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# EBIT-EPS calculations

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Complete problems 10, 12, & 15 on text pp. 414-415 of Ch. 13....6 and 8 on p. 439 of Ch. 14 and problems 4, 5, & 6 on text pp. 441-442 of Ch. 14.

10. McFrugal, Inc. has expected sales of \$20 million. Fixed operating costs are \$2.5
million, and the variable cost ratio is 65 percent. McFrugal has outstanding a
\$12 million, 8 percent bank loan. The firm also has outstanding 1 million
shares of common stock (\$1 par value). McFrugal's tax rate is 40 percent.
a. What is McFrugal's degree of operating leverage at a sales level of \$20 million?
b. What is McFrugal's current degree of financial leverage?
c. Forecast McFrugal's EPS if sales drop to \$15 million.

12. East Publishing Company is doing an analysis of a proposed new finance textbook.
Using the following data, answer (a) through (d).
Fixed Costs per Edition:
Development (reviews, class testing, and so on) \$18,000
Copyediting 5,000
Selling and promotion 7,000
Typesetting 40,000
Total \$70,000
Variable Costs per Copy:
Printing and binding \$4.20
Salespeople's commission (2% of selling price) 0.60
Author's royalties (12% of selling price) 3.60
Bookstore discounts (20% of selling price) 6.00
Total \$16.00
Projected Selling Price \$30.00
The company's marginal tax rate is 40 percent.
a. Determine the company's breakeven volume for this book:
i. In units.
ii. In dollar sales.
b. Develop a breakeven chart for the textbook.
c. Determine the number of copies East must sell in order to earn an
(operating) profit of \$21,000 on this book.
d. Suppose East feels that \$30.00 is too high a price to charge for the new
finance textbook. It has examined the competitive market and determined
that \$24.00 would be a better selling price. What would the breakeven
volume be at this new selling price?

15. Rodney Rogers, a recent business school graduate, plans to open a wholesale
dairy products firm. The business will be completely financed with equity.
Rogers expects first year sales to total \$5,500,000. He desires to earn a target
pretax profit of \$1,000,000 during his first year of operation. Variable costs are
40 percent of sales.
a. How large can Rogers' fixed operating costs be if he is to meet his profit
target?
b. What is Rogers' breakeven level of sales at the level of fixed operating costs
determined in (a)?

6. What is the underlying objective of EBIT-EPS analysis?
8. In practice what are the factors managers consider in setting a firm's target
capital structure?

4. Emco Products has a present capital structure consisting only of common
stock (10 million shares). The company is planning a major expansion. At this
time, the company is undecided between the following two financing plans
(assume a 40 percent marginal tax rate):
Plan 1 (Equity financing). Under this plan, an additional 5 million shares of
common stock will be sold at \$10 each.
Plan 2 (Debt financing). Under this plan, \$50 million of 10 percent longterm
debt will be sold.
One piece of information the company desires for its decision analysis is an
EBIT-EPS analysis.
a. Calculate the EBIT-EPS indifference point.
b. Graphically determine the EBIT-EPS indifference point.
Hint: Use EBIT 5 \$10 million and \$25 million.
c. What happens to the indifference point if the interest rate on debt
increases and the common stock sales price remains constant?
d. What happens to the indifference point if the interest rate on debt
remains constant and the common stock sales price increases?

5. Morton Industries is considering opening a new subsidiary in Boston, to be
operated as a separate company. The company's financial analysts expect the
new facility's average EBIT level to be \$6 million per year. At this time, the
company is considering the following two financing plans (use a 40 percent
marginal tax rate in your analysis):
Plan 1 (Equity financing). Under this plan, 2 million common shares will be
sold at \$10 each.
Plan 2 (Debt equity financing). Under this plan, \$10 million of 12 percent
long-term debt and 1 million common shares at \$10 each will be sold.
a. Calculate the EBIT-EPS indifference point.
b. Calculate the expected EPS for both financing plans.
c. What factors should the company consider in deciding which financing
d. Which plan do you recommend the company adopt?
e. Suppose Morton adopts Plan 2, and the Boston facility initially operates at
an annual EBIT level of \$6 million. What is the times interest earned ratio?

6. Moon and Chittenden are considering a new Internet venture to sell used
textbooks. The project requires \$300,000 in financing. Two alternatives have
been proposed:
Plan 1 (Common equity financing). Sell 30,000 shares of stock at a net price
of \$10 per share.
Plan 2 (Debt equity financing). Sell a combination of 15,000 shares of stock
at a net price of \$10 per share and \$150,000 of long-term debt at a pretax
interest rate of 12 percent.
Assume the corporate tax rate is 40 percent.
a. Compute the indifference level of EBIT between these two alternatives.
b. If the firm's EBIT next year has an expected value of \$25,000, which plan
would you recommend assuming maximizing EPS is a valid objective?

#### Solution Preview

Complete problems 10, 12, & 15 on text pp. 414-415 of Ch. 13....6 and 8 on p. 439 of Ch. 14 and problems 4, 5, & 6 on text pp. 441-442 of Ch. 14.

10. McFrugal, Inc. has expected sales of \$20 million. Fixed operating costs are \$2.5
million, and the variable cost ratio is 65 percent. McFrugal has outstanding a
\$12 million, 8 percent bank loan. The firm also has outstanding 1 million
shares of common stock (\$1 par value). McFrugal's tax rate is 40 percent.
a. What is McFrugal's degree of operating leverage at a sales level of \$20 million?

DOL = (Sales - Variable costs)/(Sales - Variable cost - fixed cost)
Variable cost = 20X0.65 = 13
DOL = (20-13)/(20-13-2.5) = 1.56 times

b. What is McFrugal's current degree of financial leverage?

DFL = EBIT/(EBIT - Interest)
EBIT = 20-13-2.5 = \$4.5 million (Sales - Variable cost - fixed cost)
Interest = 12,000,000X8% = \$0.96 million
DFL = 4.5/(4.5-0.96) = 1.27 times

c. Forecast McFrugal's EPS if sales drop to \$15 million.

The forecast EPS can be obtained from Degree of Combined Leverage (DCL)
DCL = DOL X DFL = 1.56X1.27 = 1.98
A DCL of 1.98 implies if sales change by 1%, then EPS will change by 1.98%.
Current EPS is
EBIT 4,500,000
Interest 960,000
EBT 3,540,000
Tax 1,416,000
Net Income 2,124,000
EPS = \$2.124
Change in sales is (15-20)/20 = -25%
EPS will change by 25%X1.98 = 49.4% and will be \$1.074

12. East Publishing Company is doing an analysis of a proposed new finance textbook.
Using the following data, answer (a) through (d).
Fixed Costs per Edition:
Development (reviews, class testing, and so on) \$18,000
Copyediting 5,000
Selling and promotion 7,000
Typesetting 40,000
Total \$70,000
Variable Costs per Copy:
Printing and binding \$4.20
Salespeople's commission (2% of selling price) 0.60
Author's royalties (12% of selling price) 3.60
Bookstore discounts (20% of selling price) 6.00
Total \$16.00
Projected Selling Price \$30.00
The company's marginal tax rate is 40 percent.
a. Determine the company's breakeven volume for this book:
i. In units.

Breakeven units = Fixed cost/unit contribution margin
Unit contribution margin = 30-16 = \$14
Fixed cost = 70,000
Breakeven units = 70,000/14 = 5,000 units

ii. In dollar sales.

In dollars = 5,000X30 = \$150,000

b. Develop a breakeven chart for the textbook.

In a ...

#### Solution Summary

The solution has various problems relating to EBIT-EPS analysis

\$2.19