Using the financial statements above, determine the following: a) Rosebush’s cur

ID: 2779713 • Letter: U

Question

Using the financial statements above, determine the following:

a) Rosebush’s current degree of operating leverage (DOL).

b) Rosebush’s current degree of financial leverage (DFL).

c) The impact of a 15%decrease in sales would have on EPS(in %).

Show your work.

d) Rosebush is considering expanding at a cost of $250,000. In order to finance the expansion, Rosebush has been presented with the following options

Rosebush Flowers Inc. Balance Sheet Liabilities Assets Cash A/R $69,921 Accounts Payable $52,818 Accrued Liabilities $31,333 $18,667 Inventory$137661 Long Term Debt (8% coupon,semiannual pmts $100,000 Net Property, Plant and Equipemer $139.600 $1000 par, 15 years to maturity) Preferred Shares (Par $50, dividend 7%) $50,000 Common Stock (44,000 shares outstanding) $100,000 -$100,000 Retained Earnings Total Assets $400,000 Total Liabilities & Owers Equity $400,000 Rosebush Flowers Inc. Income Statement Sales Cost of Goods Sold Gross Margin $739,100 $245,000 $494,100 Fixed Costs $320,000 $6,000 Depreciation Earnings before interest and taxes Interest Earnings before taxes Taxes (35%) Net Income $168,100 $8,000 $160,100 $56,035 $104,065 Dividends -Preferred $3,500

Explanation / Answer

Degree of operating leverage = Contribution Margin/EBIT = 494100/168100 =

2.94

[Gross margin is taken as Contribution margin)

Degree of Financial leverage with preference dividend = EBIT/[EBIT-Interest-((Preferred dividend/(1-t))] = 168100/(160100-8000-3500/0.65) =

1.15

Increase in EPS = Increase in sales*Degree of combined leverage

Degree of combined leverage=Degree of operating leverage*Degree of financial leverage.

Therefore, % increase in EPS for 15% increase in sales = 0.15*2.94*1.15=

50.72%

d) i)

EPS under Option 1:

= [(EBIT-8000-250000*9.5%)*(1-0.35)-3500]/44000

EPS under Option 2:

= [(EBIT-8000)*(1-0.35)-3500]/(44000+250000/10)

If the EPS is the same the above two equations should be eaual.

[(EBIT-31750)*0.65-3500]/44000 = [(EBIT-8000)*0.65-3500]/69000

Solving for EBIT

69*(0.65EBIT-20637.5-3500)=44*(0.65EBIT-5200-3500)

44.85EBIT-1665487.5=28.6EBIT-382800

16.25EBIT = 1282687.50

EBIT = $88,411.54 (Answer)

ii)

Option 1

Option 2

EBIT

$ 78,934.62

Interest [8000+250000*9.5% for Option 1 and 8000 for Option 2]

$ 31,750.00

$ 8,000.00

EBT

$ 47,184.62

$ 70,934.62

Tax at 35%

$ 16,514.62

$ 24,827.12

EAT

$ 30,670.00

$ 46,107.50

Preference dividend

$ 3,500.00

NI available for common shareholders

$ 27,170.00

$ 42,607.50

# of common shares outstanding

$ 44,000.00

$ 69,000.00

EPS

$ 0.62

Answer

iii)

If expected level of EBIT is more than the indifference level of EBIT of

$78934.62, then higher financial leverage would magnify EPS more.

Hence, the Option 1 of using more debt is preferable.

iv)

It should not be unconditionally selected. The impact of the higher risk due to higher debt content

on the price should be considered. Due to higher risk the P/E ratio may go down, which has to be considered.