Question

Mr. Gold is in the widget business. He currently sells 1.1 million widgets a year at $6 each. His variable cost to produce the widgets is $4 per unit, and he has $1,510,000 in fixed costs. His sales-to-assets ratio is six times, and 30 percent of his assets are financed with 6 percent debt, with the balance financed by common stock at $10 par value per share. The tax rate is 30 percent.
  
His brother-in-law, Mr. Silverman, says he is doing it all wrong. By reducing his price to $5.50 a widget, he could increase his volume of units sold by 50 percent. Fixed costs would remain constant, and variable costs would remain $4 per unit. His sales-to-assets ratio would be 7.5 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 10 percent. If this is the case, should Mr. Gold shift to the Silverman plan, based on earnings per share?

Answer 1

a. Sales to asset ratio is 6.

Assets=6* (1,100,000*6) = 39,600,000.

Total assets = Total Liabilties

30 percent of his assets are financed by debt. So the remaing that is 100-30= 70% of assets is the common stock value.

Number of shares= 70%of 39,600,000/10

= 27,720,000

= 2,772,000shares.

Computation of EPS under Gold Plan

c. Mr. Gold's wife being a Chief Financial Officer predicts a 10% surge in the fixed cost. We can see that the loss is already higher in Silverman plan than Goldplan. Thus an additon 10% increase in fixed cost would increase the loss by $151000 (10% of 1510000 which is the fixed cost) this would worsen the Earnings per share. S0 Mr. Gold SHOUKD NOT SHIFT to Silverman plan in any case.