Question

Delsing Canning Company is considering an expansion of its facilities. Its current income statement is as follows: Sales $ 6,100,000 Variable costs (50% of sales) 3,050,000 Fixed costs 1,910,000 Earnings before interest and taxes (EBIT) $ 1,140,000 Interest (10% cost) 420,000 Earnings before taxes (EBT) $ 720,000 Tax (40%) 288,000 Earnings after taxes (EAT) $ 432,000 Shares of common stock 310,000 Earnings per share $ 1.39 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 $3.1 million in additional financing. His investment banker has laid out three plans for him to consider: Sell $3.1 million of debt at 13 percent. Sell $3.1 million of common stock at $20 per share. Sell $1.55 million of debt at 12 percent and $1.55 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 $2,410,000 per year. Delsing is not sure how much this expansion will add to sales, but he estimates that sales will rise by $1.55 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 $6.1 million before expansion and $7.1 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 $7.1 million for this question. (Round your answers to 2 decimal places.) d. Compute EPS under all three methods of financing the expansion at $7.1 million in sales (first year) and $10.0 million in sales (last year). (Round your answers to 2 decimal places.)

Answer 1

a		Existing	After Expansion
	Sales	6,100,000	7,650,000
	Variable Cost (50% of Sales)	3,050,000	3,825,000
	Contribution	3,050,000	3,825,000
	Contribution Margin Ration	50	50
	Fixed Cost	1,910,000	2,410,000
	EBIT	1,140,000	1,415,000
	Interest (10% cost)	420,000
	EBT	720,000
	Tax (40%)	288,000
	EAT	432,000
	Shares of common stock	310,000
	EPS	1.39
	Break Even point in dollars	Fixed Cost / Contribution margin Ratio
	=	1910000/50%	2410000/50%
	=	3,820,000	4,820,000

b		Existing	After Expansion
	Sales (S)	6,100,000	7,100,000
	Variable Cost (50% of Sales) (TVC)	3,050,000	3,550,000
	Contribution (S - TVC)	3,050,000	3,550,000
	Contribution Margin Ration	50	50
	Fixed Cost (FC)	1,910,000	2,410,000
	EBIT (S-TVC-FC)	1,140,000	1,140,000
	DOL=	(S-TVC)/(S-TVC-FC)
	DOL=	3050000/1140000	3550000/1140000
	DOL=	2.68	3.11

c-1		Existing
	Sales (S)	6,100,000
	Variable Cost (50% of Sales) (TVC)	3,050,000
	Contribution (S - TVC)	3,050,000
	Contribution Margin Ration	50
	Fixed Cost (FC)	1,910,000
	EBIT (S-TVC-FC)	1,140,000
	Interest (10% cost)	420,000
	EBT	720,000
	DFL=	EBIT /EBT
	=	1140000/720000
	=	1.58

c-2		Method 1	Method 2	Method 3
		100% debt	100% equity	50% Equity 50% Debt
	Sales (S)	7,100,000	7,100,000	7,100,000
	Variable Cost (50% of Sales) (TVC)	3,550,000	3,550,000	3,550,000
	Contribution (S - TVC)	3,550,000	3,550,000	3,550,000
	Contribution Margin Ration	50	50	50
	Fixed Cost (FC)	2,410,000	2,410,000	2,410,000
	EBIT (S-TVC-FC)	1,140,000	1,140,000	1,140,000
	Interest	823,000	420,000	606000
		(420000+(3100000*13%))		(420000+(1550000*12%))
	EBT	317,000	720,000	534,000
	DFL=	EBIT /EBT
	=	1140000/317000	1140000/720000	1140000/534000
	=	3.60	1.58	2.13

d.		Method 1		Method 2		Method 3
		100% debt		100% equity		50% Equity 50% Debt
		1st year	last year	1st year	last year	1st year	last year
	Sales (S)	7,100,000	10,000,000	7,100,000	10,000,000	7,100,000	10,000,000
	Variable Cost (50% of Sales) (TVC)	3,550,000	5,000,000	3,550,000	5,000,000	3,550,000	5,000,000
	Contribution (S - TVC)	3,550,000	5,000,000	3,550,000	5,000,000	3,550,000	5,000,000
	Contribution Margin Ration	50	50	50	50	50	50
	Fixed Cost (FC)	2,410,000	2,410,000	2,410,000	2,410,000	2,410,000	2,410,000
	EBIT (S-TVC-FC)	1,140,000	2,590,000	1,140,000	2,590,000	1,140,000	2,590,000
	Interest	823,000	823,000	420,000	420,000	606000	606,000
		(420000+(3100000*13%))				(420000+(1550000*12%))
	EBT	317,000	1,767,000	720,000	2,170,000	534,000	1,984,000
	Tax (40%)	126,800	706,800	288,000	868,000	213,600	793,600
	EAT (A)	190,200	1,060,200	432,000	1,302,000	320,400	1,190,400
	Shares of common stock (B)	310,000	310,000	465000	465000	372000	372000
				(310000+(3100000/20))		(310000+(1550000/25))
	EPS (A/B)	0.61	3.42	0.93	2.80	0.86	3.20