Phelps Canning Company is considering an expansion of its facilities. Its curren

Question

Phelps Canning Company is considering an expansion of its facilities. Its current income statement is as follows: $5,000,000 2,500,000 1800,000 700,000 200,000 500,000O 170,000 $ 330,000 200,000 $1.65 Less: Variable expense (50% of sales) . . . . . . . . . . Earnings before interest and taxes (EBIT). Interest ( 10% cost) Earnings before taxes (EBT) Tax (34%) . EPS Phelps Canning Company is currently financed with 60 percent debt and 40 percent equity (common stock). To expand facilities, Mr. Phelps estimates a need for $2 million in additional financing. His investment dealer has laid out three plans for him to consider. 1. Sell $2 million of debt at 13 percent. 2. Sell $2 million of common stock at $20 per share 3. Sell $1 million of debt at 12 percent and $1 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 $2,300,000 per year. Mr. Phelps is not sure how much this expansion will add to sales, but he estimates that sales will rise by $1 million per year for the next five years.. Mr. Phelps is interested in a thorough analysis of his expansion plans and methods of financing. He would like you to analyze the following.

Explanation / Answer

a. Break-even point : Total Fixed Cost / Contribution Margin Ratio

Before Expansion : $ 1,800,000 / 50% = $ 3,600,000.

After Expansion : $ 2,300,000 / 50% = $ 4,600,000.

b. DOL : Contribution Margin / EBIT

Before Expansion : ( $ 5,000,000 x 50%) / $ 700,000 = 3.57 times.

After Expansion : ( $ 6,000,000 x 50%) / $ 700,000 = 4.29 times

c. DFL : EBIT / ( EBIT - Interest)

Before Expansion : $ 700,000 / $ 500,000 = 1.4 times.

After Expansion :

d. EPS at Sales Level of $ 6,000,000.

e. Best Financing Option : 100 % Equity.

This is because of the following two reasons:

i. This option alligns is compatible with Mr. Phelp's objective of maximizing shareholder wealth,

ii. It involves the least financial risk ( DFL: 1.40 times)of being unable of service the fixed interest expense arising out of additional debt.

100 % Debt 100 % Equity 50% Debt + 50% Equity Sales $ 6,000,000 $ 6,000,000 $ 6,000,000 TVC 3,000,000 3,000,000 3,000,000 TFC 2,300,000 2,300,000 2,300,000 EBIT $ 700,000 $ 700,000 $ 700,000 Interest Expense: Old Debt 200,000 200,000 200,000 Interest Expense: New Debt 260,000 ( $ 2,000,000 x 13%) 0 120,000 ( $ 1,000,000 x 12%) Total Interest $ 460,000 $ 200,000 $ 320,000 EBT ( EBIT - I) 240,000 500,000 380,000 DFL 2.92 times 1.40 times 1.84 times

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