Question

EXTERNAL EQUITY FINANCING

Coastal Carolina 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 45% with a $15 million investment in plant and machinery. The firm wants to maintain a 50% debt level in its capital structure. It also wants to maintain its past dividend policy of distributing 50% of last year's net income. In 2016, net income was $5 million. How much external equity must Coastal Carolina seek at the beginning of 2017 to expand capacity as desired? Assume that the firm uses only debt and common equity in its capital structure. Write out your answer completely. For example, 25 million should be entered as 25,000,000. Round your answer to the nearest cent.

$

Answer 1

Answer :

Given that,

Cost of equipment = $15,000,000

Debt level in investment = 50%

Then, Equity level in investment = ( 1 - 50% ) = 50%

Net income = $5,000,000

Dividend pay-out ratio = 50%

Now,

Retained earnings = Net income * ( 1 - Dividend pay-out ratio )

= $5,000,000 * ( 1 - 50% )

Retained earnings = $2,500,000

Debt investment in equipment = Cost of equipment * Debt level in investment

= $15,000,000 * 50%

= $7,500,000

Equity investment in equipment = Cost of equipment * Equity level in investment

= $15,000,000 * 50%

= $7,500,000

Therefore,

Required external equity = Equity investment in equipment - Retained earnings

= $7,500,000 - $2,500,000

Required external equity = $5,000,000