Faulkner's Fine Fries Inc. (FFF) is thinking about reducing its debt burden. Given the following capital structure information and an expected EBIT of $50 million (plus or minus 10 percent) next year, should FFF change their capital structure?
Current Proposed
Total assets $750 million $750 million
Debt 450 million 300 million
Equity 300 million 450 million
Common stock price $30 $30
Number of shares 10,000,000 15,000,000
Interest rate 12% 12%
To determine whether Faulkner's Fine Fries Inc. (FFF) should change its capital structure, we need to assess the impact of the change on the company's financial position and ability to repay debt.
The capital structure of a company refers to the way it finances its operations through debt and equity. In this case, FFF currently has a total debt of $450 million and equity of $300 million, while the proposed capital structure includes $300 million in debt and $450 million in equity.
We can calculate the interest expense for both the current and proposed capital structures using the given interest rate of 12%:
Current Interest Expense = Debt * Interest Rate = $450 million * 12% = $54 million
Proposed Interest Expense = Debt * Interest Rate = $300 million * 12% = $36 million
Next, let's analyze the impact of the capital structure change on the company's expected EBIT. Since the expected EBIT is given as $50 million plus or minus 10%, we can calculate the range of EBIT values:
Minimum EBIT = $50 million - (10% of $50 million) = $45 million
Maximum EBIT = $50 million + (10% of $50 million) = $55 million
Now, using the interest expense from above, we can calculate the interest coverage ratio (EBIT divided by interest expense) for both the current and proposed capital structures:
Current Interest Coverage Ratio:
Minimum Interest Coverage Ratio = Minimum EBIT / Current Interest Expense = $45 million / $54 million ≈ 0.833
Maximum Interest Coverage Ratio = Maximum EBIT / Current Interest Expense = $55 million / $54 million ≈ 1.019
Proposed Interest Coverage Ratio:
Minimum Interest Coverage Ratio = Minimum EBIT / Proposed Interest Expense = $45 million / $36 million ≈ 1.250
Maximum Interest Coverage Ratio = Maximum EBIT / Proposed Interest Expense = $55 million / $36 million ≈ 1.528
An interest coverage ratio below 1 indicates that the company is not generating enough EBIT to cover its interest expenses, implying a higher risk of default. On the other hand, a ratio above 1 indicates a sufficient EBIT to service the debt.
Based on the calculated interest coverage ratios, both the current and proposed capital structures appear to be able to cover the interest expenses, as the ratios are all above 1.
However, it's important to consider other factors when deciding whether to change the capital structure. These could include the company's growth prospects, industry conditions, market sentiment, and future financing needs. Additionally, it may be beneficial to perform a thorough financial analysis, including measures like return on equity and return on assets, to evaluate the long-term impact of the proposed capital structure change.
In summary, based on the given information, Faulkner's Fine Fries Inc. could consider changing its capital structure, as both the current and proposed structures seem capable of covering the interest expenses. However, a comprehensive analysis of various financial indicators and broader business considerations is recommended before making a final decision.