Delsing Canning Company is considering an expansion of its facilities. Its curre
ID: 2621197 • Letter: D
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 $2.5 million in additional financing. His investment banker has laid out three plans for him to consider:
Sell $2.5 million of debt at 13 percent.
Sell $2.5 million of common stock at $20 per share.
Sell $1.25 million of debt at 12 percent and $1.25 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 $2,350,000 per year. Delsing is not sure how much this expansion will add to sales, but he estimates that sales will rise by $1.25 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). (Enter your answers in dollars not in millions, i.e, $1,234,567.)
Before expansion:
After expansion:
b. The degree of operating leverage before and after expansion. Assume sales of $5.5 million before expansion and $6.5 million after expansion. Use the formula: DOL = (S ? TVC) / (S ? TVC ? FC). (Round your answers to 2 decimal places.)
Before expansion:
After expansion:
c-1. The degree of financial leverage before expansion. (Round your answers to 2 decimal places.)
Degree of financial leverage:
c-2. The degree of financial leverage for all three methods after expansion. Assume sales of $6.5 million for this question. (Round your answers to 2 decimal places.)
100% Debt:
100% Equity:
50% Debt & 50% Equity:
d. Compute EPS under all three methods of financing the expansion at $6.5 million in sales (first year) and $10.5 million in sales (last year). (Round your answers to 2 decimal places.)
100% Debt:
100% Equity:
50% Debt& 50% Equity:
Sales $ 5,500,000 Variable costs (50% of sales) 2,750,000 Fixed costs 1,850,000 Earnings before interest and taxes (EBIT) $ 900,000 Interest (10% cost) 300,000 Earnings before taxes (EBT) $ 600,000 Tax (40%) 240,000 Earnings after taxes (EAT) $ 360,000 Shares of common stock 250,000 Earnings per share $ 1.44Explanation / Answer
(a) Before expansion
Sales = $5,500,000
Variable expenses = $2,750,000
Contribution margin = Sales - Variable expense
= 5,500,000 - 2,750,000
= $2,750,000
Contribution margin ratio = Contribution/Sales
= 2,750,000/5,500,000
= 50%
Break even point = Fixed costs/Contribution margin ratio
= 1,850,000/50%
= $3,700,000
After expansion
Sales = $5,500,000 + 1,250,000
= $6,750,000
Variable expenses = $6,750,000 x 50%
= $3,375,000
Contribution margin = Sales - Variable expense
= 6,750,000 - 3,375,000
= $3,375,000
Contribution margin ratio = Contribution/Sales
= 3,375,000/6,750,000
= 50%
Fixed cost after expansion will rise to $2,350,000
Break even point = Fixed costs/Contribution margin ratio
= 2,350,000/50%
= $4,700,000
(b) Before expansion
Degree of operating leverage = Contribution margin/EBIT
= 2,750,000/900,000
= 3.05
After expansion
EBIT = Contribution - Fixed cost
= 3,375,000 - 2,350,000
= $1,025,000
Degree of operating leverage = Contribution margin/EBIT
= 3,375,000/1,025,000
= 3.29
(c -1) Degree of Financial leverage = EBIT/EBT
= 900,000/600,000
= 1.50
(c-2) After expansion
(d) Calculation of EPS in first year
Calculation of EPS in the last year
100% debt 100% equity 50% debt, 50% equity Contribution 3,375,000 3,375,000 3,375,000 Less: Fixed cost - 2,350,000 - 2,350,000 - 2,350,000 EBIT 1,025,000 1,025,000 1,025,000 Interest - 625,000 - 300,000 - 450,000 EBT 400,000 725,000 575,000 Financial leverage 2.56 1.41 1.78Related Questions
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