Question

Delsing Canning Company is considering an expansion of its facilities. Its current income statement is as follows:
Sales .................. $5,500,000
Less: Variable expense (50% of sales) ..... 2,750,000
Fixed expense ............... 1,850,000
Earnings before interest and taxes (EBIT) .... 900,000
Interest (10% cost) .............. 300,000
Earnings before taxes (EBT) .......... 600,000
Tax (40%) ................. 240,000
Earnings after taxes (EAT) ......... $ 360,000
Shares of common stock—250,000 .......
Earnings per share ............ $1.44
The company is currently financed with 50 percent debt and 50 percent equity (common stock, par value of $10). In order to expand the facilities, Mr. Delsing estimates a need for $2.5 million in additional financing. His investment banker has laid out three plans for him to consider:
1. Sell $2.5 million of debt at 13 percent.
2. Sell $2.5 million of common stock at $20 per share.
3. Sell $1.25 million of debt at 12 percent and $1.25 million of common stock at $25 per share.
Variable costs are expected to stay at 50 percent of sales, while fixed expenses will increase to $2,350,000 per year. Delsing is not sure how much this expansion will add to sales, but he estimates that sales will rise by $1.25 million per year for the next five years.
Delsing is interested in a thorough analysis of his expansion plans and methods of financing. He would like you to analyze the following:
a. The break-even point for operating expenses before and after expansion (in sales dollars).
b. The degree of operating leverage before and after expansion. Assume sales of $5.5 million before expansion and $6.5 million after expansion. Use the formula in footnote 2 of the chapter.
c. The degree of financial leverage before expansion and for all three methods of financing after expansion. Assume sales of $6.5 million for this question.
d. Compute EPS under all three methods of financing the expansion at $6.5 million in sales (first year) and $10.5 million in sales (last year).
e. What can we learn from the answer to part d about the advisability of the three methods of financing the expansion?



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  • CreatedOctober 14, 2014
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