# The firm also has outstanding 1 million shares of common stock

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```					10. McFrugal, Inc. has expected sales of \$20 million. Fixed operating costs are \$2.5
million, and the variable cost ratio is 65 percent. Mcfrugal has outstanding a \$12
million, 8 percent bank loan. The firm also has outstanding 1 million shares of
common stock (\$1 par value). McFrugal’s tax rate is 40 percent.

a. What is McFrugal’s degree of operating leverage at a sales level of \$20 million?
Sales - Variable cost
DOL =
EBIT
\$20,000,000-\$13,000,000
=
\$4,500,000
= 1.556

b. What is McFrugal’s current degree of financial leverage?

EBIT
DFL =
EBIT-Interest
\$4,500,000
=
\$4,500,000-\$960,000
= 1.2712
c. Forecast McFrugal’s EPS if sales drop to \$15 million.

DCL= DOL x DFL = 1.5556 x 1.2712
= 1.9775

% change in EPS = DCL x % change in Sales
% change in sales= (\$15 million - \$ 20 million) / \$ 15 million= -25%

Therefore % change in EPS= -49.44% =-0.25x1.9774

EPS at sales of \$20 million= \$2.124
Therefore EPS at sales of \$15 million= ( 1 -0.4944) x \$2.124

= \$1.074
12. Finance Question
East Publishing Company is doing an analysis of a proposed new
finance textbook. Using the following data, answer (a) through (d).

Fixed Cost per Edition:

Development (reviews, class testing , and so on)              \$18,000
Copyediting                                                     5,000
Selling and promotion                                           7,000
Typesetting                                                    40,000
Total                                                         \$70,000

Variable Cost per Copy:
Printing and binding                                            \$4.20
Salespeople's commission (2% of selling price)                   0.60
Author's royalties (12% of selling price)                        3.60
Bookstore discounts (20% of selling price)                       6.00
Total                                                          \$16.00

Projected Selling Price                                         \$30.00

The company's marginal tax rate is 40 percent.

a. Determine the company's breakeven volume for this book:
i. in units

FC = \$70,000; VC = \$16; P = \$30
Qb = \$70,000/(\$30 - \$16) = 5,000 copies

II. In dollar sales
Sb = Qb x P = 5,000 x \$30 = \$150,000

b. Develop a breakeven chart for the textbook.

Breakeven Chart

\$350,000
\$300,000
\$250,000
Amount

\$200,000
\$150,000
\$100,000
\$50,000
\$0
0

00

00

00

00

00

00

00

00

00

0
00
10

20

30

40

50

60

70

80

90

10

Units

Slope of total revenue line is P = \$30; Total revenue line originates from the origin

(0,0).

Slope of total cost line is V = \$16; Total cost line has a y-intercept of \$70,000.

Breakeven units equal 5,000 copies at a total revenue level of                \$150,000.

c. Determine the number of copies East must sell in order to earn an (operating)
profit of \$21,000 on this book.
Target profit = \$21,000

Target volume = (\$70,000 + \$21,000)/(\$30 - \$16) = 6,500 books

d. Suppose East feels that \$30.00 is too high a price to charge for a new finance
textbook. It has examined the competitive market and determined that \$24.00 would
be a better selling price. What would the breakeven volume be at this new selling
point?

Projected selling price                                \$24.00
Variable costs per copy
Printing and binding                                   \$ 4.20
Sales commissions                                        0.48*
Author's royalties                                       2.88*
Bookstore discounts                                      4.80*
Total                                                  \$13.96

*These variable costs are reduced because they are a function of

the selling price.
Qb = \$70,000 / (\$24 - \$13.96) = 6,972 copies
15. Rodney Rogers, a recent business school graduate, plans to open a wholesale dairy
products firm. The business will be completely financed with equity. Rogers expects
first year sales to total \$5,500,000. He desires to earn a target pretax profit of
\$1,000,000 during his first year of operation. Variable costs are 40 percent of sales.

a. How large can Rogers’ fixed operating costs be if he is to meet his profit target?

Sales = \$5,500,000

VC = 0.4(\$5,500,000) = \$2,200,000

Target pretax profit = \$1,000,000

\$5,500,000 - \$2,200,000 - FC = \$1,000,000

FC = \$2,300,000

b. What is Rogers’ breakeven level of sales at the level of fixed operating costs
determined in (a)?
Breakeven sales = \$2,300,000/ (1 - 0.4) = \$3,833,333

6. What is the underlining objective of EBIT-EPS analysis?

Use of EBIT-EPS analysis can determine which financing alternative maximizes
EPS. However, it is possible that maximizing EPS results in such a high risk
level that the weighted cost of capital is not minimized, and therefore the value of
the firm is not maximized.
8. In practice what are the factors managers consider in setting a firm’s target capital
structure?

A firm should use more debt if it traditionally has been more profitable than the
average firm in the industry, or if its operating income is more stable than the
operating income of the average firm in the industry. If the opposite factors (i.e.,
less profitable and less stable) are true, the firm generally should use less debt.
This answer assumes that the average firm in the industry is operating at or near
an optimal capital structure.

4. Emco Products has a present capital structure consisting only of common stock (10
million shares). The company is planning a major expansion. At this time, the
company is undecided between the following two financial plans (assume a 40
percent marginal tax rate):

Plan 1 (Equity financing). Under this plan, an additional 5 million shares of
common stock will be sold at \$10 each.

Plan 2 (Debt financing). Under this plan, \$50 million of 10 percent long term
debt will be sold.

