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Chapter 05: Operating and Financial Leverage
5-31
5-21. (Continued)
d. The debt financing plan provides a greater earnings per share
in comparison to the equity plan. Conversely, with increasing
sales, the debt plan becomes more attractive. Based on
probably be favored.
22. Leverage analysis with actual companies (LO6) Using Standard & Poor's data or annual
reports, compare the financial and operating leverage of Chevron, Eastman Kodak, and
Delta Airlines for the most current year. Explain the relationship between operating and
financial leverage for each company and the resultant combined leverage. What accounts
for the differences in leverage of these companies?
5-22. Solution:
23. Leverage and sensitivity analysis (LO6) Dickinson Company has $12 million in assets.
Currently half of these assets are financed with long-term debt at 10 percent and half with
common stock having a par value of $8. Ms. Smith, vice-president of finance, wishes to
analyze two refinancing plans, one with more debt (D) and one with more equity (E). The
company earns a return on assets before interest and taxes of 10 percent. The tax rate is 45
percent.
Under Plan D, a $3 million long-term bond would be sold at an interest rate of 12 percent
and 375,000 shares of stock would be purchased in the market at $8 per share and retired.
Under Plan E, 375,000 shares of stock would be sold at $8 per share and the $3,000,000 in
proceeds would be used to reduce long-term debt.
a. How would each of these plans affect earnings per share? Consider the current plan
and the two new plans.
b. Which plan would be most favorable if return on assets fell to 5 percent? Increased to
15 percent? Consider the current plan and the two new plans.
c. If the market price for common stock rose to $12 before the restructuring, which plan
would then be most attractive? Continue to assume that $3 million in debt will be
used to retire stock in Plan D and $3 million of new equity will be sold to retire debt
in Plan E. Also assume for calculations in part c that return on assets is 10 percent.
Chapter 05: Operating and Financial Leverage
5-32
5-23. Solution:
Dickinson Company
Income Statements
a. Return on assets = 10% EBIT = $ 1,200,000
Current
Plan D
Plan E
EBIT
$1,200,000
$1,200,000
$1,200,000
Less: Interest
600,0001
960,0002
300,0003
EBT
600,000
240,000
900,000
Less: Taxes (45%)
270,000
108,000
405,000
EAT
330,000
132,000
495,000
Common shares
750,0004
375,000
1,125,000
EPS
$ .44
$ .35
$ .44
(1) $6,000,000 debt @ 10%
financial risk to Dickinson.
Chapter 05: Operating and Financial Leverage
5-33
5-23. (Continued)
b. Return on assets = 5% EBIT = $600,000
Current
Plan D
Plan E
EBIT
$600,000
$ 600,000
$ 600,000
Less: Interest
600,000
960,000
300,000
EBT
0
(360,000)
300,000
Less: Taxes (45%)
---
(162,000)
135,000
EAT
0
$(198,000)
$ 165,000
Common shares
750,000
375,000
1,125,000
EPS
0
$ (.53)
$ .15
Current
Plan D
Plan E
EBIT
$1,800,000
$1,800,000
$1,800,000
Less: Interest
600,000
960,000
300,000
EBT
1,200,000
840,000
1,500,000
Less: Taxes (45%)
540,000
378,000
675,000
EAT
$ 660,000
$ 462,000
$ 825,000
Common shares
750,000
375,000
1,125,000
EPS
$ .88
$ 1.23
$ .73
than 2.0.
Chapter 05: Operating and Financial Leverage
5-34
Current
Plan D
Plan E
EBIT
$1,200,000
$1,200,000
$1,200,000
EAT
330,000
132,000
495,000
Common shares
750,000
500,0001
1,000,0002
EPS
$. 44
$ .26
$ .50
under Plan E.
24. Leverage and sensitivity analysis (LO6) Edsel Research Labs has $24 million in assets.
Currently half of these assets are financed with long-term debt at 8 percent and half with
common stock having a par value of $10. Ms. Edsel, the vice-president of finance, wishes
to analyze two refinancing plans, one with more debt (D) and one with more equity (E).
