Problem 5-23 (Static) Leverage and sensitivity analysis [LO5-6]

Dickinson Company has $12 million in assets. Currently half of these assets are financed with long-term debt at 10 percent and half with common stock having a par value of $8. Ms. Park, Vice President of Finance, wishes to analyze two refinancing plans, one with more debt (D) and one with more equity (E). The company earns a return on assets before interest and taxes of 10 percent. The tax rate is 45 percent. Tax loss carryover provisions apply, so negative tax amounts are permissable.

Under Plan D, a $3 million long-term bond would be sold at an interest rate of 12 percent and 375,000 shares of stock would be purchased in the market at $8 per share and retired.

Under Plan E, 375,000 shares of stock would be sold at $8 per share and the $3,000,000 in proceeds would be used to reduce long-term debt.

a. Compute earnings per share considering the current plan and the two new plans.

b-1. Compute the earnings per share if return on assets fell to 5 percent.

b-2. Which plan would be most favorable if return on assets fell to 5 percent? Consider the current plan and the two new plans.

b-3. Compute the earnings per share if return on assets increased to 15 percent.

b-4. Which plan would be most favorable if return on assets increased to 15 percent? Consider the current plan and the two new plans.

c-1. If the market price for common stock rose to $12 before the restructuring, compute the earnings per share. Continue to assume that $3 million in debt will be used to retire stock in Plan D and $3 million of new equity will be sold to retire debt in Plan E. Also assume that return on assets is 10 percent.

c-2. If the market price for common stock rose to $12 before the restructuring, which plan would then be most attractive?