I would like help with Chapter 5, Problem 21 about expansion, break-even analysis, and leverage. The book is Foundations of Financial Management, 11e by Stanley B. Block, Geoffrey A. Hirt Copyrigt 2005 The McGraw-HillCompanies
Expansion, break-even analysis, and leverage
Highland Cable Company is considering an expansion of its facilities. Its current income statement is as follows:
Less: Variable expense (50% of sales) 2,000,000
Fixed expense 1,500,000
Earnings before interest and taxes (EBIT) 500,000
Interest(10% cost) 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
Highland Cable Company is currently financed with 50 percent debt and 50 percent equity (common stock, par value of $10). To expand the facilities, Mr. Highland 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 debt at 13 percent.
2. Sell $2 million of common stock at $20 per share.
3. Sell $1 million of debt at 12% and $1 million of common stock at $25 per share.
Variable costs are expected to stay at 50 percent of sales, while fixed expenses will incr3ease to $1,900,000 per year. Mr. Highland is not sure how much this expansion will add to sales, but he estimates that sales will rise by $1 million per year for the next five years.
Mr. Highland is not sure how much this expansion will add to sales, but he estimates that sales will rise by $1 million per year for the next five years.
Mr. Highland 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)
b. 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.
c. 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 the second part of this question.
d. Compute EPS under all three methods of financing the expansion at $5 million in sales (first year) and $9 million in sales (last year).
e. What can we learn from the answer to part d about the advisability of the three methods of financing the expansion?
The solution explains the calculations required to determine the financing plan to choose for Highland Cable.