Question

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

Sales	$	5,500,000
Variable costs (50% of sales)		2,750,000
Fixed costs		1,850,000
Earnings before interest and taxes (EBIT)	$	900,000
Interest (10% cost)		300,000
Earnings before taxes (EBT)	$	600,000
Tax (40%)		240,000
Earnings after taxes (EAT)	$	360,000
Shares of common stock		250,000
Earnings per share	$	1.44

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 $2.5 million in additional financing. His investment banker has laid out three plans for him to consider:

Sell $2.5 million of debt at 13 percent.

Sell $2.5 million of common stock at $20 per share.

Sell $1.25 million of debt at 12 percent and $1.25 million of common stock at $25 per share.

  
Variable costs are expected to stay at 50 percent of sales, while fixed expenses will increase to $2,350,000 per year. Delsing is not sure how much this expansion will add to sales, but he estimates that sales will rise by $1.25 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.)
  

Before expansion:

After expansion:

b. The degree of operating leverage before and after expansion. Assume sales of $5.5 million before expansion and $6.5 million after expansion. Use the formula: DOL = (S ? TVC) / (S ? TVC ? FC). (Round your answers to 2 decimal places.)
  

Before expansion:

After expansion:

c-1. The degree of financial leverage before expansion. (Round your answers to 2 decimal places.)
  

Degree of financial leverage:

c-2. The degree of financial leverage for all three methods after expansion. Assume sales of $6.5 million for this question. (Round your answers to 2 decimal places.)
  

100% Debt:

100% Equity:

50% Debt & 50% Equity:

d. Compute EPS under all three methods of financing the expansion at $6.5 million in sales (first year) and $10.5 million in sales (last year). (Round your answers to 2 decimal places.)
  

100% Debt:

100% Equity:

50% Debt& 50% Equity:

Answer 1

(a) Before expansion

Sales = $5,500,000

Variable expenses = $2,750,000

Contribution margin = Sales - Variable expense

= 5,500,000 - 2,750,000

= $2,750,000

Contribution margin ratio = Contribution/Sales

= 2,750,000/5,500,000

= 50%

Break even point = Fixed costs/Contribution margin ratio

= 1,850,000/50%

= $3,700,000

After expansion

Sales = $5,500,000 + 1,250,000

= $6,750,000

Variable expenses = $6,750,000 x 50%

= $3,375,000

Contribution margin = Sales - Variable expense

= 6,750,000 - 3,375,000

= $3,375,000

Contribution margin ratio = Contribution/Sales

= 3,375,000/6,750,000

= 50%

Fixed cost after expansion will rise to $2,350,000

Break even point = Fixed costs/Contribution margin ratio

= 2,350,000/50%

= $4,700,000

(b) Before expansion

Degree of operating leverage = Contribution margin/EBIT

= 2,750,000/900,000

= 3.05

After expansion

EBIT = Contribution - Fixed cost

= 3,375,000 - 2,350,000

= $1,025,000

Degree of operating leverage = Contribution margin/EBIT

= 3,375,000/1,025,000

= 3.29

(c -1) Degree of Financial leverage = EBIT/EBT

= 900,000/600,000

= 1.50

(c-2) After expansion

	100% debt	100% equity	50% debt, 50% equity
Contribution	3,375,000	3,375,000	3,375,000
Less: Fixed cost	- 2,350,000	- 2,350,000	- 2,350,000
EBIT	1,025,000	1,025,000	1,025,000
Interest	- 625,000	- 300,000	- 450,000
EBT	400,000	725,000	575,000
Financial leverage	2.56	1.41	1.78

(d) Calculation of EPS in first year

	100% debt	100% equity	50% debt, 50% equity
EBT	400,000	725,000	575,000
Less: tax	- 160,000	- 290,000	- 230,000
EAT (i)	240,000	435,000	345,000
No. of common shares (ii)	250,000	375,000	300,000
EPS = (i)/(ii)	$0.96	$1.16	$1.15

Calculation of EPS in the last year

	100% debt	100% equity	50% debt, 50% equity
Sales	10,500,000	10,500,000	10,500,000
Less: Variable cost	5,250,000	5,250,000	5,250,000
Contribution	5,250,000	5,250,000	5,250,000
Less: Fixed cost	- 2,350,000	- 2,350,000	- 2,350,000
EBIT	2,900,000	2,900,000	2,900,000
Less: Interest	- 625,000	- 300,000	- 450,000
EBT	2,275,000	2,600,000	2,450,000
Less: tax	- 910,000	- 1,040,000	- 980,000
EAT	1,365,000	1,560,000	1,470,000
No. of common shares	250,000	375,000	300,000
EPS	$5.46	$4.16	$4.9