Question

BREAKEVEN AND LEVERAGE Wingler Communications Corporation (WCC) produces premium stereo headphones that sell for $29.00 per set, and this year's sales are expected to be 440,000 units. Variable production costs for the expected sales under present production methods are estimated at $10,000,000, and fixed production (operating costs at present are $1,560,000. WCC has $4,800,000 of debt outstanding at an interest rate of 9%. There are 240,000 shares of common stock outstanding, and there is no preferred stock. The dividend payout ratio is 70%, and WCC is in the 40% federal-plus-state tax bracket. The company is considering investing $7,200,000 in new equipment. Sales would not increase, but variable costs per unit would decline by 20%. Also, fixed operating costs would increase from $1,560,000 to $1,800,000. WCC could raise the required capital by borrowing $7,200,000 at 10% or by selling 240,000 additional shares of common stock at $30 per share. a. What would be WCC's EPS (1) under the old production process, (2) under the new process if it uses debt, and (3) under the new process if it uses common stock? Do not round intermediate calculations. Round your answers to the nearest cent. 1. $ 2. $ 3. $ b. At what unit sales level would WCC have the same EPS assuming it undertakes the investment and finances it with debt or with stock? {Hint: V = variable cost per unit = $8,000,000/440,000, and EPS = [(PQ - VQ- F-1)(1 - T)]/N. Set EPSStock = EPS Debt and solve for Q.} Do not round intermediate calculations. Round your answer to the nearest whole. units C. At what unit sales level would EPS = 0 under the three production/financing setups - that is, under the old plan, the new plan with debt financing, and the new plan with stock financing? (Hint: Note that Vold = $10,000,000/440,000, and use the hints for part b, setting the EPS equation equal to zero.) Do not round intermediate calculations. Round your answers to the nearest whole. Old plan New plan with debt financing units New plan with stock financing units d. On the basis of the analysis in parts a through c, and given that operating leverage is lower under the new setup, which plan is the riskiest, which has the highest expected EPS, and which would you recommend? Assume here that there is a fairly high probability of sales falling as low as 250,000 units, and determine EPS Debt and EPSStock at that sales level to help assess the riskiness of the two financing plans. Do not round intermediate calculations. Round your answers to two decimal places. Negative amount should be indicated by a minus sign. EPSDebt = $ EPSStock = $

Answer 1

a)

	Old Process	New process with debt	New process with Common stock
Sales	440000*29 = 12,760,000.00	12,760,000.00	12,760,000.00
Variable Costs	(Given) 10,000,000.00	(10000000*0.8) 8,000,000.00	8,000,000.00
Contribution	2,760,000.00	4,760,000.00	4,760,000.00
Fixed Costs	1,560,000.00	1,800,000.00	1,800,000.00
EBIT	1,200,000.00	2,960,000.00	2,960,000.00
Interest	4800000*9% = 432,000.00	432000+ (7200000*10%) = 1,152,000.00	432,000.00
EBT	768,000.00	1,808,000.00	2,528,000.00
Taxes @ 40%	307,200.00	723,200.00	1,011,200.00
EAT (A)	460,800.00	1,084,800.00	1,516,800.00
No. of Equity Shares (B)	240,000.00	240,000.00	480,000.00
EPS = A/B	1.92	4.52	3.16

b) WCC takes the investment and, EPS is same =>

Contribution per unit = 10.82 ie, 29-(8000000/440000)

Let X be the number of units, we get

{[(10.82X - 1800000) - 1152000]*60%} / 240000 = {[(10.82X - 1800000) - 432000] * 60%} / 480000

ie, 6.492X - 1771200 = 3.246X - 669600, X = 339372 units.

c) Since EPS = 0, EAT = 0. Hence no taxes ie, EBT=0. So, EBIT - Interest = 0. Hence, EBIT = Interest payable.

	Old Process	New process with debt	New process with Common stock
EPS	0	0	0
So EBIT	432,000.00	1,152,000.00	432,000.00
Fixed Cost	1,560,000.00	1,800,000.00	1,800,000.00
Contribution (A)	1,992,000.00	2,952,000.00	2,232,000.00
Contribution per unit (B)	6.27 ie, 29 - (10000000/440000)	10.82 ie, 29-(8000000/440000)	10.82 ie. 29-(8000000/440000)
Units to be Produced	317565	272874	206319

d) the operating leverage drops from 2.30 to 1.61.New Process with debt has the highest EPS and New process with Debt has higher risk as it has Higher financial leverage.

Variable costs => 8000000/440000 = 18.18

	New process with debt	New process with Common stock
Sales (29 * 250000)	7,250,000.00	7,250,000.00
Variable Costs (18.18*250000 units)	4,545,454.55	4,545,454.55
Contribution	2,704,545.45	2,704,545.45
Fixed Costs	1,800,000.00	1,800,000.00
EBIT	904,545.45	904,545.45
Interest	1,152,000.00	432,000.00
EBT	(247,454.55)	472,545.45
Taxes @ 40%	(98,981.82)	189,018.18
EAT (A)	(148,472.73)	283,527.27
No. of Equity Shares (B)	240,000.00	480,000.00
EPS = A/B	(0.62)	0.59

(Please comment in case of any query regarding the solution)