Question

BREAKEVEN AND LEVERAGE

Wingler Communications Corporation (WCC) produces premium stereo headphones that sell for $28.80 per set, and this year's sales are expected to be 440,000 units. Variable production costs for the expected sales under present production methods are estimated at $10,200,000, and fixed production (operating) costs at present are $1,560,000. WCC has $4,800,000 of debt outstanding at an interest rate of 8%. There are 240,000 shares of common stock outstanding, and there is no preferred stock. The dividend payout ratio is 70%, and WCC is in the 40% federal-plus-state tax bracket.

The company is considering investing $7,200,000 in new equipment. Sales would not increase, but variable costs per unit would decline by 20%. Also, fixed operating costs would increase from $1,560,000 to $1,800,000. WCC could raise the required capital by borrowing $7,200,000 at 10% or by selling 240,000 additional shares of common stock at $30 per share.

What would be WCC's EPS (1) under the old production process, (2) under the new process if it uses debt, and (3) under the new process if it uses common stock? Do not round intermediate calculations. Round your answers to the nearest cent.
1.  $
2.  $
3.  $

At what unit sales level would WCC have the same EPS assuming it undertakes the investment and finances it with debt or with stock? {Hint: V = variable cost per unit = $8,160,000/440,000, and EPS = [(PQ - VQ - F - I)(1 - T)]/N. Set EPSStock = EPSDebt and solve for Q.} Do not round intermediate calculations. Round your answer to the nearest whole.
  units

At what unit sales level would EPS = 0 under the three production/financing setups - that is, under the old plan, the new plan with debt financing, and the new plan with stock financing? (Hint: Note that VOld = $10,200,000/440,000, and use the hints for part b, setting the EPS equation equal to zero.) Do not round intermediate calculations. Round your answers to the nearest whole.
Old plan    units
New plan with debt financing    units
New plan with stock financing    units

On the basis of the analysis in parts a through c, and given that operating leverage is lower under the new setup, which plan is the riskiest, which has the highest expected EPS, and which would you recommend? Assume here that there is a fairly high probability of sales falling as low as 250,000 units, and determine EPSDebt and EPSStock at that sales level to help assess the riskiness of the two financing plans. Do not round intermediate calculations. Round your answers to two decimal places. Negative amount should be indicated by a minus sign.
EPSDebt = $
EPSStock = $

Answer 1

1.

Alternative	1	2	3
	Old Production Process	New Production Process	New Production Process
		Debt	Common Stock
Sales	$ 12,672,000	$ 12,672,000	$ 12,672,000
Variable Cost	10,200,000	8,160,000	8,160,000
Fixed Operating Cost	1,560,000	1,800,000	1,800,000
EBIT	912,000	2,712,000	2,712,000
Interest Expense	384,000	1,104,000	384,000
EBT	528,000	1,608,000	2,328,000
Tax	211,200	643,200	931,200
Net Income	316,800	964,800	1,396,800
Common Shares Outstanding	240,000	240,000	480,000
Earnings per Share ( EPS)	$ 1.32	$ 4.02	$ 2.91

2. EPS using debt = (EBIT - 1,104,000) x 0.60 / 240,000.

EPS using common stock = ( EBIT - 384,000) x 0.60 / 480,000

Indifference point :

( EBIT - 1,104,000) X 0.60 / 240,000 = ( EBIT - 384,000) X 0.60 / 480,000

or 1.2 EBIT - 1,324,800 = 0.6 EBIT - 230,400.

or EBIT = $ 1,824,000.

Let the unit sales be Q.

28.8 Q - 18.55 Q - 1,800,000 = 1,824,000.

or 10.25 Q = 3,624,000

or Q = 353,561 units.

At a sales level of 353,561 units, WCC will have the same EPS regardless of the alternative.

3. At what level of sales will EPS be 0 ?

EPSwill be zero at the sales level where Total Contribution Margin = Total Fixed Costs. In other words, there is no income left after meeting the fixed operating and fixed finance costs.

	Old Production Process	New Production Process with Debt	New Production Process with Common Stock
Fixed Operating Costs	$ 1,560,000	$ 1,800,000	$ 1,800,000
Fixed Finance Costs	384,000	1,104,000	384,000
Total Fixed Costs	$ 1,944,000	$ 2,904,000	$ 2,184,000
Contribution Margin per Unit	5.618	10.255	10.255
Sales level where net income will be 0.	346,031 units	283,179 units	212,969 units

4. If sales level falls to 250,000 units:

EPS Debt = - $ 1.42

EPS Stock = $ 0.79