Question

The Lopez-Portillo Company has $12.2 million in assets, 80 percent financed by debt and 20 percent financed by common stock. The interest rate on the debt is 9 percent and the par value of the stock is $10 per share. President Lopez-Portillo is considering two financing plans for an expansion to $26 million in assets.

Under Plan A, the debt-to-total-assets ratio will be maintained, but new debt will cost a whopping 12 percent! Under Plan B, only new common stock at $10 per share will be issued. The tax rate is 30 percent.

a. If EBIT is 10 percent on total assets, compute earnings per share (EPS) before the expansion and under the two alternatives. (Round your answers to 2 decimal places.)

Earnings per share

Current ___________________

Plan A____________________

Plan B____________________

b. What is the degree of financial leverage under each of the three plans? (Round your answers to 2 decimal places.)

  Degree of financial leverage

Current____________________________

Plan A ____________________________

Plan B ____________________________

c. If stock could be sold at $20 per share due to increased expectations for the firm’s sales and earnings, what impact would this have on earnings per share for the two expansion alternatives? Compute earnings per share for each. (Round your answers to 2 decimal places.)
   Earnings per share

Plan A _____________________

Plan B______________________

Answer 1

Answer a

Current

Assets: $ 12.2 mn

Debt: 80%*12.2 = $9.76 mn

Common Stock = 12.2-9.76 = $2.44 mn

No. of Shares = Common Stock/ Share price = 2.44*1000000/10 = 244000 shares

EBIT =10%*Total Assets = 10%*12.2 = $1.22 mn

Interest = 9%*9.76 = 0.8784 mn

Hence, EBT = EBIT-Interest = 1.22-0.8784 = $0.3416 mn

Tax = 30%*EBT = 30%*0.3416 = $ 0.10248 mn

Hence Net Earnings = 0.3416-0.10248=$0.23912 mn or $239120

Hence Earning Per Share = Net Earnings/ No. of shares = 239120/244000= $0.98

Plan A

Assets: $ 26 mn

Total Debt: 80%*26 = $20.8 mn

New Debt = Total Debt-Old Debt=20.8-9.76=$11.04 mn

Common Stock = 26-20.8 = $5.2 mn

No. of Shares = Common Stock/ Share price = 5.2*1000000/10 = 520000 shares

EBIT =10%*Total Assets = 10%*26 = $2.6 mn

Interest on Old Debt = 9%*9.76 = 0.8784 mn

Interest on New Debt = 12%*11.04=1.3248

Total Interest = 0.8784+1.3248=2.2032

Hence, EBT = EBIT-Interest = 2.6-2.2032 = $0.3968 mn

Tax = 30%*EBT = 30%*0.3968 = $ 0.11904 mn

Hence Net Earnings = 0.3968-0.11904=$0.27776 mn or $277760

Hence Earning Per Share = Net Earnings/ No. of shares = 277760/520000= $0.53

Plan B

Assets: $ 26 mn

Debt = $9.76 mn

Common Stock = 26-9.76 = $16.24 mn

No. of Shares = Common Stock/ Share price = 16.24*1000000/10 = 1624000 shares

EBIT =10%*Total Assets = 10%*26 = $2.6 mn

Interest = 9%*9.76 = 0.8784 mn

Hence, EBT = EBIT-Interest = 2.6-0.8784 = $1.7216 mn

Tax = 30%*EBT = 30%*1.7216 = $ 0.51648 mn

Hence Net Earnings = 1.7216-0.51648=$1.20512 mn or $1205120

Hence Earning Per Share = Net Earnings/ No. of shares = 1205120/1624000= $0.74

Hence Current EPS = $0.98

Plan A EPS = $0.53

Plan B EPS = $0.74

Answer b

Financial Leverage = Debt/ Common Stock

Current Financial Leverage = Debt/ Equity = 9.76/2.44=4.00

Plan A Financial Leverage = Debt/ Equity = 20.8/5.2=4.00

Plan B Financial Leverage = Debt/ Equity = 9.76/16.24=0.60

Answer c

Plan A

Assets: $ 26 mn

Common Stock = $5.2 mn

New Common Stock= 5.2-2.44 = $2.76

New No. of Shares = Common Stock/ Share price = 2.76*1000000/20 = 138000 shares

Total Shares = Old SHares + New Shares = 244000+138000=382000

Net Earnings = $277760

Hence Earning Per Share = Net Earnings/ No. of shares = 277760/382000= $0.73

Plan B

Common Stock = $16.24 mn

New Common Stock= 16.24-2.44 = $13.8 mn

New No. of Shares = Common Stock/ Share price = 13.8*1000000/20 = 690000 shares

Total Shares = Old SHares + New Shares = 244000+690000=934000

Hence Net Earnings = $1205120

Hence Earning Per Share = Net Earnings/ No. of shares = 1205120/934000= $1.29

Hence Plan A EPS = $0.73

Plan B EPS = $1.29