Expansion, break-even analysis, and leverage (LO2, 3 & 4) Delsing Canning Company is
considering an expansion of its facilities. Its current income statement is as follows:
Sales ..................................................................
Less: Variable expense (50% of sales) ...........
Fixed expense ..............................................
Earnings before interest and taxes (EBIT) ........
Interest (10% cost) ............................................
Earnings before taxes (EBT) .............................
Tax (30%) ..........................................................
Earnings after taxes (EAT) ................................
Shares of common stock—200,000 ..................
Earnings per share .............................................
$5,000,000
2,500,000
1,800,000
700,000
200,000
500,000
150,000
$ 350,000
$1.75
The company is currently financed with 50 percent debt and 50 percent equity (common
stock, par value of $10). In order to expand the facilities, Mr. Delsing 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.
3.
Sell $2 million of common stock at $20 per share.
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 $2,300,000 per year. Delsing 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.
Delsing 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 $5
million before expansion and $6 million after expansion. Use the formula in footnote
2 of the chapter.
c.
The degree of financial leverage before expansion and for all three methods of
financing after expansion. Assume sales of $6 million for this question.
d.
Compute EPS under all three methods of financing the expansion at $6 million in
sales (first year) and $10 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?
5-27. Solution:
Delsing Canning Company
a.
At break-even before expansion:
PQ  FC  VC
where PQ equals sales volume at break-even point
 Fixed costs  Variable costs
(Variable costs  50% of sales)
Sales
 $1,800,000  .50 Sales
.50 Sales  $1,800,000
Sales
Sales
 $3,600,000
At break-even after expansion:
Sales
 $2,300,000  .50 Sales
.50 Sales  $2,300,000
 $4,600,000
Sales
b. Degree of operating leverage, before expansion, at sales of
$5,000,000
DOL =
Q  P  VC 
Q  P  VC   FC

S  TVC
S  TVC  FC
$5,000,000  $2,500,000
$5,000,000  $2,500,000  $1,800,000
$2,500,000

 3.57x
$700,000

5-27. (Continued)
Degree of operating leverage after expansion at sales of
$6,000,000
$6,000,000  $3,000,000
$6,000,000  $3,000,000  $2,300,000
$3,000,000

 4.29x
$700,000
DOL =
This could also be computed for subsequent years.
c. DFL before expansion:
DFL =
EBIT
EBIT  1

$700,000
$700,000  $200,000

$700,000
 1.40x
$500,000
DFL after expansion:
Compute EBIT and I for all three plans:
(100% Debt)
(1)
Sales
$6,000,000
–TVC (.50)
3,000,000
–FC
2,300,000
EBIT
$ 700,000
I – Old Debt
200,000
I – New Debt
260,000
Total Interest $ 460,000
5-27. (Continued)
DFL =
(100%
Equity) (2)
$6,000,000
3,000,000
2,300,000
$ 700,000
200,000
0
$ 200,000
(50% Debt
and 50%
Equity) (3)
$6,000,000
3,000,000
2,300,000
$ 700,000
200,000
120,000
$ 320,000
EBIT
EBIT  I
(1)
(2)
(3)
$700,000
$700,000
$700,000
 $700,000  $460,000  $700,000  $200,000  $700,000  $320,000
DFL = 2.92x
1.40x
d. EPS @ sales of $6,000,000
1.84x
(refer back to part c to get the values for EBIT and Total I)
EBIT
Total I
EBT
Taxes (30%)
EAT
Shares (old)
Shares (new)
Total Shares
EPS (EAT/Total
shares)
(100%
Debt) (1)
$700,000
460,000
$240,000
72,000
$168,000
200,000
0
200,000
$.84
(50% Debt
(100%
and 50%
Equity) (2) Equity) (3)
$700,000
$700,000
200,000
320,000
$500,000
$380,000
150,000
114,000
$350,000
$266,000
200,000
200,000
100,000
40,000
300,000
240,000
$1.17
$1.11
EPS @ sales of $10,000,000
Sales
–TVC
–FC
EBIT
Total I
EBT
Taxes (30%)
EAT
Total Shares
EPS
(EAT/Total
Shares)
(100%
Debt) (1)
$10,000,000
5,000,000
2,300,000
$ 2,700,000
460,000
$ 2,240,000
672,000
$1,568,000
200,000
(100%
Equity) (2)
$10,000,000
5,000,000
2,300,000
$ 2,700,000
200,000
$ 2,500,000
750,000
$1,750,000
300,000
(50% Debt
and 50%
Equity) (3)
$10,000,000
5,000,000
2,300,000
$ 2,700,000
320,000
$2,380,000
714,000
$1,666,000
240,000
$7.84
$5.83
$6.94
e.
In the first year, when sales and profits are relatively low,
plan 2 (100% equity) appears to be the best alternative.
However, as sales expand up to $10 million, financial
leverage begins to produce results as EBIT increases and
Plan 1 (100% debt) is the highest yielding alternative.