Question

Mr. Gold is in the widget business. He currently sells 2.0 million widgets a year at $6 each. His variable cost to produce the widgets is $4 per unit, and he has $1,710,000 in fixed costs. His sales-to-assets ratio is six times, and 30 percent of his assets are financed with 13 percent debt, with the balance financed by common stock at $10 par value per share. The tax rate is 40 percent.
  
His brother-in-law, Mr. Silverman, says he is doing it all wrong. By reducing his price to $5.00 a widget, he could increase his volume of units sold by 40 percent. Fixed costs would remain constant, and variable costs would remain $4 per unit. His sales-to-assets ratio would be 8.0 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 20 percent. If this is the case, should Mr. Gold shift to the Silverman plan, based on earnings per share?
  

	Yes
	No

Answer 1

	Gold	Silver
Assets	$     2.00	$     1.75
Debt	$     0.60	$     0.88
Equity	$     1.40	$     0.88
Sales	$   12.00	$   14.00
VC	$     8.00	$   11.20
FC	$     1.71	$     1.71
EBIT	$     2.29	$     1.09
Interest	$     0.08	$     0.12
EBT	$     2.21	$     0.97
Tax (40%)	$     0.88	$     0.39
Profits	$     1.33	$     0.58
EPS	$     9.48	$     6.63

For Gold, Assets = Sales / 6 = 2 x 6 / 6 = $2 million

Debt = 30% x 2 = 0.6 million and Equity = 2 - 0.6 = 1.4 million

With par of $10, no. of shares = 1.4 / 10 = 0.14 million shares

For Silver, Assets = 2 x 1.4 x 5 / 8 = 1.75 million

Debt = 50% x 1.75 = 0.875m and Equity = 0.875m and no. of shares = 0.875 / 10 = 0.088 million

The Silverman plan already has lower EPS than Gold plan and if the fixed cost goes up in the case of Silverman plan, than the EPS will decline further and hence, Gold should not shift to Silverman plan.