| a. i. EBITDA/Interest expense |
| | | Off-Balance | EBITDA | Interest Expense Impact | Interest Coverage Impact |
| | | Sheet Items | Impact |
| | | Pre-adjustment | $4,450,000 | $942,000 | 4.72 |
| | | - Guarantee of debt (n/a) | $0 | $0 |
| | | - Sale of receivables (1) | 40000 | 40000 |
| | | - Operating lease (2) | $0 | $614,400 |
| | | Net Adjustment v | $40,000 | $654,400 |
| | | Post-adjustment | $4,490,000 | $1,596,400 | 2.81 |
| | | To adjust for sold accounts receivable and to treat them as secured loan, operating income
(EBITDA) should be increased by $40,000, i.e. interest income. It is assumed that the “loan proceeds” from the financed receivables would be invested to generate interest income (the same rate of interest is assumed for simplicity). The financing costs of the loan of $40,000 would be added to interest expense and will not affect EBITDA.
For treating operating lease as capital lease, interest expense of $614,400, for first year, should be added to adjusted interest expense.
|
| ii. Long term debt/Equity |
| | Off-Balance | Long-term Debt Impact | Equity | Leverage |
| | Sheet Item | | Impact | Impact |
| | Pre-adjustment | $10,000,000 | $33,460,000 | 0.30 |
| | Guarantee of debt | $995,000 | $0 |
| | - Sale of receivables (n/a) | $0 | $0 |
| | Operating lease | $ 5,758,400 | 0 |
| | Net Adjustment | $6,753,400 | $0 |
| | Post-adjustment | $16,753,400 | $33,460,000 | 0.50 |
| | To adjust for the guarantee of the affiliate's debt and to treat it as internal long-term debt, long-term debt should be increased by the amount of the guarantee i.e., $995,000.
To adjust operating lease and to treat it as a capital lease, long-term debt should be increased by the present value of the lease ($6,144,000) less the current or short-term portion—the principal due in the next 12 months ($1,000,000 - $614,400 = $385,600).
|
| iii. Current assets/current liabilities |
| | Off-Balance | Current Assets Impact | Current Liabilities Impact | Current Ratio Impact |
| | Sheet Item |
| | Pre-adjustment | $4,735,000 | $4,500,000 | 1.05 |
| | Guarantee of debt (n/a) | 0 | 0 |
| | Sale of receivables | $500,000 | $500,000 |
| | Operating lease | 0 | $385,600 |
| | Net Adjustment | $500,000 | $885,600 |
| | Post-adjustment | $5,235,000 | $5,385,600 | 0.97 |
| | To adjust the sold accounts receivable and to treat it as a secured loan, accounts receivable (current assets) and notes payable (current liabilities), both should be increased by the amount of the sale ($500,000).
To adjust the operating lease and treating it as a capital lease, leases payable (current liabilities) should be increased by the principal due in the next 12 months on the lease. This is equal to the annual lease payment less the first year's interest expense ($1,000,000 - $614,400 = $385,600).
|
| | The rating of Montrose bonds is ‘A’ without taking the effect of the off balance sheet items.
The credit yield premium is 55 basis points which is not enough to compensate credit risk of bonds. After making adjustment of the three off balance sheet items the bond rating criterion specify that the bond should have a lower credit rating:
1. The bond is having an interest coverage ratio of 2.81 which is low and it indicates that the bond is risky. It should have BB rating and a higher premium of +125 basis point.
2. The leverage ratio of the bond is 0.50 which indicates that the bond is risky and should have a lower rating of BBB and a higher premium of +100 basis points.
3. The lower current ratio of the bond is 0.97 which indicates that the bond is more risky. It should have a lower rating of BBB and a higher premium of +100 basis points.
The rating of Montrose bond should be ‘BBB’ and should be paying a premium of 100 basis points. The Montrose bond is more risky and should not be purchased at its current price.
|
Fin-Acc-Boss
qweek_5_homework__1_.xlsx
