Question

Delsing Canning Company is considering an expansion of its facilities. Its current income statement is as follows:

Sales	$	6,400,000
Variable costs (50% of sales)		3,200,000
Fixed costs		1,940,000
Earnings before interest and taxes (EBIT)	$	1,260,000
Interest (10% cost)		480,000
Earnings before taxes (EBT)	$	780,000
Tax (40%)		312,000
Earnings after taxes (EAT)	$	468,000
Shares of common stock		340,000
Earnings per share	$	1.38

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 $3.4 million in additional financing. His investment banker has laid out three plans for him to consider:

1. Sell $3.4 million of debt at 10 percent.
2. Sell $3.4 million of common stock at $20 per share.
3. Sell $1.70 million of debt at 9 percent and $1.70 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 $2,440,000 per year. Delsing is not sure how much this expansion will add to sales, but he estimates that sales will rise by $1.70 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.)
  

	Break-Even Point Before expansion After expansion

b. The degree of operating leverage before and after expansion. Assume sales of $6.4 million before expansion and $7.4 million after expansion. Use the formula: DOL = (S − TVC) / (S − TVC − FC). (Round your answers to 2 decimal places.)
  

	Degree of Operating Leverage Before expansion After expansion

c-1. The degree of financial leverage before expansion. (Round your answers to 2 decimal places.)
  

	Degree of financial leverage

c-2. The degree of financial leverage for all three methods after expansion. Assume sales of $7.4 million for this question. (Round your answers to 2 decimal places.)
  

	Degree of Financial Leverage 100% Debt 100% Equity 50% Debt & 50% Equity

d. Compute EPS under all three methods of financing the expansion at $7.4 million in sales (first year) and $10.3 million in sales (last year). (Round your answers to 2 decimal places.)
  

	Earnings per Share First Year Last Year 100% Debt 100% Equity 50% Debt & 50% Equity

Answer 1

A) Breakeven point = Fixed cost / PV ratio

Before expansion = 1940000/50% = 3880000

After expansion = 2440000/50% = 4880000

B) DOL = (S − TVC) / (S − TVC − FC)

Befor expansion = (6400000 - 3200000) /  (6400000 - 3200000 - 1940000) = 1.67

After expansion = (7400000 - 3700000) / (7400000 - 3700000 - 2440000) = 2.94

C-1) DOF before expansion = EBIT / ( EBIT - INTEREST)

= 1260000 / 780000 = 1.62

C-2) Calculation of EBIT AND EBT IN DIFFERENT PLANS

Particulars	100% DEBT	100% EQUITY	50%DEBT - EQUITY
Sales (6.4 + 1.7)	8100000	8100000	8100000
LESS ;- VC (50%)	4050000	4050000	4050000
LESS ;- FC	2440000	2440000	2440000
EBIT	1610000	1610000	1610000
Less - interest
Old debt	480000	480000	480000
new debt	340000	0	170000
EBT	790000	1130000	960000
/ No of common stock	340000	680000	510000
EPS	2.32	1.33	1.88

Note

1) new interest in different plans

• plan a = 3.4 million *10% = 340000
• plan b = 0 ( no debt)
• plan c = 1.7 million * 10 % = 170000

2) No of new shares issued

• Plan a = 0 ( no new equity)
• plan b = 3.4 million / 10 = 340000 shares
• plan c = 1.7 million /10 = 170000 shares

Degree of financial leverage = EBIT / EBT

100% DEBT = 1610000/790000= 2.04

100% EQUITY = 1610000/1130000 = 1.42

50% D & E = 1610000/960000 = 1.68

D) Calculation of EPS

FIRST YEAR

Particulars	100% DEBT	100% EQUITY	50%DEBT - EQUITY
Sales (6.4 + 1.7)	7400000	7400000	7400000
LESS ;- VC (50%)	3700000	3700000	3700000
LESS ;- FC	2440000	2440000	2440000
EBIT	1260000	1260000	1260000
Less - interest
Old debt	480000	480000	480000
new debt	340000	0	170000
EBT	440000	780000	610000
/ No of common stock	340000	680000	510000
EPS	1.29	1.15	1.12

Second YEAR

Particulars	100% DEBT	100% EQUITY	50%DEBT - EQUITY
Sales (6.4 + 1.7)	10300000	10300000	10300000
LESS ;- VC (50%)	5150000	5150000	5150000
LESS ;- FC	2440000	2440000	2440000
EBIT	2710000	2710000	2710000
Less - interest
Old debt	480000	480000	480000
new debt	340000	0	170000
EBT	1890000	2230000	2060000
/ No of common stock	340000	680000	510000
EPS	5.56	3.28	4.04