Wingler Communications Corporation (WCC) produces premium stereo headphones that
ID: 2672354 • Letter: W
Question
Wingler Communications Corporation (WCC) produces premium stereo headphones that sell for $28.80 per set, and this year’s sales are expected to be 450,000 units. Variable production costs for the expected sales under present production methods are estimated at $10,200,000, and fixed production (operating) costs at present are $1,560,000. WCC has $4,800,000 of debt outstanding at an interest rate of 8%. There are 240,000 shares of common stock outstanding, and there is no preferred stock. The dividend payout ratio is 70%, and WCC is in the 40% federal-plus-state tax bracket. The company is considering investing $7,200,000 in new equipment. Sales would not increase, but variable costs per unit would decline by 20%. Also, fixed operating costs would increase from $1,560,000 to $1,800,000. WCC could raise the required capital by borrowing $7,200,000 at 10% or by selling 240,000 additional shares at $30 per share.b. At what unit sales level would WCC have the same EPS assuming it undertakes the investment and finances it with debt and with stock?
c. At what unit sales level would EPS = 0 under the three production/financing setups—that is, under the old plan, the new plan with debt financing, and the new plan with stock financing?
d. On the basis of the analysis in Parts a through c and given that operating leverage is lower under the new setup, which plan is the riskiest, which has the highest expected EPS, and which would you recommend? Assume that there is a fairly high probability of sales falling as low as 250,000 units and determine EPSDebt and EPSStock at that sales level to help assess the riskiness of the two financing plans
Explanation / Answer
Estimated sales units 450,000 Selling price per unit 28.80 Variable production cost = 10,200,000/450,000 22.67 Contribution 6.13 Total contribution 2,760,000 Less: fixed cost 1,560,000 Income 1,200,000 Less: interest (4,800,000*8%) 384,000 Profit before tax 816,000 Tax @ 40% 326,400 Net income 489,600 Shares outstanding 240,000 EPS 2.04 Suppose it finances 50% with debt and 50% with stock So interest expense on debt = 3600,000 *10% If they issue additional stock = 3600,000/30 120,000 So net income required for EPS of 2.04 = 2.04* (240,000+120,000) 734400 Net income before tax = 734,400/60*100 1224000 Add: Interest expense (4,800,000*8%) + 3600,000 *10% 744,000 Fixed cost 1,560,000 Required contribtuion (a) 3,528,000 Sale price per unit 28.80 Less: variable cost per unit 18.14 Contribution per unit (b) 10.66 Required sales unit (a/b) 330,832.71 c) The level when EPS = 0, means that profit before tax will be zero. It means that the contribution earned will be equal to sum of fixed cost and interest expense. Existing plan Debt financing Stock financing Interest 384,000 384,000 384,000 Add: interest on 10% debt 720,000 Total interest expense 384,000 1,104,000 384,000 Add: fixed cost (a) 1,560,000 1,560,000 1,560,000 Sale price per unit 28.80 28.80 28.80 Less: variable cost per unit 22.67 18.14 18.14 Contribution per unit (b) 6.13 10.66 10.66 Required sales unit (a/b) 254,486 146,287 146,287
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