Question: Delsing Canning Company is considering an expansion of its facilities. Its current income statement is as follows:
The company is currently financed with 50 percent debt and 50 percent equity (common stock, par value of $10). In order to expand the facilities, Mr. Delsing 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 $2,300,000 per year. Delsing 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. Delsing 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 $5 million before expansion and $6 million after expansion. Use the formula in footnote 2 on page 129 of the chapter.
c. The degree of financial leverage before expansion and for all three methods of financing after expansion. Assume sales of $6 million for this question.
d. Compute EPS under all three methods of financing the expansion at $6 million in sales (first year) and $10 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?