Question: The Norman Automatic Mailer Machine Company is planning to expand production because of the increased volume of mailouts. The increased mailout capacity will cost $2,000,000. The expansion can be financed either by bonds at an interest rate of 12 percent or by selling 40,000 shares of common stock at $50 per share. The current income statement (before expansion) is as follows:
Assume that after expansion, sales are expected to increase by $1,500,000. Variable costs will remain at 40 percent of sales, and fixed costs will increase by $550,000. The tax rate is 35 percent.
a. Calculate the degree of operating leverage, the degree of financial leverage, and the degree of combined leverage before expansion. (For the degree of operating leverage, use the formula developed in footnote 2 of this chapter; for the degree of combined leverage, use the formula developed in footnote 3. These instructions apply throughout this problem.)
b. Construct the income statement for the two financial plans.
c. Calculate the degree of operating leverage, the degree of financial leverage, and the degree of combined leverage, after expansion, for the two financing plans. d. Explain which financing plan you favor and the risks involved.