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Delsing Canning Company is considering an expansion of its facilities. Its current income statement is as...

Delsing Canning Company is considering an expansion of its facilities. Its current income statement is as follows: Sales $ 5,700,000 Variable costs (50% of sales) 2,850,000 Fixed costs 1,870,000 Earnings before interest and taxes (EBIT) $ 980,000 Interest (10% cost) 340,000 Earnings before taxes (EBT) $ 640,000 Tax (35%) 224,000 Earnings after taxes (EAT) $ 416,000 Shares of common stock 270,000 Earnings per share $ 1.54 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 $2.7 million in additional financing. His investment banker has laid out three plans for him to consider: Sell $2.7 million of debt at 9 percent. Sell $2.7 million of common stock at $25 per share. Sell $1.35 million of debt at 8 percent and $1.35 million of common stock at $30 per share. Variable costs are expected to stay at 50 percent of sales, while fixed expenses will increase to $2,370,000 per year. Delsing is not sure how much this expansion will add to sales, but he estimates that sales will rise by $1.35 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 $5.7 million before expansion and $6.7 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 answers to 2 decimal places.) c-2. The degree of financial leverage for all three methods after expansion. Assume sales of $6.7 million for this question. (Round your answers to 2 decimal places.) d. Compute EPS under all three methods of financing the expansion at $6.7 million in sales (first year) and $10.7 million in sales (last year). (Round your answers to 2 decimal places.)

Solutions

Expert Solution

a)
At break-even before expansion
Break Even point = FC + VC = Break Even Sales
Sales = $1,870,000 + .50 Sales
.50 Sales = $1,870,000
Sales = $1,870,000 / .50 $3,740,000.00
At break-even after expansion
Break Even point = FC + VC = Break Even Sales
Sales = $2,370,000 + .50 Sales
.50 Sales = $2,370,000
Sales = $2,370,000 / .50 $4,740,000.00
b)
Before Expansion
DOL = (S ? TVC) / (S ? TVC ? FC)
DOL = (5,700,000 - 2,850,000)/( 5,700,000 - 2,850,000 - 1,870,000) 2.91
After Expansion
DOL = (S ? TVC) / (S ? TVC ? FC)
DOL = (6,700,000 - 3,350,000)/( 6,700,000 - 3,350,000 - 2,370,000) 3.42
c) 1
DFL before expansion:
DFL = EBIT/ EBIT - Interest
DFL = $980,000/$980,000 - $340,000 1.53
c) 2
DFL after expansion
Compute EBIT and Interest for all three plans 100% Debt 100% equity (50% Debt and50% Equity)
Sales $6,700,000.00 $6,700,000.00 $6,700,000.00
Less Variable Cost $3,350,000.00 $3,350,000.00 $3,350,000.00
Less Fixed Cost $2,370,000.00 $2,370,000.00 $2,370,000.00
EBIT $980,000.00 $980,000.00 $980,000.00
Interest on old debt $340,000.00 $340,000.00 $340,000.00
Interest on New debt (2.7M x 9%); (1.35 M x 8%) $243,000.00 $0.00 $108,000.00
Total Interest $583,000.00 $340,000.00 $448,000.00
DF = EBIT/(EBIT - Interest) 2.47 1.53 1.84
d) 100% Debt 100% equity (50% Debt and50% Equity)
Sales $6,700,000.00 $6,700,000.00 $6,700,000.00
Less Variable Cost $3,350,000.00 $3,350,000.00 $3,350,000.00
Less Fixed Cost $2,370,000.00 $2,370,000.00 $2,370,000.00
EBIT $980,000.00 $980,000.00 $980,000.00
Less: Interest $583,000.00 $340,000.00 $448,000.00
EBT $397,000.00 $640,000.00 $532,000.00
Less: Tax @ 35% $138,950.00 $224,000.00 $186,200.00
Net Income $258,050.00 $416,000.00 $345,800.00
Shares Outstanding
Old Shares Outstanding 270000 240000 240000
New Shares Outstanding 0 108000 45000
Net Shares Outstanding ($2.7M/$25),($1.35M/$30) 270000 348000 285000
EPS = Net Income/ Shares Outstanding $0.96 $1.20 $1.21
d) 100% Debt 100% equity (50% Debt and50% Equity)
Sales $10,700,000.00 $10,700,000.00 $10,700,000.00
Less Variable Cost $5,350,000.00 $5,350,000.00 $5,350,000.00
Less Fixed Cost $2,370,000.00 $2,370,000.00 $2,370,000.00
EBIT $2,980,000.00 $2,980,000.00 $2,980,000.00
Less: Interest $583,000.00 $340,000.00 $448,000.00
EBT $2,397,000.00 $2,640,000.00 $2,532,000.00
Less: Tax @ 35% $838,950.00 $924,000.00 $886,200.00
Net Income $1,558,050.00 $1,716,000.00 $1,645,800.00
Shares Outstanding
Old Shares Outstanding 270000 240000 240000
New Shares Outstanding 0 108000 45000
Net Shares Outstanding ($2.7M/$25),($1.35M/$30) 270000 348000 285000
EPS = Net Income/ Shares Outstanding $5.77 $4.93 $5.77

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