Question 1. The following information is taken from the financial statements of Universal Fertilizers, Inc. for it fiscal year ended December 31, 2004:
Debt $25.0 million
Shareholders’ Equity 30.0 million
Interest expense 1.2 million
Times interest earned 3.0x
The Company’s financial statement footnotes include the following:
(i) The Company has committed itself by non-cancelable contract (starting in 2005) to purchase a total of $18 million of phosphates over the next five years from OCP, which is 100% owned by the Moroccan government. The estimated present value of these payments is $9.12 million. The Company has secured the contract with a standby letter of credit running to the benefit of OCP. If the letter of credit is drawn upon, the Company must reimburse the issuing bank with which it has its main banking relationship. The Moroccan government has pledged the contract and 50% of the proceeds of the sale of the phosphates to the World Bank to retire some of the indebtedness that Morocco owes to the World Bank.
(ii) The Company has guaranteed a $15 million, 10% unsecured debenture issue, due in 2011, issued by Agro Transports Ltd., a non-consolidated 40%-owned affiliate that operates ocean going bulk cargo ships. At the present time, the affiliate has large excess shipping capacity as does the world in general and its financial situation is uncertain.
(iii) On January 2, 2004, the Company entered into an operating lease with future payments of $60 million ($7.5 million/year) with a discounted present value of $30 million. The lease has a number of renewal options going out over a 20 year period.
a. Adjust the Company’s debt and equity and recompute the debt-to-equity ratio, using the information in footnotes cited above. Assume depreciation is ten year straight line with no salvage value, and the tax rate is 35%.
b. Adjust the times-interest-earned ratio for 2004 for these commitments.
c. For each of (i), (ii) and (iii) above, give three good reasons (financial or operating) why the Company may have entered into each of these arrangements.
d. For each of (i), (ii) and (iii) above, describe two or more items of additional information required to fully evaluate the impact of these commitments on the Company’s current financial condition and future operating results