Expansion and leverage - DeSoto Tools, Inc.
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DeSoto Tools, Inc. is planning to expand production. The expansion will cost $300,000, which can be financed either by bonds at an interest rate of 14 percent or by selling 10,000 shares of common stock at $30 per share. The current income statement before expansion is as follows.
Sales....................................................................................................... $1,500,000
Less: Variable costs...$450,000
Fixed costs...............550,000 (550,000 + 450,000= 1,000,000)
Earnings before interest and taxes................................................................500,000
Less: interest expense...............................................................................100,000
Earnings before taxes....................................................................................400,000
Less: Taxes @34%....................................................................................136,000
Earnings after taxes.......................................................................................264,000
Shares....................................................................................100,000
Earnings per share.....................................................................$2.64
After the expansion, sales are expected to increase by $1,000,000. Variable costs will remain at 30% of sales, and fixed costs will increase to $800,000. The tax rate is 34%. Calculate the degree of operating leverage, the degree of financial leverage, and the degree of combined leverage before expansion. Construct the income statement for the two alternative financing plans. Calculate the degree of operating leverage, the degree of financial leverage, and the degree of combined leverage, after expansion. Explain which financing plan is more favorable and why. Explain the risk involved with each plan.
Formula for DOL:
DOL = S-TVC divided by S-TVC-FC
Formula for DCL:
DCL = S-TVC divided by S-TVC-FC- i (not the number 1) It is the letter i.
Explain and show all work.
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Solution Summary
Response discusses Expansion and leverage - DeSoto Tools, Inc.
Solution Preview
Equity Plan Debt Plan
Operating leverage is calculated by Contribution/EBIT 1.84 1.84
Operating leverage change as the quantity sold increase because of decrease in fixed costs per unit.
This means that fixed cost per unit reduced and thereby ...
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