Highland Cable Company Financing

Highland Cable Company is considering an expansion of its facilities. Its current income statement is as follows:

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% 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 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1.26

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 percent 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 increase 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 interested in a thorough analysis of his expansion plans and methods of financing. Please 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).