Question

BREAKEVEN AND LEVERAGE

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.
   1.  $
   2.  $
   3.  $
2. 
   
3. At what unit sales level would WCC have the same EPS assuming it undertakes the investment and finances it with debt or with stock? {Hint: V = variable cost per unit = $8,400,000/450,000, and EPS = [(PQ - VQ - F - I)(1 - T)]/N. Set EPS_Stock = EPS_Debt and solve for Q.} Do not round intermediate calculations. Round your answer to the nearest whole.
     units
4. 
   
5. At what unit sales level would EPS = 0 under the three production/financing setups - that is, under the old plan, the new plan with debt financing, and the new plan with stock financing? (Hint: Note that V_Old = $10,500,000/450,000, and use the hints for part b, setting the EPS equation equal to zero.) Do not round intermediate calculations. Round your answers to the nearest whole.
   Old plan    units
   New plan with debt financing    units
   New plan with stock financing    units
6. 
   
7. 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.
   EPS_Debt = $
   EPS_Stock = $

Answer 1

Answer:

a. WCC's EPS :

Particulars	Existing scheme	With new Debt	With new Stock
Sales in units	450000	450000	450000
Sale value per unit	$ 28.60	$ 28.60	$ 28.60
Sales Total = Sales in units x Sale value per unit =450000 x $ 28.60	$ 12870000	$ 12870000	$ 12870000
Less: Variable cost	$10,500,000	=$10,500,000 x (1-20%) = $8400000	$8400000
Less : fixed production (operating) costs	$1,560,000	$1,800,000	$1,800,000
Less: Interest on Debt	= $4,800,000 x 8% =$ 384000	=($4,800,000 x 8% )+ ($7,200,000 x 10% ) = $1104000	=$4,800,000 x 8% = $ 384000
Profit Before tax	$ 426000	$ 1566000	$ 2286000
Less : Tax @ 40%	$ 170400	$ 626400	$ 914400
Profit after tax	$ 255600	$ 939600	$ 1371600
Less : Dividend Pay @ 70%	$178920	$ 657720	$ 960120
Profit After Dividend	$ 76680	$ 281880	$ 411480
No. of shares outstanding	240000	240000	=240000+240000 =480000
EPS $	$ 0.32	$ 1.18	$ 0.86

b.

c. At what unit sales level would WCC have the same EPS assuming it undertakes the investment and finances it with debt or with stock:

For that we need to form an equation :

Let Sales in units be 'Q'

EPS with new Debt = EPS with new stock

( 28.60Q - ( 8400000 / 450000 ) X Q - $1,800,000 - $1104000 ) x ( 1-40% ) / 240000 = ( 28.60Q - ( 8400000 / 450000 ) X Q - $1,800,000 - $ 384000) x ( 1-40% ) / 480000

( 28.60 Q - 18.67 Q - 2904000) X 60% / 240000 = ( 28.60Q - 18.67 Q - 2184000 ) X 60% / 480000

( 5.96 Q - 1742400 ) /240000 = ( 5.96 Q - 1310400 ) / 480000

1430400 Q = 521856000000

Q = 364833

d.

e. At what unit sales level would EPS = 0

Let unit sales level be Q

1. Under Existing :

(28.60 Q - $ 10500000 / 450000 X Q - $1,560,000 - $ 384000 ) X 60% / 240000 = 0

3.16 Q = 1166400

Q = 369114

2. UNDER DEBT OPTION :

( 28.60Q - ( 8400000 / 450000 ) X Q - $1,800,000 - $1104000 ) x ( 1-40% ) / 240000 = 0

5.96 Q = 1742400

Q = 292349

3. UNDER STOCK OPTION :

( 28.60Q - ( 8400000 / 450000 ) X Q - $1,800,000 - $ 384000) x ( 1-40% ) / 480000 = 0

5.96 Q = 1310400

Q = 219866

f.

g.

On the basis of the analysis in parts a through c, and given that operating leverage is lower under the new setup,

the riskiest plan is existing plan

the highest expected EPS is under debt plan

Stock option is recommended as there is a fairly high probability of sales falling as low as 250,000 units

determine EPS_Debt and EPS_Stock at that sales level to help assess the riskiness of the two financing plans.:

EPS under debt option = ( 250000 x 28.60 - 18.67 x 250000 - $1,800,000 - $1104000 ) x 60% ) / 240000 = - $ 1.06

EPS under Stock option = ( 250000 x 28.60 - 18.67 x 250000 - $1,800,000 - $ 384000) x 60% ) / 480000 = $ 0.72