Northern Pacific Heating and Cooling, Inc. has a 6-month backlog of orders for i

Question

Northern Pacific Heating and Cooling, Inc. has a 6-month backlog of orders for its patented solar heating systems. To meet this demand, management plans to expand production capacity by 40% with a $10 million investment in plant and machinery. The firm wants to maintain a 40% debt-to-toil assets ratio in its capital structure; it also wants to maintain its past dividend policy of distributing 45% of last year's net income. In 2007, net income was $5 million. How much external equity must Northern Pacific seek at the beginning of 2008 to expand capacity as desired?

The answer is supposed to be $3,250,000 but I don't know how to arrive at that.

Explanation / Answer

if it is going to make a $10 million investment and keep a 40% debt to assets ratio it is going to have to finance the project with $4 million debt and $6 million equity. It will have $5 million in income, but plans to pay out 45% of that or $2.25 million.That means it will have $2.75 million to invest in the project. Since it needs $6 million it will have to get $6-$2.75= $3.25 million externally.

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