DeSoto Tools Inc. is planning to expand production. The expansion will cost $300

Question

DeSoto Tools Inc. is planning to expand production. The expansion will cost $300,000, which can be financed either by bonds at an interest rate of 14 percent or by selling 10,000 shares of common stock at $30 per share. The current income statement before expansion is as follows SOTO TOOLS I Income Statement Sales Variable costs Fixed costs $ 1,500,000 450,000 550,000 Eanings before interest and taxes Interest expense $ 500,000 100,000 Earnings before taxes Taxes @ 34% $ 400,000 136,000 Earmings after taxes $ 264,000 Shares Earnings per share 100,000 $ 2.64 After the expansion, sales are expected to increase by $1,000,000. Variable costs will remain at 30 percent of sales, and fixed costs will increase to $800,000. The tax rate is 34 percent.

Explanation / Answer

Ans

Ans 1 Degree of operating leverage Sales-Total VC/Sales-Total VC-Total Fixed Cost Contribution/EBIT 2.1 Degree of Financing Levergage EBIT/EBIT-Interest 1.25 Combined Leverage Sales-Total VC/Sales-Total VC-Total Fixed Cost-Interest Contribution/EBIT-Interest 2.625 Ans 2 Debt Equity Sales                                              25,00,000.00                               25,00,000.00 Less Variable Cost                                                 7,50,000.00                                  7,50,000.00 Less Fixed cost                                                 8,00,000.00                                  8,00,000.00 Earning Before interest and taxes                                                 9,50,000.00                                  9,50,000.00 Interest Expense 142000 100000 Earning Before Tax                                                 8,08,000.00                                  8,50,000.00 Taxes                                                 2,74,720.00                                  2,89,000.00 Earning After Tax                                                 5,33,280.00                                  5,61,000.00 Shares 100000 110000 EPS                                                               5.33                                                5.10 Ans 3 Degree of operating leverage Sales-Total VC/Sales-Total VC-Total Fixed Cost Sales-Total VC/Sales-Total VC-Total Fixed Cost Contribution/EBIT Contribution/EBIT                                                               1.84                                                1.84 Degree of Financing Levergage EBIT/EBIT-Interest                                                               1.18                                                1.12 Combined Leverage Sales-Total VC/Sales-Total VC-Total Fixed Cost-Interest Sales-Total VC/Sales-Total VC-Total Fixed Cost-Interest Contribution/EBIT-Interest Contribution/EBIT-Interest                                                               2.17                                                2.06

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