Question

The Lopez-Portillo Company has $12.1 million in assets, 90 percent financed by debt and 10 percent financed by common stock. The interest rate on the debt is 11 percent and the par value of the stock is $10 per share. President Lopez-Portillo is considering two financing plans for an expansion to $25.5 million in assets. Under Plan A, the debt-to-total-assets ratio will be maintained, but new debt will cost a whopping 13 percent! Under Plan B, only new common stock at $10 per share will be issued. The tax rate is 40 percent. a. If EBIT is 12 percent on total assets, compute earnings per share (EPS) before the expansion and under the two alternatives. (Round your answers to 2 decimal places.) b. What is the degree of financial leverage under each of the three plans? (Round your answers to 2 decimal places.) 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.)

Answer 1

Part a)

The EPS before the expansion and under the two alternatives is calculated as follows:

	Current (Before Expansion)	Plan A	Plan B
EBIT	1,452,000	3,060,000	3,060,000
Less Interest	1,197,900	2,765,700	1,197,900
EBT	254,100	294,300	1,862,100
Less Taxes	101,640	117,720	744,840
EAT (A)	152,460	176,580	1,117,260
Common Shares (B)	121,000	255,000	1,461,000
EPS (A/B)	$1.26	$0.69	$0.76

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Notes:

The calculations for relevant items are given as below:

EBIT

EBIT (Current) = Current Assets*Return on Total Assets = 12,100,000*12% = $1,452,000

EBIT (Plan A) = Total Assets after Expansion*Return on Total Assets = 25,500,000*12% = $3,060,000

EBIT (Plan B) = Total Assets after Expansion*Return on Total Assets = 25,500,000*12% = $3,060,000

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Interest

Interest (Current) = Current Assets*Debt Percentage*Current Interest Rate on Debt = 12,100,000*90%*11% = $1,197,900

Interest (Plan A) = Interest (Current) + (Total Assets after Expansion - Current Assets)*Debt Percentage*Interest Rate on New Debt = 1,197,900 + (25,500,000 - 12,100,000)*90%*13% = $2,765,700

Interest (Plan B) = Current Assets*Debt Percentage*Current Interest Rate on Debt = 12,100,000*90%*11% = $1,197,900

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Common Shares

Common Shares (Current) = (Total Assets*Common Stock Percentage)/Stock Price = (12,100,000*10%)/10 = 121,000 shares

Common Shares (Plan A) = Common Shares (Current) +  [(Total Assets after Expansion - Current Assets)*Common Stock Percentage]/Stock Price = 121,000 + [(25,500,000 - 12,100,000)*10%]/10 = 255,000 shares

Common Shares (Plan B) = Common Shares (Current) +  (Total Assets after Expansion - Current Assets)/Stock Price = 121,000 + (25,500,000 - 12,100,000)/10 = 1,461,000 shares

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Part b)

The degree of financial leverage under all the three plans is arrived as below:

Degree of Financial Leverage = EBIT/EBT

Degree of Financial Leverage (Current) = 1,452,000/254,100 = 5.71

Degree of Financial Leverage (Plan A) = 3,060,000/294,300 = 10.40

Degree of Financial Leverage (Plan B) = 3,060,000/1,862,100 = 1.64

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Part c)

The revised EPS under Plan A and Plan B is derived as follows:

	Plan A	Plan B
EAT (C)	176,580	1,117,260
Common Shares (D)	188,000	791,000
EPS (C/D)	$0.94	$1.41

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Notes:

The calculation for commons shares is provided as below:

Common Shares (Plan A) = Common Shares (Current) +  [(Total Assets after Expansion - Current Assets)*Common Stock Percentage]/Stock Price = 121,000 + [(25,500,000 - 12,100,000)*10%]/20 = 188,000 shares

Common Shares (Plan B) = Common Shares (Current) +  (Total Assets after Expansion - Current Assets)/Stock Price = 121,000 + (25,500,000 - 12,100,000)/20 = 791,000 shares