The company earns a return on assets before interest and taxes of 8 percent. The tax rate is
40 percent.
Under Plan D, a $6 million long-term bond would be sold at an interest rate of 10 percent
and 600,000 shares of stock would be purchased in the market at $10 per share and retired.
Under Plan E, 600,000 shares of stock would be sold at $10 per share and the $6,000,000
in proceeds would be used to reduce long-term debt.
a. How would each of these plans affect earnings per share? Consider the current plan
and the two new plans. Which plan(s) would produce the highest EPS?
b. Which plan would be most favorable if return on assets increased to 12 percent?
Compare the current plan and the two new plans. What has caused the plans to give
different EPS numbers?
c. Assuming return on assets is back to the original 8 percent, but the interest rate on
new debt in Plan D is 6 percent, which of the three plans will produce the highest
EPS? Why?
Chapter 05: Operating and Financial Leverage
5-35
5-24. Solution:
Edsel Research Labs
Income Statement
a. Return on assets = 8% EBIT = $1,920,000
Current
Plan D
Plan E
EBIT
$1,920,000
$1,920,000
$1,920,000
Less: Interest
960,0001
1,560,0002
480,0003
EBT
960,000
360,000
1,440,000
Less: Taxes (40%)
384,000
144,000
576,000
EAT
576,000
216,000
864,000
Common shares
1,200,0004
600,0005
1,800,0006
EPS
$.48
$.36
$.48
1 $12,000,000 debt @ 8%
2 $960,000 interest + ($6,000,000 new debt @ 10%)
3 ($12,000,000 − $6,000,000 debt retired) 8%
4 ($12,000,000 common equity / $10 par value) = 1,200,000
shares
5 ($6,000,000 common equity / $10 par value) = 600,000
shares
6 ($18,000,000 common equity / $10 par value) = 1,800,000
shares
Chapter 05: Operating and Financial Leverage
5-36
5-25. (Continued)
b. Return on assets = 12% EBIT = $2,880,000
Current
Plan D
Plan E
EBIT
$2,880,000
$2,880,000
$2,880,000
Less: Interest
960,000
1,560,000
480,000
EBT
1,920,000
1,320,000
2,400,000
Less: taxes (40%)
768,000
528,000
960,000
EAT
1,152,000
792,000
1,440,000
Common shares
1,200,000
600,000
1,800,000
EPS
$.96
$1.32
$.80
Pan D provides the highest return. The % EBIT (12%) is
higher than the interest rate (8% and 10%). The more
debt the better.
c. Return on assets = 8% EBIT = $1,920,000
Current
Plan D
Plan E
EBIT
$1,920,000
$1,920,000
$1,920,000
Less: Interest
960,000
1,320,0001
480,000
EBT
960,000
600,000
1,440,000
Less: taxes (40%)
384,000
240,000
576,000
EAT
576,000
360,000
864,000
Common shares
1,200,000
600,000
1,800,000
EPS
$.48
$.60
$.48
1 $960,000 + (6,000,000 6%)
Chapter 05: Operating and Financial Leverage
5-37
25. Leverage and sensitivity analysis The Lopez-Portillo Company has $10 million in assets,
80 percent financed by debt and 20 percent financed by common stock. The interest rate on
the debt is 15 percent and the par value of the stock is $10 per share. President Lopez-
Portillo is considering two financing plans for an expansion to $15 million in assets.
Under Plan A, the debt-to-total-assets ratio will be maintained, but new debt will cost a
whopping 18 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 15 percent on total assets, compute earnings per share (EPS) before the
expansion and under the two alternatives.
b. What is the degree of financial leverage under each of the three plans?
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.
d. Explain why corporate financial officers are concerned about their stock values.
