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Expansion consideration for Highland Cable Company

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

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:

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a)

Before expansion

Contribution margin ratio = Sales% - Variable cost % (which is 50% of sales)
= 100 - 50
= 50 or 0.50

Breakeven point (sales dollars) = Total Fixed Cost/Contribution margin ratio
= 1,500,000/(1 - 0.50)
= 3,000,000

After expansion

Breakeven point (sales dollars) = Total Fixed Cost/Contribution margin ratio
= 1,900,000/(1 - 0.50)
= 3,800,000

b)

Before expansion

Degree of operating leverage = Contribution Margin
Contribution Margin - Fixed Costs

Degree of operating leverage = 2,000,000/(2,000,000 - 1,500,000)
= 4

After expansion

Degree of operating leverage = 2,500,000/(2,500,000 - 1,900,000)
= 4.17

c)

Before expansion

Degree of financial leverage = Contribution Margin - Fixed Costs
(DFL) [Contribution Margin - Fixed Costs - i] - d/(1 - T)

where,
i is interest
d is dividend paid
T is tax payable
= 2,000,000 - 1,500,000
[2,000,000 - 1,500,000 -140,000] - 0/(1 - 0.30)

= 500,000
360,000

= 1.39

After expansion

Sell $2 million of debt at 13%. The interest expense is equal to 260,000 plus the original interest expense of 140,000.

Degree of financial leverage = Contribution Margin - Fixed Costs
(DFL) [Contribution Margin - Fixed Costs - i] - d/(1 - T)

where,
i is interest
d is dividend paid
T is tax payable
= 2,500,000 - 1,900,000
[2,500,000 - 1,900,000 - 400,000] - 0/(1 - 0.30)

= 600,000
200,000

= 3.00

After expansion

Sell $2 million of common stock at $20 per share

Degree of financial leverage = Contribution Margin - Fixed Costs
(DFL) [Contribution Margin - Fixed Costs - i] - d/(1 - T)

where,
i is interest
d is dividend paid
T is tax payable
= 2,500,000 - 1,900,000
[2,500,000 - 1,900,000 - 140,000] - 0/(1 - 0.30)

= 600,000
460,000

= 1.30

After ...

Solution Summary

This solution is comprised of a detailed explanation and calculation to consider expansion for Highland Cable Company.

$2.19