Question

A company has annual sales of $2.5 million and a Cost of Goods Sold of $1,000,000. The company is weighing additional financing for its operations with increased debt versus the issue of additional stock shares. The choice will impact the company’s financial leverage and earnings per share. Financing options:

i.    Issue 1,000 new stock shares (in addition to its current 2,000): company would keep its current monthly interest payments at $10,000 by raising more funds through a new stock issue.

ii.   Increase its debt (and its monthly interest payments to $20,000), if it does not issue more stock.

A. Calculate the Times Interest Earned ratio (TIE) for the two financing options available to the company:

i) Issue 1,000 new shares of stock: retain monthly interest expenses of $10,000, or

ii) Increase debt rather than issue more stock: as a result, increase monthly interest payments to $20,000.

      (To calculate TIE, use EBIT instead of net income, ignoring interest, tax and dividend payments)

B. The company originally had 1000 shares of common stock. Calculate the company’s Earnings Per Share (EPS) for each scenario in (i) and (ii) above:

i) The company adds an additional 1,000 shares of stock to the original 1000 shares,

ii) The company keeps the original number of shares (1,000).

C. Based on your answers for A and B above, what impact does a decision to fund a company’s growth with debt rather than equity (stock) have on the company’s TIE, EPS, and degree of financial leverage?

Answer 1

A. i) issuing new stocks

EBIT= revenue - all COGS= 2.5-1=$1.5 million

interest coverage ratio= EBIT/interest expense= 1.5 million/10,000*12= 1,500,000/120,000=12.5

ii) issuing debt

EBIT= revenue - all COGS= 2.5-1=$1.5 million

interest coverage ratio= EBIT/interest expense= 1.5 million/20,000*12= 1,500,000/120,000=12.5/2=6.25

B) i) issuing new stocks

EBIT= revenue - all COGS= 2.5-1=$1.5 million

net income= EBIT- interest= 1,500,000-120,000=$1,380,000

EPS= net income/number of shares= 1,380,000/2000=$690

ii) issuing debt

EBIT= revenue - all COGS= 2.5-1=$1.5 million

net income= EBIT- interest= 1,500,000-240,000=$1,260,000

EPS= net income/number of shares= 1,260,000/1000=$1260

C) so funding growth with debt reduces net income, interest coverage ratio decreased and leveraage ratio will increase.