In 2016, Natural Selection, a nationwide computer dating service, had $504 million of assets and $202 million of liabilities.

In 2016, Natural Selection, a nationwide computer dating service, had $504 million of assets and $202 million of liabilities. Earnings before interest and taxes were $122 million, interest expense was $27.5 million, the tax rate was 40 percent, principal repayment requirements were $24.2 million, and annual dividends were 25 cents per share on 22 million shares outstanding.

 

a. Calculate the following for Natural Selection: (Round your answers to 2 decimal places.)

b. What percentage decline in earnings before interest and taxes could Natural Selection have sustained before failing to cover: (Round your answers to 1 decimal place.)

a.

  1. i. Liabilities-to-equity ratio = 202/302 = 0.67
  2. ii. Times interest earned = EBIT/interest expense = 122/27.5 = 4.44
  3. iii. Times burden covered = EBIT/[interest + principal repayment/(1 − tax rate)] = 122/[27.5 + 24.2/(1 − 0.4)] = 1.80

b.

  1. i. To fail to cover the existing interest payments, the times interest earned ratio has to fall below one.= (4.44 − 1)/4.44 = 77.5%, or (122 − 27.5)/122 = 77.5%
  2. ii. To fail to cover the interest and sinking fund payment, the times burden covered ratio has to fall to below one.= (1.80 − 1)/1.80 = 44.4%, or [122 − (27.5 + 24.2/(1 − 0.4))]/122 = 44.4% (The difference is due to rounding.)
  3. iii. To fail to cover interest, principal, and dividend payments we must further subtract the impact of dividends on the EBIT.= [122 − (27.5 + ((24.2 + 0.25 × 22)/(1 − 0.4))]/122 = (122 − 77)/122 = 36.9%
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