracting dividends from net income: \(\\(5\ million - \\)2.25\ million = \$2.75\ million.\)
06

Calculate the External Equity Needed

Since the equity portion required is \(6 million, and the firm has \)2.75 million available from retained earnings, the external equity that must be sought can be calculated by subtracting retained earnings from the equity portion: \(\\(6\ million - \\)2.75\ million = \$3.25\ million.\)

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Key Concepts

These are the key concepts you need to understand to accurately answer the question.

Capital Structure
Understanding a company's capital structure is pivotal in grasping how a business finances its operations and growth. Capital structure is essentially a mix of debt and equity that a firm uses to fund its activities. A well-balanced capital structure is crucial as it impacts the firm鈥檚 risk, cost of capital, and flexibility.

The exercise highlights Northern Pacific's goal to maintain a 40% debt-to-total-assets ratio. This type of ratio indicates the portion of a company鈥檚 assets that are financed through debt. A high debt ratio may increase financial risk, but it could also lower taxes due to interest deductibility.
  • **Debt:** A lower-cost source of capital but increases fixed obligations (interest payments).
  • **Equity:** More expensive but does not contribute to cash outflows for service.

    For a coherent capital structure, Northern Pacific uses the combination of debt and equity that aligns with their strategic goals while considering the financial risks involved. This approach ensures that the company can meet its expansion requirement without compromising financial health.
Retained Earnings
Retained earnings are the portion of a company's net income that is not paid out as dividends but instead reinvested in the business or used to pay down debt. These earnings are a crucial part of internal financing, allowing companies to fund new projects without seeking external sources, thereby saving on interest and dilution of ownership.

Northern Pacific retained earnings were calculated after determining the dividends to be distributed from the previous year's profits. Here's how the calculation works:
  • **Net Income:** Total earnings after all expenses.
  • **Dividends:** A portion of net income distributed to shareholders; in this exercise, it was 45% of net income, equating to $2.25 million.
  • **Retained Earnings:** Remaining income after dividends; in our scenario, it was $2.75 million, providing internal equity for the investment.

    Retained earnings represent shareholder funds reinvested into the firm, enhancing its earning potential and value. For Northern Pacific, these earnings contributed significantly to funding their capacity expansion with internal resources.
External Equity
When a company needs to raise capital beyond what is available from retained earnings and appropriate levels of debt, it may seek external equity. External equity involves issuing new shares of stock, which can dilute existing ownership but brings new resources without increasing financial obligations.

Northern Pacific's need for external equity arises after considering their internal earnings and maintaining a balanced capital structure. Here's the step-by-step understanding:
  • **Equity Requirement:** The total equity needed was $6 million.
  • **Internal Funding:** Available retained earnings were $2.75 million.
  • **Need for External Equity:** To meet the shortfall, they require $3.25 million from external sources.

    Issuing new shares for $3.25 million ensures Northern Pacific can proceed with its expansion plans without altering their preferred debt-to-asset ratio. This balancing act allows the firm to strategically grow while maintaining fiscal prudence and shareholder satisfaction.

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Most popular questions from this chapter

Gamma Medical's stock trades at \(\$ 90\) a share. The company is contemplating a 3 -for- 2 stock split. Assuming that the stock split will have no effect on the market value of its equity, what will be the company's stock price following the stock split?

After a 5 -for-1 stock split, Strasburg Company paid a dividend of \(\$ 0.75\) per new share, which represents a \(9 \%\) increase over last year's pre-split dividend. What was last year's dividend per share?

Bowles Sporting Inc. is prepared to report the following income statement (shown in thousands of dollars) for the year 2009 Prior to reporting this income statement, the company wants to determine its annual dividend. The company has 500,000 shares of stock outstanding, and its stock trades at \(\$ 48\) per share. a. The company had a \(40 \%\) dividend payout ratio in 2008 . If Bowles wants to maintain this payout ratio in \(2009,\) what will be its per-share dividend in \(2009 ?\) b. If the company maintains this \(40 \%\) payout ratio, what will be the current dividend yield on the company's stock? c. The company reported net income of \(\$ 1.5\) million in 2008 . Assume that the number of shares outstanding has remained constant. What was the company's per-share dividend in \(2008 ?\) d. \(A\) s an alternative to maintaining the same dividend payout ratio, Bowles is considering maintaining the same per-share dividend in 2009 that it paid in \(2008 .\) If it chooses this policy, what will be the company's dividend payout ratio in \(2009 ?\) e. Assume that the company is interested in dramatically expanding its operations and that this expansion will require significant amounts of capital. The company would like to avoid transactions costs involved in issuing new equity. Given this scenario, would it make more sense for the company to maintain a constant dividend payout ratio or to maintain the same per-share dividend?

Beta Industries has net income of \(\$ 2,000,000,\) and it has 1,000,000 shares of common stock outstanding. The company's stock currently trades at \(\$ 32\) a share. Beta is considering a plan in which it will use available cash to repurchase \(20 \%\) of its shares in the open market. The repurchase is expected to have no effect on net income or the company's \(P / E\) ratio. What will be Beta's stock price following the stock repurchase?

Rubenstein Bros. Clothing is expecting to pay an annual dividend per share of \(\$ 0.75\) out of annual earnings per share of \(\$ 2.25\). Currently, Rubenstein Bros.' stock is selling for \(\$ 12.50\) per share. Adhering to the company's target capital structure, the firm has \(\$ 10\) million in assets, of which \(40 \%\) is funded by debt. Assume that the firm's book value of equity equals its market value. In past years, the firm has earned a return on equity (ROE) of \(18 \%\), which is expected to continue this year and into the foreseeable future. a. Based on that information, what long-run growth rate can the firm be expected to maintain? (Hint: \(\mathrm{g}=\) Retention rate \(\times\) ROE.) b. What is the stock's required return? c. If the firm changed its dividend policy and paid an annual dividend of \(\$ 1.50\) per share, financial analysts would predict that the change in policy will have no effect on the firm's stock price or ROE. Therefore, what must be the firm's new expected long-run growth rate and required return? d. Suppose instead that the firm has decided to proceed with its original plan of disbursing \(\$ 0.75\) per share to shareholders, but the firm intends to do so in the form of a stock dividend rather than a cash dividend. The firm will allot new shares based on the current stock price of \(\$ 12.50 .\) In other words, for every \(\$ 12.50\) in dividends due to shareholders, a share of stock will be issued. How large will the stock dividend be relative to the firm's current market capitalization? (Hint: Remember that market capitalization \(=\mathrm{P}_{0} \times\) number of shares outstanding. e. If the plan in Part d is implemented, how many new shares of stock will be issued and by how much will the company's earnings per share be diluted?
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