Palmetto Soups Case Study
Palmetto Soups is a well-known company on the market, which has experienced an impressive increase in sales and profits and which expects to have even better results in the future.
Robert Rivera, the founder of the company is now facing an issue concerning the sources of financing the switch to a highly capital-intensive method of production which the board of directors agreed upon.
Even though 1996 will be a transition year for the company, the change will be very profitable on the long term so now the question is whether to finance the change through debt or equity.
Robert Rivera is inclined to use as source of financing debt, because he doesn’t want to share his creation with outsiders, nor the profits that are about to take off, and he considers that given the fact that the demand for the company’s products is stable, there is only a minimal risk for Palmetto Soups.
On the other hand, Theodore Tipps, a financial officer, strongly recommends equity as a method of financing because debt could “embarrass” the company and there’s the threat of bankruptcy and its effects on the customers to be considered. He would also recommend lengthening the loan term to lower the yearly payments but he is against liquidating assets as those will be needed to support future sales projections.
The company’s investment banking firm, Smith, Peabody and Associates, thinks that debt would be a good source of financing as Palmetto Soups has a strong net working capital, competitive debt ratio and low business risk.
- The 1996 Income Statement projection – assuming the firm uses debt and that sales will increase by 10%.
1995 | 1996 | |
Sales | 25500000 | 28050000 |
Cost of Goods Sold * | 20400000 | 17671500 |
Gross Profit | 5100000 | 10378500 |
Administrative exp | 1275000 | 3000000 |
Depreciation | 850000 | 3750000 |
Other fixed exp | 425000 | 1000000 |
EBIT | 2550000 | 2628500 |
Interest | 400000 | 1400000 |
EBT | 2150000 | 1228500 |
Tax(40%) | 860000 | 491400 |
Net Income | 1290000 | 737100 |
* Cost of Goods Sold = (28050000 - X) / 2805000 = 0.37 => X = 17671500
- The company’s EBT break-even sales volume (expressed as percentage of sales) and DOL for 1996.
Cost of Goods Sold / Sales = 17671500 / 28050000 = 0.63
For every 1$ of sales, profits before tax would be 1 - 0.63 = 0.37$
Break Even Revenues = (Fixed Costs + Depreciation) / 0.37
= (3000000 + 1000000 + 3750000) / 0.37
= 20946000
DOL = (delta Income / Income(95) ) / (delta Sales / Sales(95) )
= ((737100 - 1290000) / 1290000) / ((28050000 - 25500000) / 25500000)
= -0.43 / 0.1 = -4.3
- The predicted EBIT for 1996 if sales are 10% below the 1996 estimate:
Sales | 25500000 |
Cost of Goods Sold * | 16065000 |
Gross Profit | 9435000 |
Administrative exp | 3000000 |
Depreciation | 3750000 |
Other fixed exp | 1000000 |
EBIT | 1685000 |
Interest | 1400000 |