Question

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

Sales	$	5,300,000
Variable costs (50% of sales)		2,650,000
Fixed costs		1,830,000
Earnings before interest and taxes (EBIT)	$	820,000
Interest (10% cost)		260,000
Earnings before taxes (EBT)	$	560,000
Tax (30%)		168,000
Earnings after taxes (EAT)	$	392,000
Shares of common stock		230,000
Earnings per share	$	1.70

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 $2.3 million in additional financing. His investment banker has laid out three plans for him to consider:

1. Sell $2.3 million of debt at 11 percent.
2. Sell $2.3 million of common stock at $25 per share.
3. Sell $1.15 million of debt at 10 percent and $1.15 million of common stock at $40 per share.

  

Variable costs are expected to stay at 50 percent of sales, while fixed expenses will increase to $2,330,000 per year. Delsing is not sure how much this expansion will add to sales, but he estimates that sales will rise by $1.15 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 $5.3 million before expansion and $6.3 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 $6.3 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 $6.3 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

1-		before expansion	after expanison
Sales	$	5,300,000	6,450,000
Variable costs (50% of sales)		2,650,000	3225000
contribution margin		2,650,000	3,225,000
Fixed costs		1,830,000	2330000
Earnings before interest and taxes (EBIT)	$	820,000	895,000
contribution margin ratio = contribution/sales	2650000/5300000	50%	50%
Break even point in sales	fixed cost/contribution margin ratio	3660000	4660000
2-
degree of operating leverage	(S −TVC) / (S − TVC − FC)	(5300000-2650000)/(5300000-2650000-1830000)	3.23
degree of operating leverage after expansion	(S −TVC) / (S − TVC − FC)	(6450000-3225000)/(6450000-3225000-2330000)	3.60
3-
Degree of operating leverage before expansion	(S − TVC − FC)/(S −TVC-FC-Interest)	(5300000-2650000-1830000)/(5300000-2650000-1830000-260000)	1.46
Degree of operating leverage after expansion
Plan 1
Degree of operating leverage after expansion	(S − TVC − FC)/(S −TVC-FC-Interest)	(5300000-2650000-1830000)/(5300000-2650000-1830000-513000)	2.67
total interest	(260000)+(2300000*11%)	513000
Plan 2
Degree of operating leverage after expansion	(S − TVC − FC)/(S −TVC-FC-Interest)	(5300000-2650000-1830000)/(5300000-2650000-1830000-260000)	1.46
total interest	(260000)+(0*11%)	260000
plan 3
Degree of operating leverage after expansion	(S − TVC − FC)/(S −TVC-FC-Interest)	(5300000-2650000-1830000)/(5300000-2650000-1830000-375000)	1.84
total interest	(260000)+(1150000*10%)	375000
4-		6.3 million sales	10.3 million of sales
Sales		6300000	10300000
v.cost-50% of sales		3150000	5150000
fixed cost		2330000	2330000
operating profit		820000	2820000
plan 1
operating profit		820000	2820000
less interest		513000	513000
before tax profit		307000	2307000
less tax-30%		92100	692100
net income		214900	1614900
no of shares outstanding		230000	230000
EPS	net income/no of shares outstanding	0.93	7.02
plan 2
operating profit		820000	2820000
less interest		260000	260000
before tax profit		560000	2560000
less tax-30%		168000	768000
net income		392000	1792000
no of shares outstanding		322000	322000
EPS	net income/no of shares outstanding	1.22	5.57
No of total share outstanding	(230000)+(2300000/25)	322000
plan 3
operating profit		820000	2820000
less interest		375000	375000
before tax profit		445000	2445000
less tax-30%		133500	733500
net income		311500	1711500
no of shares outstanding		258750	258750
EPS	net income/no of shares outstanding	1.20	6.61
No of total share outstanding	(230000)+(1150000/40)	258750