# 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

Administrative costs 1.60

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

plan to adopt?

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?

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#### Solution Preview

Please see the attached file

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

Administrative costs 1.60

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

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