The Norman Automatic mailer Machine Company is planning to expand production. The expansion will cost $2000,000, which can either be financed by bonds at an interest rate of 12 percent or by selling 40,000 shares of common stock at $50 per share. The current income statement before expansion is as follows:
Norman Automatic Mailer
Income Statement
Sales $3000,000
Variable Costs (40%) 1,200,000
Contribution margin 1,800,000
Fixed Costs 800,000
earnings before interest and taxes 1000,000
interest expense 400,000
Earnings beofre tax 600,000
taxes @ 34% 204,000
earnings after tax $396,000
Shares 100,000
earnings per share $3.96
After the expansion sales are expected to increase by 1,500,000. Variable Costs will remain at 40 percent of sales, and fixed costs will increase to $550,000. The tax rate is 34 percent.
a) construct the income statement for the two financial plans.
b) calculate the degree of operating leverage, the degree of financial leverage, and the degree of combined leverage, after expansion for the two financing plans
c) calculate the ebit/eps indifference point.
d) explain which plan you favor and the risks involved.
formulas: DOL= CM/EBIT
DFL=EBIT/EBT
DCL= DOL * DFL
indifference point= (S(B) * I(A)- S(A) * I(B) / S(B) - S(A)
I is interet costs under plan A and B
S is shares Outstanding under plan A and B
this is yusra :)
To solve this problem, we will need to calculate the income statement for the two financial plans, calculate the degree of operating leverage (DOL), degree of financial leverage (DFL), and degree of combined leverage (DCL) for each plan, calculate the EBIT/EPS indifference point, and discuss which plan is favored and the risks involved.
a) Income Statement for the Two Financial Plans:
Plan A (Financed by Bonds):
Sales: $3,000,000 + $1,500,000 = $4,500,000
Variable Costs: 40% of $4,500,000 = $1,800,000
Contribution Margin: $4,500,000 - $1,800,000 = $2,700,000
Fixed Costs: $800,000 + $550,000 = $1,350,000
EBIT: $2,700,000 - $1,350,000 = $1,350,000
Interest Expense: $1,350,000 * 12% = $162,000
EBT: $1,350,000 - $162,000 = $1,188,000
Taxes: $1,188,000 * 34% = $403,920
Earnings After Tax: $1,188,000 - $403,920 = $784,080
Plan B (Financed by Selling Shares):
Shares: 100,000 + 40,000 = 140,000
Sales: $4,500,000
Variable Costs: 40% of $4,500,000 = $1,800,000
Contribution Margin: $4,500,000 - $1,800,000 = $2,700,000
Fixed Costs: $1,350,000
EBIT: $2,700,000 - $1,350,000 = $1,350,000
Interest Expense: 0 (There are no interest expenses with this financing plan)
EBT: $1,350,000
Taxes: $1,350,000 * 34% = $459,000
Earnings After Tax: $1,350,000 - $459,000 = $891,000
b) Degree of Operating Leverage (DOL), Degree of Financial Leverage (DFL), and Degree of Combined Leverage (DCL):
Plan A:
DOL = $2,700,000 / $1,350,000 = 2
DFL = $1,350,000 / $1,188,000 = 1.136
DCL = DOL * DFL = 2 * 1.136 = 2.272
Plan B:
DOL = $2,700,000 / $1,350,000 = 2
DFL = N/A (There are no interest expenses with this financing plan)
DCL = N/A (There are no interest expenses with this financing plan)
c) EBIT/EPS Indifference Point:
Indifference Point = (S(B) * I(A) - S(A) * I(B)) / (S(B) - S(A))
Where:
S(A) = Shares Outstanding under Plan A = 100,000
S(B) = Shares Outstanding under Plan B = 140,000
I(A) = Interest Costs for Plan A = $1,350,000 * 12% = $162,000
I(B) = Interest Costs for Plan B = 0 (There are no interest expenses with this financing plan)
Indifference Point = (140,000 * $162,000 - 100,000 * 0) / (140,000 - 100,000) = $7,988,000
The EBIT/EPS indifference point is $7,988,000.
d) Favored Plan and Risks Involved:
Based on the calculations above, it seems that Plan B (Financed by Selling Shares) is more favorable. This is because it results in higher earnings after tax ($891,000) compared to Plan A ($784,080). Additionally, Plan B does not incur any interest expenses, which can put a strain on the company's cash flow.
However, it is important to note that selling shares dilutes the ownership of existing shareholders. This means that they will have a smaller percentage of ownership in the company. Additionally, if the company's financial performance does not meet expectations, the dilution of ownership and higher number of shares outstanding can lead to a decrease in the stock price.
Overall, the decision between the two plans will depend on factors such as the company's long-term growth prospects, its ability to generate profits, and the impact of dilution on existing shareholders.