Question

Yellow Tartan is a levered firm with the following financial statements:

Balance Sheet Income Statement

Total assets $ 1,000,000 Sales $ 3,500,000

Variable costs -$ 1,200,000

Bonds (coupon rate of 8%) $200,000 Fixed costs -$ 1,000,000

Bonds (coupon rate of 6%) $ 300,000 Depreciation -$ 600,000

Common stock (50,000 o/s) $ 250,000 EBIT $ 700,000

Retained earnings $ 250,000 Interest ??

EBT ??

Total liability $ 1,000,000 Taxes (40%) ??

NI ??

Yellow Tartan is planning to raise $400,000 through the sale of common stock at $50 per share or through the issuance of debt with a 10% annual coupon rate.

a) Determine Yellow Tartan’s current DOL (degree of operating leverage), DFL (degree of financial leverage), and DCL (degree of combined leverage). (5 marks)

b) If maximization of earning per share is the goal, what is the indifference EBIT (EBIT* )? (6 marks)

c) Once the expansion is completed, the sales are expected to increase to $5,000,000. Calculate the new EBIT. At the new EBIT which method of financing results in a higher EPS? Calculate EPS for both plans at this new EBIT. (6 marks)

Answer 1

Sales Less: Variable cost Contribution Less: Fixed Cost $8.500.000 (1.200.0001 12.300.000 11.000.000 1.300.000 600.000 700,000 Less: Depreciation TEBIT Less: Interest on Bond 6%Bond IEBT Less: Tax 40% Net Income $16.000 18.000 534,000 666,000 286400 $399,600 Answer(1) DOLIDegree of operating leverage) Contribution EBIT 2300,000 700.000 3.29 DFL Degree of Financial leverage) 700.000 BE000 1.05 DCL Degree of Combined leverage Contbubon EBT 2.300.000 88 000 3.45 Answer(2) Calculation of indifference EBIT Particulars Plan 2 Plan 1 Issue of Shares Issue of Debt $250,000+ $250.000+400.000 Owner's Fund S900.000 $500.000 $250.000250.000 $200.000-300.000+ 400.000 Borrower und $200.000+300.000 500.000 900.000 Total capital employed S1 400 000 S1 400.000 Lal EBIT box Plan 1 Plan 2 Issue of Debt Issue of Shares I EBIT Less: Interest EBT Less: Tax 40% EAT Nod Shures 34.000 X . 34.000 40X-13.600 BOX-20 400 50,000 74,000 X-74.000 40X-29.600 60X-44 400 50 000 EPS X -20.400 58,000 50X-4400 50.000 FRIT 504.000 Answer(3) Plan 1 Issue of Shares Plan 2 Issue of Debt Sang Less: Variable cost Contribution Lans: Fed Cast S5.000.000 (171428571) $ 285.714.29 11.000.000 52 28571429 S5.000.000 (171428571) $325 71429 $2.28571429 $1.685.714,29 $1685.714 29 $16.000 18.000 $34.000 LOS Depreciation EBIT Less: Irrest on Band 8%Bond 6%Bond 10%Bond ЕВТ Less: Tax 40% Net Income No of Shares EPS $16.000 18.00 40.000 $74 TI $1.651.714.29 Sa 0.685.72 $991.028.57 50.000 $17.09 $1.611.714.29 S644.685.72 $957,028,57 50.000 $19.34 Plan 2 issue of 10% debt is better Working note: Calculation of variable cost $1,200,000 3,500.000 5000,000 1,714,286.71