Wired Communications Corporation (WCC) supplies headphones to airlines for use with movie and stereo programs. The headphones sell for $288 per set, and this year’s sales are expected to be 45,000 units. Variable production costs for the expected sales under present production methods are estimated at $10,200,000, and fixed production (operating) costs at present are $1,560,000. WCC has $4,800,000 of debt outstanding at an interest rate of 8 percent. There are 240,000 shares of common stock outstanding, and there is no preferred stock. WCC pays out 70 percent of earnings and is in the 40 percent marginal tax bracket.
The company is considering investing $7,200,000 in new equipment. Sales would not increase, but variable costs per unit would decline by 20 percent. Also, fixed operating costs would increase from $1,560,000 to $1,800,000. WCC could raise the required capital by borrowing $7,200,000 at 10 percent or by selling 240,000 additional shares at $30 per share.
a. What would be WCC’s EPS (1) under the old production process, (2) under the new process if it uses debt, and (3) under the new process if it uses common stock?
b. At what unit sales level would WCC have the same EPS, assuming it under- takes the investment and finances it with debt or with stock? (V = variable cost per unit = $8,160,000 / 45,000, and EPS = [(P × Q – V × Q – F – I) (1 – T)] / Shares. Set EPSStock EPSDebt and solve for Q.)
c. At what unit sales level would EPS = 0 under the three production and financing setups—that is, under the old plan, the new plan with debt financing, and the new plan with stock financing? (That VOld $10,200,000/45,000, and use the hints for part (b), setting the EPS equation equal to $0.)
d. On the basis of the analysis in parts (a) through (c), which plan is the riskiest, which has the highest expected EPS, and which would you recommend? Assume here that there is a fairly high probability of sales falling as low as 25,000 units, and determine EPSDebt and EPSStock at that sales level to help assess the riskiness of the two financing plans.

  • CreatedNovember 24, 2014
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