DeSoto Tools Inc. is planning to expand production. The expansion will cost $2,900,000, which can be financed
Question:
DeSoto Tools Inc. is planning to expand production. The expansion will cost $2,900,000, which can be financed either by bonds at an interest rate of 6 percent or by selling 58,000 shares of common stock at $50 per share. The current income statement before expansion is as follows:
DESOTO TOOLS INC. Income Statement 20X1 | ||
Sales | $ | 3,090,000 |
Variable costs | 927,000 | |
Fixed costs | 809,000 | |
Earnings before interest and taxes | $ | 1,354,000 |
Interest expense | 490,000 | |
Earnings before taxes | $ | 864,000 |
Taxes @ 40% | 345,600 | |
Earnings after taxes | $ | 518,400 |
Shares | 190,000 | |
Earnings per share | $ | 2.73 |
After the expansion, sales are expected to increase by $1,590,000. Variable costs will remain at 40 percent of sales, and fixed costs will increase to $1,368,000. The tax rate is 40 percent.
a. Calculate the degree of operating leverage, the degree of financial leverage, and the degree of combined leverage before expansion. (For the degree of operating leverage, use the formula: DOL = (S − TVC) / (S − TVC − FC). For the degree of combined leverage, use the formula: DCL = (S − TVC) / (S − TVC − FC − I). These instructions apply throughout this problem.) (Round your answers to 2 decimal places.)
b. Construct the income statement for the two alternative financing plans. (Round EPS to 2 decimal places.)
c. Calculate the degree of operating leverage, the degree of financial leverage, and the degree of combined leverage, after expansion. (Round your answers to 2 decimal places.)
Corporate Finance A Focused Approach
ISBN: 978-1439078082
4th Edition
Authors: Michael C. Ehrhardt , Eugene F. Brigham