One piece of information the company desires for its decision analysis is an EBIT-
EPS analysis.

a. Calculate the EBIT-EPS indifference point.
Interest under Debt Alternative = \$50 (million) × 10% = \$5 (million)

EPS (debt financing) = EPS (equity financing)
(EBIT - Interest)(1-Tax Rate)                        (EBIT)(1-Tax Rate)

Number of CS Shares Outstanding Under Debt Alt. Number of CS Shares Outstanding Under Equi

(EBIT - 5)(0.6) (EBIT)(0.6)

10             15
0.6 EBIT  3 0.6 EBIT

10           15
(10)(0.6EBIT )  (15)(0.6EBIT  3)

6EBIT = 9EBIT - 45

3 EBIT = 45

EBIT = \$15

B.Graphically determine the EBIT-EPS indifference point
Hint: Use EBIT = \$10 million and \$25 million.
Please see the attached excel sheet for calculations
Indifference Point

\$1.40

\$1.20

\$1.00

\$0.80                                                                             Debt
EPS

\$0.60                                                                             Equity

\$0.40

\$0.20

\$0.00
\$10                    \$15                  \$25
EBIT

c. What happens to the indifference point if the interest rate on debt increases and the
common stock sales price remains constant?
Indifference point moves to right, i.e., higher EBIT

d. What happens to the indifference point if the interest rate on debt remains constant
and the common stock sales prices increases?
Indifference point moves to right, i.e., higher EBIT.

5. Morton Industries is considering opening a new subsidiary in Boston, to be
operated as a separate company. The company’s financial analysts expect the new
facility’s average EBIT level to be \$6 million per year. At this time, the company is
considering the following two financing plans (use a 40 percent marginal tax rate in

Plan 1 (Equity Financing). Under this plan, \$2 million common shares will be
sold at \$10     each.
Plan 2 (Debt equity financing). Under this plan, \$10 million of 12 percent
long-term debt         and 1 million common shares at \$10 each will be sold.

a. Calculate the EBIT-EPS indifference point.

EPS (Plan 1) = EPS (Plan 2)

[(EBIT - 0)(1 - .4)]/2 = [(EBIT - 1.2)(1 - .4)]/1

EBIT* = \$2.4 million
b. Calculate the expected EPS for both financing plans.

Plan 1             Plan 2

EBIT                           \$6.0              \$6.0

I                               0                 1.2

EBT                            \$6.0               \$4.8

T @ 40%                          2.4               1.92

EAT                             \$3.6              \$2.88

Shares Outstanding                  2.0             1.0

EPS                              \$1.80              \$2.88

c. What factors should the company consider in deciding which financing plan to

The factors the company should consider include the following:

1. The plan's effect on the company's stock price (difficult to determine in practice).

2. The capital structure of the parent company.

3. The probability distribution of expected EBIT.

d. Which plan do you recommend the company adopt?

Adopt plan 2 if the company can be reasonably sure that EBIT will not drop too

much in a recession. Otherwise, plan 1 appears better.

e. Suppose Morton adopts Plan 2, and the Boston facility initially operates at an
annual EBIT level of \$6 million. What is the times interest earned ratio?

T.I.E. = (EBIT/I) = (6.0/1.2) = 5 times

Note: This calculation assumes no short-term debt, either permanent or seasonal.

6. Moon and Chittenden are considering a new Internet venture to sell used textbooks.
The project requires \$300,000 in financing. Two alternatives have been proposed.

Plan 1 (Common equity financing). Sell 30, 000 shares of stock at a net price
of \$10 per      share.
Plan 2 (Debt equity financing). Sell a combination of 15,000 shares of stock at
a net price     of \$10 per share and \$150,000 of long-term debt at a pretax interest
rate of 12 percent.
Assume the corporate tax rate is 40 percent.

a. Compute the indifference level of EBIT between these two alternatives
Plan A
Debt= \$0
Equity= \$300,000
# of shares= 30,000
Interest rate= 12.00%
Interest expense= \$0.00

Plan B
Debt= \$150,000
Equity= \$150,000
# of shares= 15,000
Interest rate= 12.00%
Interest expense= \$18,000 =12.% x \$150,000.

EPS = (EBIT - Interest)x (1-Tax rate) / # of shares

EPS
Plan A : (EBIT-0) (1-0.4)/30000
Plan B : (EBIT-18000) (1-0.4)/15000
For point of indifference EPS under two plans should be eaual
or
(EBIT-0) (1-0.4)/30000 = (EBIT-18000) (1-0.4)/15000

Solving for EBIT:
EBIT= \$36,000

b. If the firm’s EBIT next year has an expected value of \$25,000, which plan would
you recommend assuming maximizing EPS is a valid objective?

Below the indifference point, the plan with lower debt is better
Hence opt for Plan A as it would give a higher EPS

Check:

EBIT= \$25,000
Plan A
Debt \$0

Earnings before interest and taxes (EBIT) . . . . . . . . . . . . . . . . . 25,000
Less Interest expense @ 12.00% 0 =12.% x \$.
Earnings before taxes (EBT) . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25,000
Less Taxes @ 40% 10,000 =40.% x \$25,000.
Net Income= 15,000
Number of shares= 30,000
EPS= \$0.500 =\$15,000. / 30,000.

Plan B
Debt \$150,000

Earnings before interest and taxes (EBIT) . . . . . . . . . . . . . . . . . 25,000
Less Interest expense @ 12.00% 18,000 =12.% x \$150,000.
Earnings before taxes (EBT) . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7,000
Less Taxes @ 40% 2,800 =40.% x \$7,000.
Net Income= 4,200

Number of shares= 15,000
EPS= \$0.280 =\$4,200. / 15,000.

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