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    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.

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    Solution Preview

    a. The debt equity ratio is calculated by dividing the external debt by shareholder equity, In the current scenario the Debt equity would be 25/ 30 = 0.83, a very healthy situation.
    However, the situation changes when we consider item no 1. in this there is an addition of $9.12 to the debt of the company that is the estimated present value of the payments to be made of the phosphates.
    In item no 2 there are two parts, first we have the present value of the 10% payments to be made for seven years till the debentures are redeemed. It is immaterial that the shareholding is 40 percent because the entire debenture issue is guaranteed. So, we have 15mx 10/100 x 4.8664 (discounting factor) = 7.3 million dollars. We need to add to this the present value of the 15m that will be repaid in 2011. this will be 15million x 0.56447(discounting factor) = 8.47 million. If we add these we get a total of 15.77 million dollars.
    In item no 3 the present value is 30 million but this value is on January 2nd 2004 and our calculations refer to December 2004. So, taking the tax rate of 35% and an equal yearly straight-line depreciation of 6 million dollars, we get 135% of 6millon that is 8.1 million. So, the net effect is we subtract 8.1 million from 30 and we get 21.90 million ...

    Solution Summary

    The debt equity ratio is considered.