Task: Expansion, break-even analysis, and leverage
Highland Cable Company is considering an expansion of its facilities. Its current income statement is as follows:
Sales $4,000,000
Less: Variable expense (50% of sales) 2,000,000
Fixed expense 1.500.000
Earnings before interest and taxes (EBIT) 500,000
Interest (10% cost) 140.000
Earnings before taxes (EBT) 360,000
Tax (30%) 108.000
Earnings after taxes (EAT) $ 252,000
Shares of common stock 200,000
Earnings per share $1.26
Highland Cable Company is currently financed with 50 percent debt and 50 percent equity (common stock, par value of $10). To expand the facilities, Mr. Highland estimates a need for $2 million in additional financing. His investment banker has laid out three plans for him to consider:
1. Sell $2 million of debt at 13 percent.
2. Sell $2 million of common stock at $20 per share.
3. Sell $1 million of debt at 12 percent and $1 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 $1,900,000 per year. Mr. Highland is not sure how much this expansion will add to sales, but he estimates that sales will rise by $1 million per year for the next five years.
Mr. Highland is interested in a thorough analysis of his expansion plans and methods of financing. He would like you to analyze the following:
1. The break-even point for operating expenses before and after expansion (in sales dollars).
2. The degree of operating leverage before and after expansion. Assume sales of $4 million before expansion and $5 million after expansion. Use the formula in footnote
3. The degree of financial leverage before expansion at sales of $4 million and for all three methods of financing after expansion. Assume sales of $5 million for the second part of this question.
4. Compute EPS under all three methods of financing the expansion at $5 million in sales (first year) and $9 million in sales (last year).
5. What can we learn from the answer to part d about the advisability of the three methods of financing the expansion?