5-25. Solution:
Lopez-Portillo Company
a. Return on Assets = 12%
Current
Plan A
Plan B
EBIT
$1,500,000
$2,250,000
$2,250,000
Less: Interest
1,200,000(a)
1,920,000(c)
1,200,000(e)
EBT
300,000
330,000
1,050,000
Less: Taxes (40%)
120,000
132,000
420,000
EAT
$ 180,000
$ 198,000
$ 630,000
Common shares
200,000(b)
300,000(d)
700,000(f)
EPS
$.90
$.66
$.90
(a) (80% $10,000,000) 15% = $8,000,000 15% =
$1,200,000
(b) (20% $10,000,000)/$10 = $2,000,000/$10 = 200,000 shares
Chapter 05: Operating and Financial Leverage
5-25. (Continued)
b.
EBIT
DFL EBIT I
=
−
$1,500,000
DFL (Current) 5.00x
$1,500,000 $1,200,000
$2,250,000
DFL (Plan A) 6.82x
$2,250,000 $1,920,000
$2,250,000
DFL (Plan B) 2.14x
$2,250,000 $1,200,000
==
−
==
−
==
−
c.
Plan A
Plan B
EAT
$198,000
$630,000
Common Shares
250,0001
450,0002
EPS
$. 79
$ 1.40
1 200,000 shares (current) + (20% $5,000,000)/$20
than that indicated in part (a).
d. Not only does the price of the common stock create wealth to
the shareholder, which is the major objective of the financial
Chapter 05: Operating and Financial Leverage
5-39
26. Operating leverage and ratios (LO6) Mr. Gold is in the widget business. He currently
sells 1 million widgets a year at $5 each. His variable cost to produce the widgets is $3 per
unit, and he has $1,500,000 in fixed costs. His sales-to-assets ratio is five times, and 40
percent of his assets are financed with 8 percent debt, with the balance financed by
common stock at $10 par value per share. The tax rate is 40 percent.
His brother-in-law, Mr. Silverman, says he is doing it all wrong. By reducing his price
to $4.50 a widget, he could increase his volume of units sold by 40 percent. Fixed costs
would remain constant, and variable costs would remain $3 per unit. His sales-to-assets
ratio would be 6.3 times. Furthermore, he could increase his debt-to-assets ratio to 50
percent, with the balance in common stock. It is assumed that the interest rate would go up
by 1 percent and the price of stock would remain constant.
a. Compute earnings per share under the Gold plan.
b. Compute earnings per share under the Silverman plan.
c. Mr. Gold's wife, the chief financial officer, does not think that fixed costs would
remain constant under the Silverman plan but that they would go up by 15 percent.
If this is the case, should Mr. Gold shift to the Silverman plan, based on earnings per
share?
5-26. Solution:
Gold-Silverman
a. Gold Plan
Sales ($1,000,000 units $5)
$5,000,000
−Fixed costs
−1,500,000
−Variable costs
−3,000,000
Operating income (EBIT)
$ 500,000
−Interest1
32,000
EBT
$ 468,000
−Taxes @ 40%
187,200
EAT
$ 280,800
Shares2
60,000
Earnings Per Share
$ 4.68
Sales $5,000,000
Assets $1,000,000
AssetTurnover 5
= = =
1 Debt = 40% of Assets = 40% × $1,000,000 = $400,000
Chapter 05: Operating and Financial Leverage
5-40
5-26. (Continued)
b. Silverman Plan
Sales ($1,400,000 units at $4.50)
$6,300,000
−Fixed costs
1,500,000
−Variable costs (1,400,000 units $3)
4,200,000
Operating income (EBIT)
$ 600,000
−Interest3
45,000
EBT
$ 555,000
−Taxes @ 40%
222,000
EAT
$ 333,000
Shares4
50,000
Earnings Per Share
$ 6.66
Sales $6,300,000
Assets $1,000,000
AssetTurnover 6.3
= = =
3 Debt = 50% of Assets = 50% × $1,000,000 = $500,000
Interest = 9% × $500,000 = $45,000
4 Stock = 50% of $1,000,000 = $500,000
Shares = $500,000/$10 = 50,000 shares
