Question

Fessenden Corporation has accumulated a significant amount of debt as a result of debt-financed acquisitions of other companies. It is currently considering acquiring one of its competitors, Sonar Corporation. Fessenden’s existing debt covenants stipulate that it cannot go beyond a debt to equity ratio of 1.25:1 and a net debt as a percentage of capitalization ratio of 0.90:1. The acquisition of Sonar will cost $88 million. Fessenden’s current level of equity is $460 million and its current level of interest-bearing debt is $621 million. Fessenden has a cash balance of $69 million. It will finance the acquisition with a 10-year bond of $88 million that carries a 5% interest rate sold at par.

Answer 1

ANSWER:

As per the given Question

Part (a)

Debt to equity ratio prior to the proposed transaction = Debt / Equity = 575 / 450 = 1.28 : 1

Net debt as a percentage of capitalization ratio prior to the proposed acquisition = Net debt / total capital = (Debt - cash) / (Debt - Cash + Equity) = (575 - 75) / (575 - 75 + 450) = 500 / 950 = 0.53

Part (b)

Debt to equity ratio after the proposed transaction = Debt / Equity = (575 + 80) / 450 = 1.46 : 1

Net debt as a percentage of capitalization ratio after the proposed acquisition = Net debt / total capital = (Debt - cash) / (Debt - Cash + Equity) = (575 + 80 - 75) / (575 + 80 - 75 + 450) = 580 / 1,030 = 0.53

Fessenden could not acquire Sonar Corporation with the bond issue and still remain in compliance with the existing debt covenants. The first covenant on debt to equity ratio is violated.

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