16-10A. (Analysis of recessionary cash flows) The management of Idaho Produce is considering an increase in its use of financial leverage. The proposal on the table is to sell $10 million of bonds that would mature in 20 years. The interest rate on these bonds would be 15 percent. The bond issue would have a sinking fund attached to it requiring that one-twentieth of the principal be retired each year. Most business economists are forecasting a recession that will affect the entire economy in the coming year. Idaho’s management has been saying, “If we can make it through this, we can make it through anything.” The firm prefers to carry an operating cash balance of $1 million. Cash collections from sales next year will total $4 million. Miscellaneous cash receipts will be $300,000. Raw material payments will be $800,000. Wage and salary costs will total $1.4 million on a cash basis. On top of this, Idaho will experience nondiscretionary cash outflows of $1.2 million including all tax payments. The firm faces a 50 percent tax rate.
a. At present, Idaho is unlevered. What will be the total fixed financial charges the firm must pay next year?
b. If the bonds are issued, what is your forecast for the firm’s expected cash balance at the end of the recessionary year (next year)?
c. As Idaho’s financial consultant, do you recommend that it issue the bonds?
Click here for the solution: The management of Idaho Produce is considering an increase in its use of financial leverage
