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Purchase Decision / Degree of Financial Leverage

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5. You are considering the purchase of new equipment for your company and you have narrowed down the possibilities to two models which perform equally well. However, the method of paying for the two models is different. Model A requires $5,000 per year payment for the next five years. Model B requires the following payment schedule. Which model should you buy if your opportunity cost is 8 percent?
Year Payment (Model B)
1 $7,000
2 6,000
3 5,000
4 4,000
5 3,000

Table 8.1
Plan 1 Plan 2
Interest Expense $25,000 $50,000
Preferred Dividend $3,000 $1,500
Common Shares Outstanding 200,000 100,000

What is the degree of financial leverage at a base level EBIT of $120,000 for both financing plans? The firm has a 40 percent tax rate. (See Table 8.1.)

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Solution Summary

The solution looks at two questions - making the purchase decison among alternatives and how to calculate the degree of financial leverage. This solution is formatted in an attached Word document.

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Finance Decision-Making : Contribution Margin Ratio CVP ( Cost-Volume-Profit ), Incone Statement Equation, Bonds, Coupon Interest Rate, Cash Flow, Risk Management and WACC

Question 1 (2.50 points)
The following are the monthly fixed expenses for Peyton Travel:
Office rent: $3,000.00
Depreciation of office furniture 200.00
Utilities 110.00
Telephone 520.00
Reservation Service Fees 380.00
Travel Agent Salaries 1,400.00

Variable expenses include the following:
Travel Agent Commission 5.0% of sales
Advertising 6.0% of sales
Supplies and Postage 1.0% of sales
Telephone and Reservation Service usage fees 3.0% of sales

a) Use the contribution margin ratio CVP formula to compute Peyton Travel's break-even sales in dollars. If the average sales price of a ticket is $660.00; how many tickets must be sold to reach break-even?
b) Use the income statement equation [revenue - (variable expense + fixed expense) = operating income] to compute the dollar sales needed to earn a target monthly operating income of $6,290.00. How many tickets is this if the average sales price of a ticket is $660.00?
c) Assume the average sales price decreases to $440.00 per ticket. Use the contribution margin approach to compute Peyton Travel's new break-even point in tickets sold. How does this compare to your answer in part a) ?

Question 2 (2.50 points)
Quinn Electric Company has outstanding a bond issue that will mature to its $1,000 par value in 12 years. The bond has a coupon rate of 15% and pays the interest annually.

a) Find the value of the bond if the required return is (1) 10 percent, (2) 15 percent and (3) 17 percent.
b) Use your findings in part a) to discuss the relationship between coupon interest rate on a bond and the required return and the market value of the bond relative to its par value.
c) What two reasons cause the required return to differ from the coupon interest rate?

Question 3 (2.50 points)
JSC Corporation is attempting to determine whether to lease or purchase research equipment. The firm is in the 30% tax bracket, and its after-tax cost of debt is currently 7%. The terms of the lease and the purchase are as follows:
Lease Scenario: Annual end-of-year lease payments of $25,200 are required over the 3-year life of the lease. All maintenance costs will be paid by the lessor; insurance and other costs will be borne by the lessee. The lessee will exercise its option to purchase the asset for $5,000 at termination of the lease.

Purchase Scenario: The research equipment, costing $60,000, can be financed entirely with a 14% loan requiring annual end-of-year payments of $25,844 for 3 years. The firm in this case will depreciate the asset under MACRS using a 3-year recovery period. The firm will pay $1,800 per year for a service contract that covers all maintenance costs; insurance and other costs will be borne by the firm. The firm plans to keep the equipment and use it beyond its 3-year recovery period.

a) Calculate the after-tax cash outflows associated with each alternative.
b) Calculate the present value of each cash outflow stream using the after-tax cost of debt.
c) Which alternative, lease or purchase, would you recommend? Why?

Question 4 (2.50 points)
Drake Company is planning to expand production because of the increased volume of sales. The CFO estimates that the increased capacity will cost $2,000,000. The expansion can be financed either by bonds at an interest rate of 12% or by selling 40,000 shares of common stock at $50 per share. The current income statement (before expansion) is as follows:

Drake Company
Income Statement
Sales $3,000,000
Less: Variable costs (40%) $1,200,000
Fixed costs 800,000
Earnings before interest and taxes 1,000,000
Less: Interest expense 400,000
Earnings before taxes 600,000
Less: Taxes (@ 35%) 210,000
Earnings after taxes 390,000
Shares 100,000
Earnings per share $3.90

Assume that after expansion, sales are expected to increase by $1,500,000. Variable costs will remain at 40% of sales, and fixed costs will increase by $550,000. The tax rate is 35%.

a) Calculate the degree of operating leverage, the degree of financial leverage, and the degree of combined leverage, before expansion.
b) Construct the income statement for the two financial plans.
c) Calculate the degree of operating leverage, the degree of financial leverage, and the degree of combined leverage, after expansion, for the two financing plans.
d) Explain which financing plan you favor and the risks involved.

Bonus Question (1.50 points)
Suppose that you want to purchase a new truck from a local dealership. The dealership is offering 2.0% financing for 4 years (term= 48 months). They are also offering a $3,000 cash rebate (subtracted from the purchase price) for an externally financed deal. You are able to secure a note from your local bank for the same 4 year term at 3.95% interest up to a maximum purchase amount of $50,000. At what total purchase price will you have the same monthly payment between these two offers? Under what circumstances would you choose one over the other?

WACC Problem #1
Copernicus, Inc. has determined that its target capital structure will be 60% debt, 10% preferred stock, and 30% common stock. As the financial manager, the CFO has informed you that the companys' before tax cost of debt is 10%, preferred stock is 14%, and common stock is 16%. In addition, the company's marginal tax rate is 40%. Based on the information provided, calculate the weighted average cost of capital (WACC).

WACC Problem #2
Kepler, Inc. has determined that its target capital structure will be 30% debt, 15% preferred stock, and 55% common stock. Also, the company provides the following information:

Bond coupon rate 13% Bond yield to maturity 11%
Dividend, expected common $3.00 Dividend,preferred $10.00
Price, common $50.00 Price, preferred $98.00
Growth rate 8%
Corporate tax rate 30%

Based on the information provided, calculate the firm's weighted average cost of capital (WACC).

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