Question

The Lopez-Portillo Company has $11.1 million in assets, 70 percent financed by debt and 30 percent financed by common stock. The interest rate on the debt is 8 percent and the par value of the stock is $10 per share. President Lopez-Portillo is considering two financing plans for an expansion to $20.5 million in assets.

Under Plan A, the debt-to-total-assets ratio will be maintained, but new debt will cost a whopping 11 percent! Under Plan B, only new common stock at $10 per share will be issued. The tax rate is 35 percent.

a. If EBIT is 9 percent on total assets, compute earnings per share (EPS) before the expansion and under the two alternatives. (Round your answers to 2 decimal places.)
  

	earnings per share
current
plan A
plan B

b. What is the degree of financial leverage under each of the three plans? (Round your answers to 2 decimal places.)
  

	degree of financial level
current	$2. 63
plan A
plan B	$1.50

c. If stock could be sold at $20 per share due to increased expectations for the firm’s sales and earnings, what impact would this have on earnings per share for the two expansion alternatives? Compute earnings per share for each. (Round your answers to 2 decimal places.)
  

	earnings per share
plan A
plan B

Answer 1

Answer 2

a.

Current:

Total assets = $11.1 million Debt = 70% x $11.1 million = $7.77 million Equity = 30% x $11.1 million = $3.33 million EBIT = 9% x $11.1 million = $999,000

Interest on debt = 8% x $7.77 million = $621,600

Earnings before taxes (EBT) = $999,000 - $621,600 = $377,400 Taxes (at 35%) = $132,090 Net income = $245,310

Number of common shares = $3.33 million / $10 per share = 333,000 EPS = $245,310 / 333,000 = $0.74 per share

Plan A:

Debt = 70% x $20.5 million = $14.35 million Equity = 30% x $20.5 million = $6.15 million EBIT = 9% x $20.5 million = $1,845,000

Interest on debt = 11% x $14.35 million = $1,578,500

Earnings before taxes (EBT) = $1,845,000 - $1,578,500 = $266,500 Taxes (at 35%) = $93,275 Net income = $173,225

Number of common shares remains the same: 333,000 EPS = $173,225 / 333,000 = $0.52 per share

Plan B:

Debt remains the same: $7.77 million Equity = $11.1 million + ($20.5 million - $11.1 million) = $20.5 million EBIT remains the same: $1,845,000

No interest expense.

Earnings before taxes (EBT) = $1,845,000 Taxes (at 35%) = $646,750 Net income = $1,198,250

Number of common shares increases to: $20.5 million / $10 per share = 2,050,000 EPS = $1,198,250 / 2,050,000 = $0.58 per share

b.

Current:

DFL = EBIT / (EBIT - Interest) = $999,000 / ($999,000 - $621,600) = 2.57

Plan A:

DFL = EBIT / (EBIT - Interest) = $1,845,000 / ($1,845,000 - $1,578,500) = 4.63

Plan B:

DFL = EBIT / (EBIT - Interest) = $1,845,000 / $1,845,000 = 1.00

c.

Plan A:

New net income = $1,845,000 - ($14,350,000 x 0.11 x (1 - 0.35)) = $614,487.50

New EPS = $614,487.50 / 333,000 = $1.85 per share

Plan B:

New net income = $1,845,000 x (1 - 0.35) = $1,198,250

New number of shares = $20.5 million / $20 per share = 1,025,000

New EPS = $1,198,250 / 1,025,000 = $1.17 per share