Question:
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.