Purchase Solution

# Leverage and Break even

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1. Carlsbad Machine Company is considering an expansion of its facilities. Its current income statement is as follows:
Income Statement
Sales \$4,000,000
Less: Variable expense (50% of sales) 2,000,000
Fixed expense 1,500,000
Earnings before interest and taxes (EBIT) 500,000
Interest (10% interest rate) 140,000
Earnings before taxes (EBT) 360,000
Tax (30%) 108,000
Earnings after taxes (EAT) 252,000
Shares of common stock 200,000
Earnings per share \$1.26
2. Carlsbad Machine Company's capitalization currently is \$1,400,000 in long-term debt and \$4,000,000 in common equity (200,000 shares of common stock, with a book value of \$20 per share). To expand facilities, Mr. Carlsbad estimates a need for \$2 million in additional financing. His investment banker has laid out three plans for him to consider.
1. Sell \$2 million of additional debt at an interest rate of 13 percent.
2. Sell \$2 million of common stock at \$20 per share.
3. Sell \$1 million of additional debt at an interest rate of 12 percent and \$1 million of common stock at \$25 per share. (It is not unusual for stock to sell at a price higher than book value.)
Variable costs are expected to stay at 50 percent of sales, while fixed operating expenses will increase to \$1,900,000 per year. Mr. Carlsbad is not sure how much this expansion will add to sales, but he believes sales will rise by \$1 million per year for the next five years.
Mr. Carlsbad is interested in a thorough analysis of his expansion plans and methods of financing. He would like you to analyze the following:
4. The operating break-even point for operating expenses before and after expansion (in sales dollars). (Note that the break-even point for an actual company cannot be calculated using the dollar contribution per physical unit of output because not all products sell for the same price. Study carefully the section entitled "A More General Approach to Calculating Break-Even" in the Discussion Material for this lesson for guidance on this.)
5. The degree of operating leverage before and after expansion. Assume sales of \$4 million before expansion and \$5 million after expansion. Use the formula in footnote 2 on page 126 of the text.
6. The degree of financial leverage before expansion at sales of \$4 million and for all three methods of financing after expansion (assume sales of \$5 million for all three methods of financing after expansion).
7. Compute EPS under all three methods of financing in the expansion at \$5 million in sales (first year) and \$9 million in sales (last year).
8. What can we learn from the answer to part d about the advisability of the three methods of financing the expansion? Which method provides the greatest opportunity for future earnings per share? Which method presents the greatest risk of disappointment should sales not increase?
The \$140,000 interest on the existing debt will continue whichever financing method is chosen. If additional debt is added to the financial structure of the company, any new interest associated with the new debt raised to help finance this major expansion project will be in addition to the existing \$140,000 interest expense. If the new financing consists entirely of equity, interest expense will remain \$140,000 per year.

##### Solution Summary

The solution explains the impact on leverage and breakeven of different financing plans

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