Question

Wingler Communications Corporation (WCC) produces premium stereo headphones that sell for $28.60 per set, and this year's sales are expected to be 450,000 units. Variable production costs for the expected sales under present production methods are estimated at $10,500,000, and fixed production (operating) costs at present are $1,560,000. WCC has $4,800,000 of debt outstanding at an interest rate of 8%. There are 240,000 shares of common stock outstanding, and there is no preferred stock. The dividend payout ratio is 70%, and WCC is in the 40% federal-plus-state tax bracket.

The company is considering investing $7,200,000 in new equipment. Sales would not increase, but variable costs per unit would decline by 20%. Also, fixed operating costs would increase from $1,560,000 to $1,800,000. WCC could raise the required capital by borrowing $7,200,000 at 10% or by selling 240,000 additional shares of common stock at $30 per share.

1. What would be WCC's EPS (1) under the old production process, (2) under the new process if it uses debt, and (3) under the new process if it uses common stock? Do not round intermediate calculations. Round your answers to the nearest cent.

On the basis of the analysis in parts a through c, and given that operating leverage is lower under the new setup, which plan is the riskiest, which has the highest expected EPS, and which would you recommend? Assume here that there is a fairly high probability of sales falling as low as 250,000 units, and determine EPS_Debt and EPS_Stock at that sales level to help assess the riskiness of the two financing plans. Do not round intermediate calculations. Round your answers to two decimal places. Negative amount should be indicated by a minus sign.

Answer 1

Step 1. Determination of option

Option 1: Old Production Process

Option 2: Investment in New Equipment - Debt Financing

Option 3 : Investment in New Equipment - Equity Financing  

Step 2: Calculation of EPS under the given alternatives:

	Old Production Process	New Equipment
Debt Financing	Equity Financing
Sales (4,50,000*$28.60)	$12,870,000.00	$12,870,000.00	$12,870,000.00
Less: Variable cost (Note 1)	$(10,500,000.00)	$(8,400,000.00)	$(8,400,000.00)
Contribution	$2,370,000.00	$4,470,000.00	$4,470,000.00
Less: Fixed Production Cost	$(1,560,000.00)	$(1,800,000.00)	$(1,800,000.00)
Earning Before Interest & Tax(EBIT)	$810,000.00	$2,670,000.00	$2,670,000.00
Less: Interest on Debt	$(384,000.00)	$(1,104,000.00)	$(384,000.00)
Net Income	$426,000.00	$1,566,000.00	$2,286,000.00
Less:Tax @40%	$(170,400.00)	$(626,400.00)	$(914,400.00)
Earning after tax	$255,600.00	$939,600.00	$1,371,600.00
Number of shareholder	240000	240000	480000
EPS (Note 2)	$1.07	$3.92	$2.86
Operating Leverage (Note 3)	2.93	1.67	1.67

Note:

1. Variable cost p.u.= 10500000/450000= 23.33

Revised Variable Cost p.u. = 23.33*80% = 18.67

2. EPS = Earnings available to Equity shareholder/Number of outstanding equity shares

3. Operating Leverage = Contribution/EBIT

Operating Leverage indicates the degree of increase in operating income by increase in revenue. We can see that operating Leverage in case of New Equipment (1.67) is Lower in Comparison to the Old Production Process (2.93) It is important to monitor the operating leverage as high ratio indicate that small percentage change in sales can result in a dramatic increase (or decrease) in profits. Therefore, high operating leverage ratio is riskier as a small forecasting error may translate into much larger errors in both net income and cash flows.

Therefore, New Equipment option is Better

Also, Debt is effective tool of raising funds for investments as over exposure to equity financing leads to dilution in earnings (EPS). Use of debt provides a Financial Leverage to the business in the form that additional income is greater than the cost of Borrowings. Also, since the interest is tax deductible earnings are available in the hands of the equity holders increase. This is also reflected in above figures above as EPS (3.92) in case where Debt Financing is used is higher than Equity Financing (2.86).

Decision: Select Option 2: Replace the old Production Process with New Equipment as it has a lower operating leverage and Debt Financing should be used as it leads to higher EPS.

Step 3: It Has been given that there is high risk of sales falling to as low as 2,50,000

Calculation of EPS at Sales Volume of 250,000

	New Equipment
	Debt Financing	Equity Financing
Sales (2,50,000*$28.60)	$7,150,000.00	$7,150,000.00
Less: Variable cost	$(4,666,666.67)	$(4,666,666.67)
Contribution	$2,483,333.33	$2,483,333.33
Less: Fixed Production Cost	$(1,800,000.00)	$(1,800,000.00)
Earning Before Interest & tax(EBIT)	$683,333.33	$683,333.33
Less: Interest on Debt	$(1,104,000.00)	$(384,000.00)
Net Income	$(420,666.67)	$299,333.33
Less:Tax @40%	$-	$(119,733.33)
Earning After tax	$(420,666.67)	$179,600.00
Number of shareholder	240000	480000
EPS	$(1.75)	$0.37

Decision: Select Option 3 Replace old system by new equipment and use equity fancying. Financial Leverage can only be attained by using debt financing when rate of return on investments is greater than the cost of financing. In a situation where sales volume has declined, the revenue falls with no corresponding change in the fixed costs leading to low returns. Using Debt in such situation will further reduce the income or turn it into loss. Like in our case using of debt Financing when low sales volume has declined resulted in negative EPS. Therefore in such a situation we should opt for equity financing.