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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).

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    Solution Summary

    Excel attachment gives an analysis of expansion plans using break-even point, degree of operating/financial leverage and EPS.

    $2.49

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