Question

13-12)

Wingler Communications Corporation (WCC) produces premium stereo headphones that sell for $28.90 per set, and this year's sales are expected to be 450,000 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 7%. 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.

A. 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. _________$

B. 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 = $8,160,000/450,000, 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

C. 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 = $10,200,000/450,000, 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

D. 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

The answers are given below.Thanks

Variable cost / unit = 10,200,000 / 450,000 = $ 22.67 / unit 1. 1. Under the old production process, net income = (sales - variable costs - fixed costs - debt*interest rate)*(1-tax rate) = (450,000*28.9-10,200,000-1,560,000-4,800,000*7%)*(1-40%) = 726840 EPS = net income / total shares = 726840 / 240,000 = 3.03 1. 2. Under the new production process with debt, new variable cost / unit = old variable cost / unit *(1-20%) = 22.67*(1-20%) = 18.14 Net income = (sales - variable costs - fixed costs - debt 1*interest rate 1 - debt 2*interest rate 2)*(1-tax rate) = (450,000*28.9-450,000*18.14-1,800,000-4,800,000*7%-7,200,000*10%)*(1-40%) = 1191600 New EPS under debt = net income / total shares = 1,191600 / 240,000 = 4.97 1. 3. Under the new production process with equity, net income = (sales - variable costs - fixed costs - debt*interest rate)*(1-tax rate) = (450,000*28.9-450,000*18.14-1,800,000-4,800,000*7%)*(1-40%) = 1594800 New EPS under stock = net income / total shares = 1,594800 / (240,000+240,000) = 3.32 2. Assuming the sales units sold = Q, then EPS 1 under debt = ((28.9-18.14)*Q - 1,800,000 - 4,800,000*7% - 7,200,000*10%) *(1-40%) / 240,000 = (10.76Q - 2,856,000) *0.6 / 240,000 EPS 2 under debt = ((28.9-18.14)*Q - 1,800,000 - 4,800,000*7%) * (1-40%) / 480,000 = (10.76Q - 2,136,000) *0.6 / 480,000 Equating the 2 EPS, we get (10.76Q - 2,856,000) *0.6 / 240,000 = (10.76Q - 2,136,000) *0.6 / 480,000 Or 2*(10.76Q - 2,856,000) = (10.76Q - 2,184,000) Solving, we get Q = 327881 units 3. Under old process, EPS=0 when sales - variable cost = fixed cost + debt * interest rate Or Q*(28.9-22.67) = 1,560,000+4,800,000*7% = 1,896000 Solving, we get Q = 304334 units (old plan) Under new process with debt financing, Q*(28.9-18.14) = 1,800,000+4,800,000*7%+7,200,000*10% = 2,904,000 Solving, we get Q = 269888 units (new plan with debt) Under new process with stock financing, Q*(28.9-18.14) = 1,800,000+4,800,000*7% = 2,156000 Solving, we get Q = 200371 units (new plan with stock) 4. As sales may fall to 250,000 units which is below breakeven EPS of 200371 units under the debt financing plan, this debt financing plan would be the riskiest plan. This is also the plan with the highest EPS. However we should recommend the plan with stock financing as its EPS will be positive under 250,000 units and will also be higher than the current no-financing situation. Under 250,000 units sales, EPS debt = (250,000*28.9-250,000*18.14-1,800,000-4,800,000*7%-7,200,000*10%)*(1-40%)/240,000 = -0.42 Under 250,000 units sales, EPS stock = (250,000*28.9-250,000*18.14-1,800,000-4,800,000*8%)*(1-40%)/480,000 = 0.69