Question

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

Sales	$	6,800,000
Variable costs (50% of sales)		3,400,000
Fixed costs		1,980,000
Earnings before interest and taxes (EBIT)	$	1,420,000
Interest (10% cost)		560,000
Earnings before taxes (EBT)	$	860,000
Tax (30%)		258,000
Earnings after taxes (EAT)	$	602,000
Shares of common stock		380,000
Earnings per share	$	1.58

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 $3.8 million in additional financing. His investment banker has laid out three plans for him to consider:

1. Sell $3.8 million of debt at 14 percent.
2. Sell $3.8 million of common stock at $20 per share.
3. Sell $1.90 million of debt at 13 percent and $1.90 million of common stock at $25 per share.

  

Variable costs are expected to stay at 50 percent of sales, while fixed expenses will increase to $2,480,000 per year. Delsing is not sure how much this expansion will add to sales, but he estimates that sales will rise by $1 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.)
  

b. The degree of operating leverage before and after expansion. Assume sales of $6.8 million before expansion and $7.8 million after expansion. Use the formula: DOL = (S − TVC) / (S − TVC − FC). (Round your answers to 2 decimal places.)
  

c-1. The degree of financial leverage before expansion. (Round your answer to 2 decimal places.)
  

c-2. The degree of financial leverage for all three methods after expansion. Assume sales of $7.8 million for this question. (Round your answers to 2 decimal places.)
  

d. Compute EPS under all three methods of financing the expansion at $7.8 million in sales (first year) and $10.7 million in sales (last year). (Round your answers to 2 decimal places.)
  

Answer 1

Answer A :-
Breakeven Point =	Fixed Cost / Contribution %
Particulars	Before Expansion	Expansion Option 1	Expansion Option 2	Expansion option 3
Fixed Cost	1980000	2480000	2480000	2480000
Interest	560000	1092000	560000	826000
Total FC	2540000	3572000	3040000	3306000
Cont. %	50%	50%	50%	50%
BEP Sales	5080000	7144000	6080000	6612000
Answer B : -
Operating Leverage =	Contribution / Contribution - FC
Particulars	Before Expansion	Expansion Option 1	Expansion Option 2	Expansion option 3
Sales	6800000	7800000	7800000	7800000
Variable cost	3400000	3900000	3900000	3900000
Contribution	3400000	3900000	3900000	3900000
Fixed Cost	1980000	2480000	2480000	2480000
Cont. - Fixed cost (EBIT)	1420000	1420000	1420000	1420000
Opearing Leverage	1.39	1.75	1.75	1.75
Answer C-1 :-
Financial leverage	EBIT / EBT
Before Expansion
EBIT	1420000
EBT	860000
Financial Leverage	1.65
Answer C-2 :-
Financial Leverage (After Expansion0
Particulars	Expansion Option 1	Expansion Option 2	Expansion option 3
Sales	7800000	7800000	7800000
Variable cost	3900000	3900000	3900000
Contribution	3900000	3900000	3900000
Fixed Cost	2480000	2480000	2480000
Earning before Int & Tax	1420000	1420000	1420000
Interest	1092000	560000	826000
Earning before Tax	328000	860000	594000
Fiancial Leverage	4.33	1.65	2.39
Comments :- Higher the Interest cos, Higher the Financial leverage
Answer D :-
	Option 1 - First Year	Option 2 - First Year	Option 3 - First Year
Particulars	Expansion Option 1	Expansion Option 2	Expansion option 3
Sales	7800000	7800000	7800000
Variable cost	3900000	3900000	3900000
Contribution	3900000	3900000	3900000
Fixed Cost	2480000	2480000	2480000
Earning before Int & Tax	1420000	1420000	1420000
Interest	1092000	560000	826000
Earning before Tax	328000	860000	594000
Earning after Tax	229,600	602,000	415,800
Total Shares	380000	540000	475000
EPS	0.60	1.11	0.88
	Option 1 - First Year	Option 2 - First Year	Option 3 - First Year
Particulars	Expansion Option 1	Expansion Option 2	Expansion option 3
Sales	10700000	10700000	10700000
Variable cost	5350000	5350000	5350000
Contribution	5350000	5350000	5350000
Fixed Cost	2480000	2480000	2480000
Earning before Int & Tax	2870000	2870000	2870000
Interest	1092000	560000	826000
Earning before Tax	1778000	2310000	2044000
Earning after Tax	1244600	1617000	1430800
Total Shares	380000	540000	475000
EPS	3.28	2.99	3.01

Thanks & Regards,

Devendra Agarwal