Question

Delsing Canning Company is considering an expansion of its facilities. Its current income statement is as follows: Sales Variable costs (50% of sales) Fixed costs Earnings before interest and taxes (EBIT) Interest (10% cost) Earnings before taxes (EBT) Tax (40%) Earnings after taxes (EAT) Shares of common stock Earnings per share $5,200,000 2,600,000 1,820,000 $ 780,000 240,000 $ 540,000 216,000 $ 324,000 220,000 $ 1.47 The company is currently financed with 50 percent debt and 50 percent equity (common stock, par value of $10). In order to expand the facilities, Mr. Delsing estimates a need for $2.2 million in additional financing. His investment banker has laid out three plans for him to consider: 1. Sell $2.2 million of debt at 10 percent. 2. Sell $2.2 million of common stock at $20 per share. 3. Sell $1.10 million of debt at 9 percent and $1.10 million of common stock at $25 per share.

Answer 1

As a first step let's cast out the operating income for the first year and last year on the basis of the information given Please see the table below. The filled in cells in the last two column should be paid attention to:

Parameter	Current	First year	Last year
Sales	5,200,000	6,200,000	10,200,000
Variable cost (50%)	2,600,000	3,100,000	5,100,000
Fixed costs	1,820,000	2,320,000	2,320,000
EBIT	780,000	780,000	2,780,000
Interest (10%)	240,000
EBT	540,000
Taxes (40%)	216,000
EAT	324,000
Number of shares	220,000
EPS	1.47

Now we need to figure out EPS in each of the circumstances.

Parameter	Linkage	100% Debt	100% equity	50% debt & 50% equity
Proportion of debt	Wd	100%	0%	50%
Proportion of equity	We = 1 - Wd	0%	100%	50%
Incrmental financing	C	2,200,000	2,200,000	2,200,000
Incremental debt	D = C x Wd	2,200,000	-	1,100,000
Incremental equity	E = C x We	-	2,200,000	1,100,000
Interest rate	i	10%	NA	9%
Incremental interest	I = i x D	220,000	-	99,000
Fresh shares Issue price	P	NA	20	25
Incremental number of shares	N = E / P	0	110,000	44,000
First Year
EBIT		780,000	780,000	780,000
Interest	240,000 + I	460,000	240,000	339,000
EBT		320,000	540,000	441,000
Taxes (40%)	40% x EBT	128,000	216,000	176,400
EAT		192,000	324,000	264,600
Number of shares	220,000 + N	220,000	330,000	264,000
EPS	EAT / Nos. of shares	0.87	0.98	1.00
Last year
EBIT		2,780,000	2,780,000	2,780,000
Interest	240,000 + I	460,000	240,000	339,000
EBT		2,320,000	2,540,000	2,441,000
Taxes (40%)	40% x EBT	928,000	1,016,000	976,400
EAT		1,392,000	1,524,000	1,464,600
Number of shares	220,000 + N	220,000	330,000	264,000
EPS	EAT / Nos. of shares	6.33	4.62	5.55

Hence, your answer grid should be as shown below:

	Earnings per share
	First year	Last year
100% Debt	0.87	6.33
100% equity	0.98	4.62
50% debt & 50% equity	1.00	5.55