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Delsing Canning Company is considering an expansion of its facilities. Its current income statement is as follows:
Sales $ 7,300,000
Variable costs (50% of sales) 3,650,000
Fixed costs 2,030,000
Earnings before interest and taxes (EBIT) 1,620,000
Interest (10% cost) 660,000
Earnings before taxes (EBT) $ 960,000
Tax (40%) 384,000
Earnings after taxes (EAT) $ 576,000
Shares of common stock 430,000
Earnings per share $ 1.34
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 $4.3 million in additional financing. His investment banker has laid out three plans for him to consider:
Sell $4.3 million of debt at 13 percent.
Sell $4.3 million of common stock at $25 per share.
Sell $2.15 million of debt at 12 percent and $2.15 million of common stock at $40 per share.
Variable costs are expected to stay at 50 percent of sales, while fixed expenses will increase to $2,530,000 per year. Delsing is not sure how much this expansion will add to sales, but he estimates that sales will rise by $1 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). (Enter your answers in dollars not in millions, i.e, $1,234,567.)
b. The degree of operating leverage before and after expansion. Assume sales of $7.3 million before expansion and $8.3 million after expansion. Use the formula: DOL = (S − TVC) / (S − TVC − FC). (Round your answers to 2 decimal places.)
c-1. The degree of financial leverage before expansion. (Round your answer to 2 decimal places.)
c-2. The degree of financial leverage for all three methods after expansion. Assume sales of $8.3 million for this question. (Round your answers to 2 decimal places.)
d. Compute EPS under all three methods of financing the expansion at $8.3 million in sales (first year) and $10.1 million in sales (last year). (Round your answers to 2 decimal places.)

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Answer:

a. The break-even point for operating expenses before and after expansion

break even point before expansion = fixed costs + variable costs

fixed costs = $2,030,000

variable costs = $3,650,000

break even point = $2,030,000 + $3,650,000 = $5,680,000

break even point after expansion = = fixed costs + variable costs

fixed costs = $2,530,000

variable costs = $8,300,000 x 50% = $4,150,000

break even point = $2,530,000 + $4,150,000 = $6,680,000

b. The degree of operating leverage before and after expansion.

degree of operating leverage before expansion = (sales - variable costs) / (sales - variable costs - fixed costs)

sales = $7,300,000

variable costs = $3,650,000

fixed costs = $2,030,000

DOL = ($7,300,000 - $3,650,000) / ($7,300,000 - $5,680,000) = $3,650,000 / $1,620,000 = 2.25

degree of operating leverage after expansion = (sales - variable costs) / (sales - variable costs - fixed costs)

sales = $8,300,000

variable costs = $4,150,000

fixed costs = $2,530,000

DOL = ($8,300,000 - $4,150,000) / ($8,300,000 - $6,680,000) = $4,150,000 / $1,620,000 = 2.56

c-1. The degree of financial leverage before expansion.

DFL = EBIT / (EBIT - interest expense)

EBIT before expansion = $1,620,000

Interest expense = $660,000

DFL = $1,620,000 / ($1,620,000 - $660,000) = 1.69

c-2. The degree of financial leverage for all three methods after expansion. Assume sales of $8.3 million for this question.

EBIT after option A = $1,620,000

Interest expense after option A = $660,000 + ($4,300,000 x 13%) = $1,219,000

DFL (option A) = $1,620,000 / ($1,620,000 - $1,219,000) = 4.04

EBIT after option B = $1,620,000

Interest expense after option A = $660,000

DFL (option B) = $1,620,000 / ($1,620,000 - $660,000) = 1.69

EBIT after option C = $1,620,000

Interest expense after option A = $660,000 + ($2,150,000 x 12%) = $918,000

DFL (option C) = $1,620,000 / ($1,620,000 - $918,000) = 2.31

d. Compute EPS under all three methods of financing the expansion at $8.3 million in sales (first year) and $10.1 million in sales (last year).

first year:

EBIT after option A = $1,620,000

Interest expense after option A = $1,219,000

Pre tax income = $401,000

Income tax (40%) = $160,400

Net income = $240,600

EPS = $240,600 / 430,000 stocks = $0.56

EBIT after option B = $1,620,000

Interest expense after option A = $660,000

Pre tax income = $960,000

Income tax (40%) = $384,000

Net income = $576,000

EPS = $576,000 / 602,000 stocks = $0.96

EBIT after option C = $1,620,000

Interest expense after option A = $918,000

Pre tax income = $702,000

Income tax (40%) = $280,800

Net income = $421,200

EPS = $421,200 / 483,750 stocks = $0.87

last year:

EBIT after option A = $2,520,000

Interest expense after option A = $1,219,000

Pre tax income = $1,301,000

Income tax (40%) = $520,400

Net income = $780,600

EPS = $780,600 / 430,000 stocks = $1.82

EBIT after option B = $2,520,000

Interest expense after option A = $660,000

Pre tax income = $1,860,000

Income tax (40%) = $744,000

Net income = $1,116,000

EPS = $1,116,000 / 602,000 stocks = $1.85

EBIT after option C = $2,520,000

Interest expense after option A = $918,000

Pre tax income = $1,602,000

Income tax (40%) = $640,800

Net income = $961,200

EPS = $961,200 / 483,750 stocks = $1.99

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