Question

The Lopez-Portillo Company has $11.8 million in assets, 80 percent financed by debt and 20 percent financed by common stock. The interest rate on the debt is 14 percent and the par value of the stock is $10 per share. President Lopez-Portillo is considering two financing plans for an expansion to $24 million in assets. Under Plan A, the debt-to-total-assets ratio will be maintained, but new debt will cost a whopping 17 percent! Under Plan B, only new common stock at $10 per share will be issued. The tax rate is 40 percent.

a. If EBIT is 15 percent on total assets, compute earnings per share (EPS) before the expansion and under the two alternatives. (Round your answers to 2 decimal places.)

b. What is the degree of financial leverage under each of the three plans? (Round your answers to 2 decimal places.)

c. If stock could be sold at $20 per share due to increased expectations for the firm’s sales and earnings, what impact would this have on earnings per share for the two expansion alternatives? Compute earnings per share for each. (Round your answers to 2 decimal places.)

Answer 1

PROJECT PLAN A
Particulars	interest or FV	total	interest
OLD ASSETS($)		11.8
Debt 80%	14.00%	9.44	1.3216
Equity 20%	10	2.36
Old number of equity shares		0.236
ADDITIONAL ASSETS ($)		24
ADDITIONAL Debt 80%	17.00%	19.2	3.264
ADDITIONAL Equity 20%	10	4.8
New number of equity shares		0.48
total number of eq sh ( old + new )		0.716
total interest ( old + new )			4.5856
PROJECT PLAN B
Particulars	interest or FV	total	interest
OLD ASSETS($)		11.8
Debt 80%	14.00%	9.44	1.3216
Equity 20%	10	2.36
number of equity shares		0.236
ADDITIONAL ASSETS ($)		24
ADDITIONAL Equity 100%	10	24
New number of equity shares		2.4
total number of eq sh ( old + new )		2.636
total interest ( old + new )			1.3216
A	$ in million	$ in million	$ in million
Particulars	PRESENT	OPTION A	OPTION B
EBIT	1.77	5.37	5.37
15%*(11.8+24)
(-)interest	1.3216	4.5856	1.3216
PBT	0.4484	0.7844	4.0484
(-)TAX@40%	0.17936	0.31376	1.61936
PAT	0.26904	0.47064	2.42904
total number of eq sh ( old + new )	0.236	0.716	2.636
EPS	1.14	0.66	0.92
	$ in million	$ in million	$ in million
B	PRESENT	OPTION A	OPTION B
degree of financial leverage	3.95	6.85	1.33
(EBIT/PBT)
C
IF STOCK SOLD AT $20 PER SHARE
		OPTION A	OPTION B
OLD NUMBER OF SHARES		0.236	0.236
ADDITIONAL Equity 20%		4.8
ADDITIONAL Equity 100%			24
SHARE PRICE ($)		20	20
number of equity shares TO ISSUE		0.24	1.2
total number of eq sh ( old + new )		0.476	1.436
	$ in million	$ in million	$ in million
	PRESENT	OPTION A	OPTION B
EBIT	1.77	5.37	5.37
15%*(11.8+24)
(-)interest	1.3216	4.5856	1.3216
PBT	0.4484	0.7844	4.0484
(-)TAX@40%	0.17936	0.31376	1.61936
PAT	0.26904	0.47064	2.42904
total number of eq sh ( old + new )	0.236	0.476	1.436
EPS= PAT/ number of shares	1.14	0.99	1.69