Question

Tropical, Inc. has provided the following financial information in its application for a loan.

Assets Liabilities and Equity

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Cash $ 20 Accounts Payable $ 30

Accounts Receivables $ 90 Notes Payable $ 90

Inventory $ 90 Accruals $ 30

Long Term Debt $150

Plant and equipment $500 Equity $400

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Also assume sales = $500, cost of goods sold = $360, taxes = $56, interest payments = $40, net income = $44, the dividend payout ratio is 50%, and the market value of equity is equal to the book value.

What is the Altman discriminant function value for Tropical, Inc.? Recall that:

Net working capital = Current assets minus current liabilities.

Current assets = Cash + accounts receivable + inventories.

Current liabilities = Accounts payable + accruals + notes payable.

EBIT = Revenues - Cost of goods sold - depreciation.

Taxes = (EBIT - Interest) (tax rate).

Net income = EBIT - interest - taxes.

Retained earnings = Net income (1 - dividend payout ratio)

Altman’s discriminant function is given by:

Z = 1.2X1+ 1.4X2 + 3.3X3 + 0.6X4 + 1.0X5

Assume prior retained earnings are zero.

X1= Working capital/total assets

X2 = Retained earnings/ total assets

X3 = EBIT/ total assets

X4 = Market value of equity/long term debt

X5 = Sales/ total assets

Answer 1

Working capital (WC) = Current Assets (CA) - Current Liabilities (CL)

Current Assets (CA) = Cash + Accounts Receivables + Inventory = 20 +90 +90 = 200

Current Liabilities (CL) = Accounts payable + Notes Payable + Accruals = 30+90+30 = 150

Thus, Working capital (WC) = 200 - 150 = 50

Total assets = Current Assets + Plant and equipment = 200 + 500 = 700

X1= Working capital/total assets = 50/700 = 0.071428

Retained earnings = Net income (1 - dividend payout ratio)

Retained earnings = 44*(1-50%) = 22

X2 = Retained earnings/ total assets = 22/700 = 0.031428

EBIT = revenues – cost of goods sold – depreciation

EBIT = 500 - 360 - 0 = 140

X3 = EBIT/ total assets = 140/700 = 0.2

Since the market value of equity is equal to the book value.

Thus, the market value of equity = 400

X4 = Market value of equity/long term debt = 400/150 = 2.67

X5 = Sales/ total assets = 500/700 = 0.7143

Altman’s discriminant function is given by:

Z = 1.2X1+ 1.4X2 + 3.3X3 + 0.6X4 + 1.0X5

Putting the calculated values, we get:

Z = 1.2*0.071428+ 1.4*0.031428 + 3.3*0.2 + 0.6*2.67 + 1.0*0.7143

Z = 3.106

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