Blackwell Company Operating Leverage

Blackwell Company is planning to expand production because of the increased volume of sales. The CFO estimates that the increased capacity will cost $2,000,000. The expansion can be financed either by bonds at an interest rate of 12% or by selling 40,000 shares of common stock at $50 per share. The current income statement (before expansion) is as follows:

Blackwell Company
Income Statement
200X

Sales

$3,000,000

Less: Variable costs (40%)
$1,200,000

Fixed costs
800,000

Earnings before interest and taxes

1,000,000

Less: Interest expense

400,000

Earnings before taxes

600,000

Less: Taxes (@ 35%)

210,000

Earnings after taxes

390,000

Shares

100,000

Earnings per share

$3.90

Assume that after expansion, sales are expected to increase by $1,500,000. Variable costs will remain at 40% of sales, and fixed costs will increase by $550,000. The tax rate is 35%.

Based on the data provided, answer to the following questions:

a. Calculate the degree of operating leverage using the following formula:

DC=S-TVC/S-TVC-FC-I

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b. Calculate the degree of financial leverage using the following formula:

DCL = S-TVC/S-TVC-FC-I

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c. Calculate the degree of combined leverage before expansion using the following formula:

DCL = S-TVC/S-TVC-FC-I

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d. Construct the income statement for the two financial plans.

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e. Calculate the degree of operating leverage, the degree of financial leverage, and the degree of combined leverage, after expansion, for the two financing plans.
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f. Explain which financing plan you favor and the risks involved.