5-21 Highland Cable Company is considering an expansion of its facilities
Complete all requirements for Chapter 5, Problem 21 Expansion, Breakeven Analysis, and Leverage problem
Text Problem
Complete all requirements for Chapter 5, Problem 21 Expansion, Breakeven Analysis, and Leverage problem from your text, Foundations of Financial Management SOLUTION
21. Highland Cable Company is considering an expansion of its facilities. Its current income statement is as follows:
Sales. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $4,000,000
Less: Variable expense (50% of sales) . . . . . . . . . . . . . . 2,000,000
Fixed expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,500,000
Earnings before interest and taxes (EBIT) . . . . . . . . . . . . . 500,000
Interest (10% cost) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 140,000
Earnings before taxes (EBT) . . . . . . . . . . . . . . . . . . . . . . . 360,000
Tax (30%) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 108,000
Earnings after taxes (EAT) . . . . . . . . . . . . . . . . . . . . . . . . . $ 252,000
Shares of common stock . . . . . . . . . . . . . . . . . . . . . . . . . . 200,000
Earnings per share . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1.26
Highland Cable Company is currently financed with 50 percent debt and 50 percent equity (common stock, par value of $10). To expand the facilities, Mr. Highland estimates a need for $2 million in additional financing. His investment banker has laid out three plans for him to consider:
1. Sell $2 million of debt at 13 percent.
2. Sell $2 million of common stock at $20 per share.
3. Sell $1 million of debt at 12 percent and $1 million of common stock at $25 per share.
Variable costs are expected to stay at 50 percent of sales, while fixed expenses will increase to $1,900,000 per year. Mr. Highland is not sure how much this expansion will add to sales, but he estimates that sales will rise by $1 million per year for the next five years.
Mr. Highland is interested in a thorough analysis of his expansion plans and methods of financing. He would like you to analyze the following:
a. The break-even point for operating expenses before and after expansion(in sales dollars).
b. The degree of operating leverage before and after expansion. Assume sales of $4 million before expansion and $5 million after expansion. Use the formula in footnote 2.
c. The degree of financial leverage before expansion at sales of $4 million and for all three methods of financing after expansion. Assume sales of $5 million for the second part of this question.
d. Compute EPS under all three methods of financing the expansion at $5 million in sales (first year) and $9 million in sales (last year).
e. What can we learn from the answer to part d about the advisability of the three methods of financing the expansion?
