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Financial Leverage Problems

1. Romeo & Juliette are competitors in selling college finance textbooks. The separate capital structures of each company are as follows:
Romeo Juliette
Debt @ 10% (interest) $500,000 Debt @ 10% (interest) $1,000,000
Common Stock 1,000,000 Common Stock 500,000
Total Capital $1,500,000 Total Capital $1,500,000
Shares Outstanding 100,000 Shares Outstanding 50,000

a. Compute EPS, Return on Assets (assume assets = capital), and Return on Equity if earnings before interest and taxes are $100,000; $150,000; and $500,000 respectively (you'll need ratios for each of the 3 alternatives) with a 30% income tax rate.
b. If the cost of the debt went up to 12% and all factors remained equal, what would be EPS, ROA and ROE?

2. Ricko makes its current product using a very labor intensive process. The product sells for $50, variable costs are $30 and fixed costs $10,000 per month. Current volume is 6,000 units.
An option is available that would boost fixed costs to $20,000 per month, but drop variable costs to $20.
a. Calculate break even under the current plan vs the alternative.
b. Calculate number of units to be sold to be indifferent under the 2 plans. Hint: use an algebraic formula for each net profit (current profit = 50x sales - 30x variable costs - 10000 fixed where x is number of units sold. Come up with a similar equation for the alternative plan) then set the 2 equations equal to one another, meaning at that level of sales, net income would be the same under each alternative. Solve for x.
c. Calculate the number of units to be sold to make a return of 5% of sales dollars under the new alternative. Hint: use the equation profit = sales - variable costs - fixed costs. Profit desired is 5% of sales or .05*$50 each*x units.
d. If the company expects steady increases in volume over the next several years (for example annual increases of 1,000 per year - compounded - for the next 5 years) would you suggest the company undertake the alternative?

3. ABC Co is planning to expand. The expansion will cost $2,000,000. It can be financed with bonds at 12% or with 40,000 shares of common stock, sold at $50 per share.

Current Data:
sales are $3,000,000; variable costs 40% of sales; fixed costs $750,000; interest expense $450,000; income taxes 30% of taxable income; and 100,000 shares outstanding.

Expansion will:
Increase sales by $1,500,000. Variable costs will remain at 40% of sales, and fixed costs will INCREASE by $500,000.

Required :
Compute EPS current, and under the 2 alternatives for expansion. What do you suggest?

Solution Summary

The solution computes the return on assets for the Romeo and Juliette case.

$2.19