Expansion, break-even analysis, and leverage
Problem: 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
|
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% 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 incr3ease 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 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:
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 $4 million before expansion and $5 million after expansion.
c. 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.
d. Compute EPS under all three methods of financing the expansion at $5 million in sales (first year) and $9 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?