Question

The Lopez-Portillo Company has $12.1 million in assets, 90 percent financed by debt and 10 percent financed by common stock. The interest rate on the debt is 11 percent and the par value of the stock is $10 per share. President Lopez-Portillo is considering two financing plans for an expansion to $25.5 million in assets. Under Plan A, the debt-to-total-assets ratio will be maintained, but new debt will cost a whopping 13 percent! Under Plan B, only new common stock at $10 per share will be issued. The tax rate is 40 percent.

a. If EBIT is 12 percent on total assets, compute earnings per share (EPS) before the expansion and under the two alternatives. (Round your answers to 2 decimal places.

	Earnings Per Share
Current
Plan A
Plan B

b. What is the degree of financial leverage under each of the three plans? (Round your answers to 2 decimal places.)

	Degree of Financial Leverage
Current
Plan A
Plan B

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.)

	Earnings Per Share
Plan A
Plan B

Answer 1

a)  If EBIT is 12 percent on total assets, Earnings per share (EPS) before the expansion and under the two alternatives =

	Earnings per Share
Current	$ 1.30
Plan A	$ .69
Plan B	$ .76

	Current	Plan A	Plan B
EBIT	1452000	3060000	3060000
Less- Interest	11979001	27657003	11979005
EBT	264100	294300	1862100
Less- Taxes @ 40%	105640	117720	744840
EAT	158460	176580	1117260
Common Shares	1210002	2550004	14610006
EPS (EAR / Common shares)	1.3	0.69	0.76

1. (90% x $12,100,000) x 11% = $10,890,000 x 11% = $1,197,900

2. (10% x $12,100,000)/$10 = $1,210,000/$10 = 121,000 shares

3. $1,197,900 (current) + (90% x $13,400,000) x 13% = $1,197,900 + $1,567,800 = $2,765,700

4. 121,000 shares (current) + (10% x $13,400,000)/$10 = 121,000 + 134,000 = 255,000 shares

5. Unchanged

6. 121,000 shares (current) + ( $13,400,000)/$10 = 121,000 + 1,340,000 = 1,461,000 shares

b)

Degree of Financial Leverage
Current	5.50
Plan A	10.40
Plan B	1.64

DFL =EBIT / EBT

DFL ( current) = 1,452,000 / 264,100 = 5.5

DFL ( Plan A) = 3,060,000 / 294,300 = 10.4

DFL ( Plan B) = 3,060,000 / 1,862,100 = 1.64

c)

	Plan A	Plan B
EAT	176580	1117260
Common Shares	188000	791000
EPS	0.94	1.41

1. 121,000 shares (current) + (10% x $13,400,000)/$20 = 121,000 + 67,000 = 188,000 shares

2. 121,000 shares (current) + ( $13,400,000)/$20 = 121,000 + 670,000 = 791,000 shares