Question

Your firm should raise $2 million so that the firm can make more profitable investments in inventory and fixed assets. This $2 million investment will more than triple their capacity. The NPV for this new investment is positive. Currently, the firm has no interest bearing debt and no preferred stock outstanding. However, there are 20 thousand shares of common stock outstanding. Each of these common shares has a market value of $50. Furthermore, if the firm wants to raise $2 million by selling stock, they can. New common shares could be sold for $50 per share. On the other hand, they firm could raise this $2 million by selling debt. The interest rate that they would pay on this debt is equal to 8 percent. Going forward the firm projects a gross profit margin of 40 percent on future sales, fixed operating costs equal to $60,000 per year, and a corporate tax rate equal to 35 percent. Calculate the crossover point in both annual sales revenue and EPS.

a. $750,000 and $2.60 per share

b. $325,000 and $1.30 per share

c. $162,500 and $0.65 per share

d. $ 81,250 and $0.325 per share

Answer 1

In this problem there is no process to find the actual revenue since only given that investment is more than triple there capacity which means sales revenue might be less than 1/3rd of 2 $million .. So maximum should be $20,00,000/3=$6,66,667/-

Evaluating Option A Revenue Suppose if Debt is raised

Particulars	amount
Sales	$7,50,000
Gross profit	$3,00,000
Fixed expenses	($60,000)
Interest Expenses	($1,60,000)
Profit before tax	$80,000
Tax Amount	($28,000)
Profit After tax	$52,000
No of Shares	20,000

EPS = 52,000/20000=2.6/- i.e EPS is 2.60

If No debt is raised then

No of shares to issued is

20,00,000/50== 40,000. Shares to issued

So Total no. of shares

Particulars	No .of Shares
Opening	20,000
New issue	40,000
Total no of shares outstanding closing	60,000

Profit after Tax is == 2,40,000-35%

$156000

EPS = PAT/No of shares Outstanding

$1,56,000/60,000=2.6

EPS is 2.6/-

Evaluating option 2

Particulars	amount
Sales	$3,25,000
Gross profit	$1,30,000
Fixed expenses	($60,000)
Interest Expenses	0
Profit before tax	$70,000
Tax Amount	($24,500)
Profit After tax	$45,500
No of Shares	60,000

EPS under New Shares are issued is $45,500/60,000

0.7583is EPS

There is no option of issuing the debt since Profit is not enough to meet the interest expenses of $1,60,000

Always in the three option B,C,D, since there us less revenue there is no chance of getting EPS...

So have check for EPS under New Share Issue only

Option C

New Issue EPS IS

PAT $3,250

No of shares is 60,000

So EPS is 3250/60000= 0.0541667/-

So wrong option

Option D

No Eps since not able to meet fixed expenses also/...

From All the Above option Only Option is A,, is correct under both Debt raised fund and New Equity raised fund

Option A is correct ….