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5-24. Solution:
Edsel Research Labs
Income Statement
a. Return on assets = 5% EBIT = $1,350,000
Current Plan D Plan E
EBIT $1,350,000 $1,350,000 $1,350,000
1$13,500,000 debt @ 5% = $675,000
2$675,000 interest + ($6,750,000 new debt @ 11%) = $1,417,500
The current plan and Plan E provide the highest return of $0.35.
5-25. (Continued)
b. Return on assets = 8% EBIT = $2,160,000
Current Plan D Plan E
EBIT $2,160,000 $2,160,000 $2,160,000
The current plan and Plan D provides the highest return. The % EBIT
(12%) is higher than the interest rate (8% and 10%). Thus, the more debt the
firm takes on, the higher the EPS.
c. Return on assets = 5% EBIT = $1,350,000
Current Plan D Plan E
EBIT $1,350,000 $1,350,000 $1,350,000
25. Leverage and sensitivity analysis (LO6) The Lopez-Portillo Company has $10.6 million
in assets, 80 percent financed by debt, and 20 percent financed by common stock. The
interest rate on the debt is 9 percent and the par value of the stock is $10 per share.
President Lopez-Portillo is considering two financing plans for an expansion to $18 million
in assets.
Under Plan A, the debt-to-total-assets ratio will be maintained, but new debt will cost a
whopping 12 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 9 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 = 20%
Current Plan A Plan B
EBIT $954,000 $1,620,000 $1,620,000
Less: Interest 763,200(a) 1,473,600(c) 763,200(e)
(a) (80% $10,600,000) 9% = $8,480,000 9% = $763,200
(b) (20% $10,600,000)/$10 = $2,120,000/$10 = 212,000 shares
5-25. (Continued)
b.
EBIT
DFL EBIT I
=-
$954,000
DFL (Current) 5.00x
$954,000 $763, 200
$1,620,000
DFL (Plan A) 11.07x
$1, 620, 000 $1, 473, 600
$1,620,000
DFL (Plan B) 1.89x
$1, 620, 000 $763, 200
= =
-
= =
-
= =
-
c.
Plan A Plan B
EAT $87,840 $514,080
2212,000 shares (current) + $7,400,000/$20
d. Not only does the price of the common stock create wealth to the shareholder,
which is the major objective of the financial manager, but it greatly influences the
26. Operating leverage and ratios (LO6) Mr. Gold is in the widget business. He currently
sells 1.5 million widgets a year at $6 each. His variable cost to produce the widgets is $4
per unit, and he has $1,550,000 in fixed costs. His sales-to-assets ratio is six times, and 30
percent of his assets are financed with 10 percent debt, with the balance financed by
common stock at $10 par value per share. The tax rate is 35 percent.
His brother-in-law, Mr. Silverman, says he is doing it all wrong. By reducing his price to
$5.00 a widget, he could increase his volume of units sold by 60 percent. Fixed costs would
remain constant, and variable costs would remain $4 per unit. His sales-to-assets ratio
would be 7.5 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 ($1,500,000 units $6) $9,000,000
Fixed costs 1,550,000
Variable costs 6,000,000
Operating income (EBIT) $ 1,450,000
Sales $9,000,000
Assets $1,500,000
Asset turnover 6
= = =
1Debt = 30% of Assets = 30% × $1,500,000 = $450,000
5-26. (Continued)
b. Silverman Plan
Sales ($2,400,000 units at $5.00) $12,000,000
Fixed costs 1,550,000
Variable costs (2,400,000 units $4) 9,600,000
Interest 104,000
No! Gold should not shift to the Silverman Plan if Mrs. Gold’s assumption is
correct.
27. Expansion, break-even analysis, and leverage (LO2, 3, and 4) Delsing Canning
Company is considering an expansion of its facilities. Its current income statement is as
follows:
Sales.................................................................. $5,500,000
Less: Variable expense (50% of sales)........... 2,750,000
Fixed expense.............................................. 1,850,000
Earnings before interest and taxes (EBIT)........ 900,000
Interest (10% cost)............................................ 300,000
Earnings before taxes (EBT)............................. 600,000
Tax (40%).......................................................... 240,000
Earnings after taxes (EAT)................................ $ 360,000
Shares of common stock—250,000..................
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
$2.5 million in additional financing. His investment banker has laid out three plans for him
to consider:
1. Sell $2.5 million of debt at 13 percent.
2. Sell $2.5 million of common stock at $20 per share.
3. Sell $1.25 million of debt at 12 percent and $1.25 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 $2,350,000 per year. Delsing is not sure how much this expansion will add to sales, but
he estimates that sales will rise by $1.25 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).
b. The degree of operating leverage before and after expansion. Assume sales of $5.5
million before expansion and $6.5 million after expansion. Use the formula in
footnote 2 of the chapter.
c. The degree of financial leverage before expansion and for all three methods of
financing after expansion. Assume sales of $6.5 million for this question.
d. Compute EPS under all three methods of financing the expansion at $6.5 million in
sales (first year) and $10.5 million in sales (last year).
e. What can we learn from the answer to part d about the advisability of the three
methods of financing the expansion?
5-27. Solution:
Delsing Canning Company
a. At break-even before expansion:
PQ FC VC
where PQ equals sales volume at break-even point
= +
Sales Fixed costs Variable costs
(Variable costs 50% of sales)
Sales $1,850,000 .50 Sales
.50 Sales $1,850,000
Sales $3,700,000
= +
=
= +
=
=
At break-even after expansion:
Sales $2,350,000 .50 Sales
.50 Sales $2,350,000
Sales $4,700,000
= +
=
=
b. Degree of operating leverage, before expansion, at sales of $5,500,000
( )
( )
VC TVC
DOL = VC FC TVC FC
$5,500,000 $2,750,000
$5,500,000 $2,750,000 $1,850,000
$2,750,000 3.06x
$900,000
Q P S
Q P S
--
=
- - - -
-
=- -
= =
5-27. (Continued)
Degree of operating leverage after expansion at sales of $6,500,000
$6,500,000 $3, 250,000
DOL = $6,500, 000 $3, 250,000 $2,350,000
$3, 250, 000 3.61x
$900,000
-
- -
= =
This could also be computed for subsequent years.
c. DFL before expansion:
EBIT
DFL = EBIT 1
$900,000
$900,000 $300,000
$900,000 1.50x
$600,000
=-
= =
(100% Debt) (1)
(100% Equity)
(2)
(50% Debt and
50% Equity) (3)
Sales $6,500,000 $6,500,000 $6,500,000
– TVC (.50) 3,250,000 3,250,000 3,250,000
5-27. (Continued)
EBIT
DFL = EBIT I-
(1) (2) (3)
( ) ( ) ( )
$900,000 $900,000 $900,000
$900,000 $625,000 $900,000 $300,000 $900,000 $450,000- - -
DFL = 3.27x 1.50x 2.00x
d. EPS @ sales of $6,500,000
(refer back to part c to get the values for EBIT and Total I)
(100% Debt) (1)
(100% Equity)
(2)
(50% Debt and
50% Equity)
(3)
EBIT $900,000 $900,000 $900,000
Total I 625,000 300,000 450,000
EPS @ sales of $10,500,000
(100% Debt) (100% Equity) (2) (50% Debt and
(1) 50% Equity) (3)
Sales $10,500,000 $10,500,000 $10,500,000
– TVC 5,250,000 5,250,000 5,250,000
– FC 2,350,000 2,350,000 2,350,000
e. In the first year, when sales and profits are relatively low, plan 2 (100% equity)
