Question

Mr. Gold is in the widget business. He currently sells 1.9 million widgets a year at $5 each. His variable cost to produce the widgets is $3 per unit, and he has $1,700,000 in fixed costs. His sales-to-assets ratio is five times, and 20 percent of his assets are financed with 12 percent debt, with the balance financed by common stock at $10 par value per share. The tax rate is 35 percent.    His brother-in-law, Mr. Silverman, says he is doing it all wrong. By reducing his price to $4.50 a widget, he could increase his volume of units sold by 60 percent. Fixed costs would remain constant, and variable costs would remain $3 per unit. His sales-to-assets ratio would be 7.5 times. Furthermore, he could increase his debt-to-assets ratio to 50 percent, with the balance in common stock. It is assumed that the interest rate would go up by 1 percent and the price of stock would remain constant. a. Compute earnings per share under the Gold plan. (Round your answer to 2 decimal places.)    b. Compute earnings per share under the Silverman plan. (Round your answer to 2 decimal places.)    c. Mr. Gold’s wife, the chief financial officer, does not think that fixed costs would remain constant under the Silverman plan but that they would go up by 15 percent. If this is the case, should Mr. Gold shift to the Silverman plan, based on earnings per share?    No Yes

Answer 1

a)	Gold Plan
	Sales (1900000 * 5)	9500000
	Less: Fixed Cost	1700000
	Less: Variable Cost	5700000
	EBIT	2100000
	Less: Interest(Note 1)	45600
	EBT	2054400
	Less: Taxes @35%	719040
	EAT	1335360
	No of Shares(Note 2)	152000
	EPS	8.79
	Assets = Sales / Asset Turnover
	=9500000/5
	=1900000
	Debt = 20% of Asset
	=1900000*20%
	=3800000
Note 1	Interest = 12% of 380000
	=380000*12%
	=45600
Note 2	Stock = 80% of 1900000
	=1520000
	No. of Stock = 1520000/10
	=152000	Shares
b)	Silverman Plan
	Sales (1900000*1.6*4.5)	13680000
	Less: Fixed Cost	1700000
	Less: Variable Cost	9120000
	EBIT	2860000
	Less: Interest(Note 1)	118560
	EBT	2741440
	Less: Taxes @35%	959504
	EAT	1781936
	No of Shares(Note 2)	91200
	EPS	19.54
	Assets = Sales / Asset Turnover
	=13680000/7.5
	=1824000
	Debt = 50% of Asset
	=1824000*50%
	=912000
Note 1	Interest = 13% of 912000
	=118560
Note 2	Stock = 50% of 1824000
	=912000*50%
	No. of Stock = 912000/10
	=91200
b)	Goldman Wifes Plan
	Sales (1900000*1.6*4.5)	13680000
	Less: Fixed Cost	1955000
	Less: Variable Cost	9120000
	EBIT	2605000
	Less: Interest(Note 1)	118560
	EBT	2486440
	Less: Taxes @35%	870254
	EAT	1616186
	No of Shares(Note 2)	91200
	EPS	17.72
	Mr. Gold should not shift to the Silverman plan
	Assets = Sales / Asset Turnover
	=13680000/7.5
	=1824000
	Debt = 50% of Asset
	=1824000*50%
	=912000
Note 1	Interest = 13% of 912000
	=118560
Note 2	Stock = 50% of 1824000
	=912000*50%
	No. of Stock = 912000/10
	=91200