DFL and graphical display of financing plans Wells and Associates has EBIT of $7
ID: 2739238 • Letter: D
Question
DFL and graphical display of financing plans Wells and Associates has EBIT of $75000. Interest costs are $27,500, and the firm has 15,000 shares of common stock outstanding. Assume a 40% tax rate.
a. Use the degree of financial leverage (DFL) formula to calculate the DFL for the firm.
b. Using a set of EBIT–EPS axes, plot Wells and Associates’ financing plan.
c. If the firm also has 1,400 shares of preferred stock paying a $6.00 annual dividend per share, what is the DFL?
d. Plot the financing plan, including the 1,400 shares of $6.00 preferred stock, on the axes used in part b.
e. Briefly discuss the graph of the two financing plans.
Explanation / Answer
a.
DFL = EBIT / (EBIT – Interest)
= $75,000 / ($75,000 - $27,500)
= $75,000 / $47,500
= 1.58
b.
Earnings per share of W and Associates are $1.90 (i.e., $47,500 * 1-0.40) / 15,000) each.
c.
There would be no change in the DFL, because preferred dividend will not affect the EBIT but EPS. The DFL result would be same as follows.
DFL = EBIT / (EBIT – Interest)
= $75,000 / ($75,000 - $27,500)
= $75,000 / $47,500
= 1.58
d.
Earnings per share of W and Associates are $1.34 (i.e., ($47,500 * 1-0.40) – (1400*$6)) / 15,000) each.
e.
On introducing the preferred stock issue, EPS has been dropped to $1.34 from $1.90. EPS is The Earnings Per Share after preferred dividend.
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