Problem:
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% debt and 50% equity (common stock, par value of $10). To expand the facilities Mr. Highland estimates a need for $2 million in additional financing. His investment broker has laid out three plans for him to consider:
1. Sell $3 million of debt at 13%
2. Sell $2 million of commons 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% 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.
Q1. The degree of operating 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.
Q2. Compute EPS under all three methods of financing the expansion at $5 million in sales (first year) and $9 million in sales (last year).