Answer:
a. The break-even point for operating expenses before and after expansion
break even point before expansion = fixed costs + variable costs
fixed costs = $2,030,000
variable costs = $3,650,000
break even point = $2,030,000 + $3,650,000 = $5,680,000
break even point after expansion = = fixed costs + variable costs
fixed costs = $2,530,000
variable costs = $8,300,000 x 50% = $4,150,000
break even point = $2,530,000 + $4,150,000 = $6,680,000
b. The degree of operating leverage before and after expansion.
degree of operating leverage before expansion = (sales - variable costs) / (sales - variable costs - fixed costs)
sales = $7,300,000
variable costs = $3,650,000
fixed costs = $2,030,000
DOL = ($7,300,000 - $3,650,000) / ($7,300,000 - $5,680,000) = $3,650,000 / $1,620,000 = 2.25
degree of operating leverage after expansion = (sales - variable costs) / (sales - variable costs - fixed costs)
sales = $8,300,000
variable costs = $4,150,000
fixed costs = $2,530,000
DOL = ($8,300,000 - $4,150,000) / ($8,300,000 - $6,680,000) = $4,150,000 / $1,620,000 = 2.56
c-1. The degree of financial leverage before expansion.
DFL = EBIT / (EBIT - interest expense)
EBIT before expansion = $1,620,000
Interest expense = $660,000
DFL = $1,620,000 / ($1,620,000 - $660,000) = 1.69
c-2. The degree of financial leverage for all three methods after expansion. Assume sales of $8.3 million for this question.
EBIT after option A = $1,620,000
Interest expense after option A = $660,000 + ($4,300,000 x 13%) = $1,219,000
DFL (option A) = $1,620,000 / ($1,620,000 - $1,219,000) = 4.04
EBIT after option B = $1,620,000
Interest expense after option A = $660,000
DFL (option B) = $1,620,000 / ($1,620,000 - $660,000) = 1.69
EBIT after option C = $1,620,000
Interest expense after option A = $660,000 + ($2,150,000 x 12%) = $918,000
DFL (option C) = $1,620,000 / ($1,620,000 - $918,000) = 2.31
d. Compute EPS under all three methods of financing the expansion at $8.3 million in sales (first year) and $10.1 million in sales (last year).
first year:
EBIT after option A = $1,620,000
Interest expense after option A = $1,219,000
Pre tax income = $401,000
Income tax (40%) = $160,400
Net income = $240,600
EPS = $240,600 / 430,000 stocks = $0.56
EBIT after option B = $1,620,000
Interest expense after option A = $660,000
Pre tax income = $960,000
Income tax (40%) = $384,000
Net income = $576,000
EPS = $576,000 / 602,000 stocks = $0.96
EBIT after option C = $1,620,000
Interest expense after option A = $918,000
Pre tax income = $702,000
Income tax (40%) = $280,800
Net income = $421,200
EPS = $421,200 / 483,750 stocks = $0.87
last year:
EBIT after option A = $2,520,000
Interest expense after option A = $1,219,000
Pre tax income = $1,301,000
Income tax (40%) = $520,400
Net income = $780,600
EPS = $780,600 / 430,000 stocks = $1.82
EBIT after option B = $2,520,000
Interest expense after option A = $660,000
Pre tax income = $1,860,000
Income tax (40%) = $744,000
Net income = $1,116,000
EPS = $1,116,000 / 602,000 stocks = $1.85
EBIT after option C = $2,520,000
Interest expense after option A = $918,000
Pre tax income = $1,602,000
Income tax (40%) = $640,800
Net income = $961,200
EPS = $961,200 / 483,750 stocks = $1.99