Question

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

Sales	$	7,500,000
Variable costs (50% of sales)		3,750,000
Fixed costs		2,050,000
Earnings before interest and taxes (EBIT)	$	1,700,000
Interest (10% cost)		700,000
Earnings before taxes (EBT)	$	1,000,000
Tax (35%)		350,000
Earnings after taxes (EAT)	$	650,000
Shares of common stock		450,000
Earnings per share	$	1.44

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 $4.5 million in additional financing. His investment banker has laid out three plans for him to consider:

1. Sell $4.5 million of debt at 9 percent.
2. Sell $4.5 million of common stock at $15 per share.
3. Sell $2.25 million of debt at 8 percent and $2.25 million of common stock at $20 per share.

  

Variable costs are expected to stay at 50 percent of sales, while fixed expenses will increase to $2,550,000 per year. Delsing is not sure how much this expansion will add to sales, but he estimates that sales will rise by $2.25 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 $7.5 million before expansion and $8.5 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 answers to 2 decimal places.)
  

c-2. The degree of financial leverage for all three methods after expansion. Assume sales of $8.5 million for this question. (Round your answers to 2 decimal places.)
  

d. Compute EPS under all three methods of financing the expansion at $8.5 million in sales (first year) and $10.3 million in sales (last year). (Round your answers to 2 decimal places.)
  

Break-Even Point Before expansion After expansion

Degree of Operating Leverage Before expansion After expansion

Degree of financial leverage

Degree of Financial Leverage 100% Debt 100% Equity 50% Debt & 50% Equity

Earnings per Share First Year Last Year 100% Debt 100% Equity 50% Debt & 50% Equity

Answer 1

Answer a :

At break-even before expansion:

PQ = FC + VC. Where PQ equals sales volume at break-even point

Fixed Costs = 20,50,000

Variable costs = 50% of sales

Sales = Fixed costs + Variable costs

Sales = 2,050,000 + .50 sales

.50 sales = 2,050,000

Sales = $ 4,100,000

At break-even after expansion:

Fixed Costs = 25,50,000

Variable Costs = 50% of sales

Sales = Fixed costs + Variable costs

Sales = 2,550,000 + .50 sales

.50 sales = 22,550,000

Sales = $ 5,100,000

Answer b:

Before expansion

S 75,00,000

TVC 37,50,000 37,50,000

FC 20,50,000 17,00,000

DOL = (S-TVC)/(S-TVC-FC)

Degree of Operating Leverage (7500000-3750000)/(7500000-3750000-2050000)

Degree of Operating Leverage 3750000/1700000

Degree of Operating Leverage 2.21

After expansion

S 85,00,000

TVC 42,50,000

FC 25,50,000 17,00,000

DOL = (S-TVC)/(S-TVC-FC)

Degree of Operating Leverage (8500000-4250000)/(8500000-4250000-2550000)

Degree of Operating Leverage 4250000/1700000

Degree of Operating Leverage 2.50

Answer The degree of financial leverage before expansion

c-1

EBIT 1700000

I 700000

DFL = EBIT / EBIT -1

DFL 1700000/1700000-700000

DFL 1.70

c-2

	(100%Debit)	(100%Equity)	(50%Debt and Equity)
Sales	8500000	8500000	8500000
-TVC	4250000	4250000	4250000
-FC	2550000	2550000	2550000
EBIT	1700000	1700000	1700000
I-Old Debt	700000	700000	700000
I-New Debt	405000	0	180000
Total Interest(I)	1105000	700000	880000
EBT	595000	1000000	820000
DFL = EBIT/EBIT-I	2.86	1.70	2.07

d-1

EPS under-expansion at $8.5 million in sales

	(100%Debt)	(100%Equity)	(50%Debt and Equity)
Sales	8500000	8500000	8500000
-TVC	4250000	4250000	4250000
-FC	2550000	2550000	2550000
EBIT	1700000	1700000	1700000
I-Old Debt	700000	700000	700000
I-New Debt	405000	0	180000
Total Interest(I)82	1105000	700000	880000
EBT	595000	1000000	820000
TAX @ 35%	208250	350000	287000
EAT	386750	650000	533000
Share of common stock	450000	750000	562500
EPS = EAT/Share of common stock	0.86	0.87	0.95

d-2

EPS under-expansion at $10.3 million in sales

	(100%Debt)	(100%Equity	50%Debt and Equity
Sales	10300000	10300000	10300000
-TVC	5150000	5150000	5150000
-FC	2550000	2550000	2550000
EBIT	2600000	2600000	2600000
I-Old Debt	700000	700000	700000
I-New Debt	405000	0	180000
Total Interest(I)	1105000	700000	880000
EBT	1495000	1900000	1720000
TAX @ 35%	523250	665000	602000
EAT	971750	1235000	1118000
Share of common stock	450000	750000	562500
EPS = EAT/Share of common stock	2.16	1.65	1.99