Question

1. Leverage Analysis:  Your employer has decided to purchase a new manufacturing line.  The new line will generate an additional $3,000,000 of operating income annually and will cost $50,000,000.  You are trying to decide if the line should be financed with debt or with equity.  The company currently has $60,000,000 of debt (borrowing rate is 8%) and $30,000,000 of equity.  

(Part #1) Complete the income statement below (shaded region) including the two ratios at the bottom of the table. (Part #2) Recommend one of the two financing options and DEFEND your decision with sound reasoning in the white space below.

• New manufacturing line cost:                        $50,000,000
• Additional annual Operating Profit:               $3,000,000
• Financing Alternatives:                      $50,000,000 loan or 1,000,000 shares of common stock
• Interest Expense is 8%
• Tax rate is 25%

(7 pts)

PART #1	Before New Line	Financed 100% with Debt	Financed 100% with Equity
Sales	200,000,000	260,000,000	260,000,000
COGS	160,000,000	208,000,000	208,000,000
Gross Profit	40,000,000	52,000,000	52,000,000
Operating Expenses	30,000,000	39,000,000	39,000,000
Operating Profit	10,000,000	13,000,000	13,000,000
Interest Expense	4,800,000
EBT	5,200,000
Income Tax Expense (25%)	1,300,000
Net Income	3,900,000
Times Int. Earned	2.08
EPS (1,000,000 shares)	3.90

Part #2:  Which financing (debt or equity) do you choose and WHY?

Answer 1