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# Expansion, Break Even Analysis and Leverage

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