1) 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?

DOL =

=

= 1.556

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

DFL =

=

= 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

2) 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

Administrative costs 1.60

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.

**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**

Administrative costs 1.60

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

3) 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

4) 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.

5) 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.

6) 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)

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

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.

7) 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 your analysis):

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 adopt?

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.

8) 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

Answer: 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.