Question

Bangla Communications Corporation (BCC) supplies headphones to airlines for use with movie and stereo programs. The headphones sell for Tk. 288 per set, and this year's sales are expected to be 45,000 units. Variable production costs for the expected sales under present production methods are estimated at Tk. 10,200,000 and fixed production (operating) costs at present are Tk. 1,560,000. BCC has Tk. 4,800,000 of debt outstanding at an interest rate of eight percent. There are 240,000 shares of common stock outstanding, and there is no preferred stock. The dividend payout ratio is 70, and BCC is in the 40% marginal tax bracket The company is considering investing Tk. 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 Tk. 1,560,000 to Tk. 1,800,000. BCC would raise the required capital by borrowing Tk. 7,200,000 at ten percent interest or by selling 240,000 additional shares at Tk. 30 per share. a) What would be the BCC's EPS (i) under the old production process, (ii) under the new production process if it uses debt, and (iii) under the new process if it uses common stock? b) Calculate the DOL, DFL and DTL under the existing setup and under the new setup with cach type of financing. c) On the basis of the analysis in part b, which plan is the riskiest? Why?

Answer 1

Based on the given information, the table below is prepared, Revenue = Price * Volume = $12.96 Million.Interest = Debt*Interest Rate. Operating Profit = Revenue - Variable Costs - Fixed Costs. Tax = PBT *40%. PAT = PBT - Tax.

If loan is taken to fund the investment in new equipment, interest = 4,800,000*8% + 7,200,000*10% = 1,104,000. If Equity is raised to fund the investment for new plan, total shares = 240,000 + 7,200,000/30 = 480,000.

Based on this, EPS for the three options current plan, new plan with debt, new plan with equity are computed as 2.04, 4.74 & 3.27 respectively.

DOL = (Revenue - Variable Costs)/Operating Profit; DFL = PAT/Operating Profit; DTL = DOL*DFL.

As it can be seen from the table, DTL is highest for current plan. Hence, current plan is the riskiest. It is riskiest as fixed costs as a proportion of contribution margin is high with current plan.

	Current Plan	New Plan Debt	New Plan Equity
Price	288	288	288
Volume	45,000	45,000	45,000
Revenue	12,960,000	12,960,000	12,960,000
Variable Costs	10,200,000	8,160,000	8,160,000
Fixed Costs	1,560,000	1,800,000	1,800,000
Operating Profit	1,200,000	3,000,000	3,000,000
Interest	384,000	1,104,000	384,000
PBT	816,000	1,896,000	2,616,000
Tax	326,400	758,400	1,046,400
PAT	489,600	1,137,600	1,569,600
Shares	240,000	240,000	480,000
EPS	2.04	4.74	3.27
DOL	2.30	1.60	1.60
DFL	2.45	2.64	1.91
DTL	5.64	4.22	3.06