Problem:
Mr. Katz is in the widget business. He currently sells 2 million widgets a year at $4 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 four times, and 40 percent of his assets are financed with 9 percent debt, with the balance financed by common stock at $10 per share. The tax rate is 30 percent.
His brother-in-law, Mr. Doberman, says Mr . Katz is doing it all wrong. By reducing his price to $3.75 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 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 andthe price of stock would remain constant.
1) Compute earnings per share under the Katz plan.
2) Compute earnings per share under the Doberman plan.
3) Mr. Katz's wife does not think that fixed costs would remain constant under the Doberman plan but that they would go up by 20 percent. If this is the case, should Mr. Katz shift to the Doberman plan, based on earnings per share?