Delsing Canning Company is considering an expansion of its facilities. Its curre

Question

Delsing Canning Company is considering an expansion of its facilities. Its current income statement is as follows:

The company is currently financed with 50 percent debt and 50 percent equity (common stock, par value of $10). In order to expand the facilities, Mr. Delsing estimates a need for $2.6 million in additional financing. His investment banker has laid out three plans for him to consider:

Sell $2.6 million of debt at 14 percent.

Sell $2.6 million of common stock at $20 per share.

Sell $1.30 million of debt at 13 percent and $1.30 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 $2,360,000 per year. Delsing is not sure how much this expansion will add to sales, but he estimates that sales will rise by $1.30 million per year for the next five years.
Delsing is interested in a thorough analysis of his expansion plans and methods of financing.He would like you to analyze the following:

a. The break-even point for operating expenses before and after expansion (in sales dollars). (Enter your answers in dollars not in millions, i.e, $1,234,567.)
Before ______________

After _______________  

b. The degree of operating leverage before and after expansion. Assume sales of $5.6 million before expansion and $6.6 million after expansion. Use the formula: DOL = (S TVC) / (S TVC FC). (Round your answers to 2 decimal places.)
Before _____________
After _____________

c-1. The degree of financial leverage before expansion. (Round your answers to 2 decimal places.)
Degree of financial leverage _______________

c-2. The degree of financial leverage for all three methods after expansion. Assume sales of $6.6 million for this question. (Round your answers to 2 decimal places.)
100% debt ________
100% equity _________
50% debt & 50% equity _________

d. Compute EPS under all three methods of financing the expansion at $6.6 million in sales (first year) and $10.6 million in sales (last year). (Round your answers to 2 decimal places.)
100% debt ________
100% equity _________
50% debt & 50% equity _________

Sales $ 5,600,000 Variable costs (50% of sales) 2,800,000 Fixed costs 1,860,000 Earnings before interest and taxes (EBIT) $ 940,000 Interest (10% cost) 320,000 Earnings before taxes (EBT) $ 620,000 Tax (30%) 186,000 Earnings after taxes (EAT) $ 434,000 Shares of common stock 260,000 Earnings per share $ 1.67

Explanation / Answer

a. Break-even point for operating expenses: Fixed Costs / Contribution Margin Ratio

Before: $ 1,860,000 / 50% = $ 3,720,000

After : $ 2,360,000 / 50 % = $ 4,720,000

b. Degree of Operating Leverage :

Before : 2.98

After : 3.51

c-1. Degree of Financial Leverage : EBIT / EBT

Before Expansion = 940,000 / 620,000 = 1.52

c-2. Degree of Financial Leverage After Expansion :

100 % Debt : 3.67

100 % Equity:1.52

50% Debt & 50% Equity : 2.08

d.

100% Debt 100 % Equity 50% Debt + 50 % Equity Sales $ 6,600,000 $ 6,600,000 $ 6,600,000 Variable Costs 3,300,000 3,300,000 3,300,000 Contribution Margin 3,300,000 3,300,000 3,300,000 Fixed Costs 2,360,000 2,360,000 2,360,000 EBIT 940,000 940,000 940,000 Interest 684,000 320,000 489,000 EBT 256,000 620,000 451,000 Degree of Financial Leverage 3.67 1.52 2.08

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