Question

The Lopez-Portillo Company has $12.3 million in assets, 70 percent financed by debt and 30 percent financed by common stock. The interest rate on the debt is 8 percent and the par value of the stock is $10 per share. President Lopez-Portillo is considering two financing plans for an expansion to $26.5 million in assets.

Under Plan A, the debt-to-total-assets ratio will be maintained, but new debt will cost a whopping 11 percent! Under Plan B, only new common stock at $10 per share will be issued. The tax rate is 35 percent.

a. If EBIT is 9 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

a.

Initial Case:

Debt = 0.7 x 12.3 = $8.61 million

Interest expense = 0.08 X 8.61 =$0.6888 million

Therefore, Equity = 12.3 - 8.61 = $3.69 million

Face value = $10 per share

So, number of shares = 3690000/10 = 369000

EBIT = 9% of assets = 0.09 x 12.3 = $1.107 million …. (a)

Interest expense = $0.6888 million …. (b)

EBT = (a –b) = 1.107-0.6888 = $0.4182 Million … (c )

Tax = 35% of EBT = 0.35 x 0.4182 = $0.1464 million … (d)

Therefore Earnings = (c – d) = 0.4182-0.1464 = $0.2718 million

So, Earnings per share = 271800/369000 = $0.737

Expansion Plan A:

Debt = 0.7 x 26.5 = $18.55 million

Therefore equity = 26.5 – 18.55 = $7.95 million

Additional debt = 18.55 - 8.61 = $9.94 million

Interest expense on old debt = $0.6888 million

Interest on additional debt = 0.11 x 9.94 = $1.09 million

Total interest expense = 0.6888 + 1.09 = $1.7788 million

Face value = $10 per share

So, number of shares = 7950000/10 = 795000

EBIT = 9% of assets = 0.09 x 26.5 = $2.385 million …. (a)

Interest expense = $1.7788 million …. (b)

EBT = (a –b) = 2.385 - 1.7788 = $0.6062 Million … (c )

Tax = 35% of EBT = 0.35 x 0.6062 = $0.2122 million … (d)

Therefore Earnings = (c – d) = 0.6062 - 0.2122 = $0.394 million

So, Earnings per share = 394000/795000 = $0.495

Expansion Plan B:

Debt = 0.7 x 12.3 = $8.61 million

Interest expense = 0.08 X 8.61 =$0.6888 million

Total assets = $26.5 million

Since the new fund is completely equity financed, Equity = 26.5 – 8.61 = $17.89 million

Face value = $10 per share

So, number of shares = 17890000/10 = 1789000

EBIT = 9% of assets = 0.09 x 26.5 = $2.385 million …. (a)

Interest expense = $0.6888 million …. (b)

EBT = (a –b) = 2.385 – 0.6888 = $1.6962 Million … (c )

Tax = 35% of EBT = 0.35 x 1.6962 = $0.5937 million … (d)

Therefore Earnings = (c – d) = 1.6962 - 0.5937 = $1.1025 million

So, Earnings per share = 1102500/1789000 = $0.616

b. Degree of financial leverage (DFL) = EBIT / ( EBIT – Interest)

Initial case:

DFL = 1.107 / (1.107 – 0.6888) = 2.647

Expansion Plan A:

DFL = 2.385 / (2.385 – 1.7788) = 3.934

Expansion Plan B:

DFL = 2.385 / (2.385 – 0.6888) = 1.406

c. Expansion Plan A:

Debt = 0.7 x 26.5 = $18.55 million

Therefore equity = 26.5 – 18.55 = $7.95 million

Additional debt = 18.55 - 8.61 = $9.94 million

Interest expense on old debt = $0.6888 million

Interest on additional debt = 0.11 x 9.94 = $1.09 million

Total interest expense = 0.6888 + 1.09 = $1.7788 million

Therefore equity = 26.5 – 18.55 = $7.95 million

Additional Equity = 7.95 – 3.69 =$4.26

Face value = $10 per share

So, number of shares = 3690000/10 = 396000

Face value of new equity =$20

Therefore, number of shares in new issue = 4260000/20 = 213000

Therefore total number of outstanding shares = 369000 + 213000 = 582000

EBIT = 9% of assets = 0.09 x 26.5 = $2.385 million …. (a)

Interest expense = $1.7788 million …. (b)

EBT = (a –b) = 2.385 - 1.7788 = $0.6062 Million … (c )

Tax = 35% of EBT = 0.35 x 0.6062 = $0.2122 million … (d)

Therefore Earnings = (c – d) = 0.6062 - 0.2122 = $0.394 million

So, Earnings per share = 394000/582000 = $0.677

Expansion Plan B:

Debt = 0.7 x 12.3 = $8.61 million

Interest expense = 0.08 X 8.61 =$0.6888 million

Total assets = $26.5 million

Since the new fund is completely equity financed, Equity = 26.5 – 8.61 = $17.89 million

Face value = $20 per share

So, number of shares = 17890000/20 = 894500

EBIT = 9% of assets = 0.09 x 26.5 = $2.385 million …. (a)

Interest expense = $0.6888 million …. (b)

EBT = (a –b) = 2.385 – 0.6888 = $1.6962 Million … (c )

Tax = 35% of EBT = 0.35 x 1.6962 = $0.5937 million … (d)

Therefore Earnings = (c – d) = 1.6962 - 0.5937 = $1.1025 million

So, Earnings per share = 1102500/894500 = $1.233