Foundations of Financial Management

Block, Hirt, Short, and Perretta: Ninth Canadian Edition

Problem 5-20 (LO 1. LO 3, LO 4)

Plan for expansion

Student Name:
Course Name:
Student ID:
Course Number:

Phelps Canning Company is considering an expansion of its facilities. Its current income statement is as
follows:
Sales $5,000,000
Less: Variable expense (50% of sales) 2,500,000
Fixed expense 1,800,000
Earnings before interest and taxes (EBIT) 700,000
Interest expense 200,000
Earnings before taxes 500,000
Tax (34%) 170,000
Earnings after taxes (EAT) $330,000
Shares of common stock 200,000
Earnings per share 1.65

Phelps Canning Company is currently financed with 50 percent debt and 50 percent equity (common stock).
To expand facilities, Mr. Phelps estimates a need for $2 million in additional financing. His investment dealer
has laid out three plans for him to consider:

1. Sell $2 million of debt at 13 percent.

2. Sell $2 million of common stock at $20 per share.
3. 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. Mr. Phelps 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.

Mr. Phelps 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.
c. The degree of financial leverage before expansion at sales of $5 million and for all three methods of
financing after expansion. Assume sales of $6 million for the second part of this question.
d. Computer 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? Make your selection of the financing method that best suits Mr. Phelps' objective
of maximizing shareholders' wealth.

Solution
Problem 5-20 (LO 1. LO 3, LO 4)
Instructions
Using the facts below, set up the cells in the templates to calculate the required amounts.
Key facts:
Fixed costs before expansion (FC) $1,800,000
Fixed costs after expansion (FC) $2,300,000
Variable costs per unit (VC) 0.50 sales
Sales before expansion (S) $5,000,000
Sales estimate after expansion (S) $6,000,000
Total variable costs (TVC) 0.50 sales
EBIT $700,000
Interest before expansion $200,000
If $2 million debt at 13% $260,000
If $1 million debt at 12% $120,000
Total shares before expansion 200,000
If sell 2 million shares ($20 each) 100,000
If sell 1 million shares ($25 each) 40,000

a. Break-even calculations

Problem 5-20 Copyright © 2012 McGraw-Hill Ryerson

 PQ = FC + VC
Where PQ equals sales volume at break-even point
If insert VC as a relation to the sales quantity the formula becomes:
PQ = FC + .5PQ or PQ = FC x 2

Break-even sales before expansion: FORMULA

Break-even sales after expansion: FORMULA

b. Degree of operating leverage

DOL before expansion: FORMULA times

DOL after expansion: FORMULA times

c. Degree of financial leverage

DFL before expansion: FORMULA times

DFL after expansion:

50% Debt +
100% Equity
100% Debt (1) 50% Equity
(2)
(3)
Sales CELL REF CELL REF CELL REF
- TVC FORMULA FORMULA FORMULA
- FC CELL REF CELL REF CELL REF
EBIT #VALUE! #VALUE! #VALUE!
Interest (old) CELL REF CELL REF CELL REF
Interest (new) CELL REF 0 CELL REF
Total Interest (I) #VALUE! #VALUE! #VALUE!

DFL FORMULA FORMULA FORMULA times

d. EPS at sales of $6,000,000 under all three scenarios

50% Debt +
100% Equity
100% Debt (1) 50% Equity
(2)
(3)
EBIT #VALUE! #VALUE! #VALUE! * from above
Total Interest (I) #VALUE! #VALUE! #VALUE! * from above
EBT #VALUE! #VALUE! #VALUE!
Taxes (34%) #VALUE! #VALUE! #VALUE!
EAT FORMULA FORMULA FORMULA
Shares (old) CELL REF CELL REF CELL REF
Shares (new) 0 CELL REF CELL REF
Total shares #VALUE! #VALUE! #VALUE!
EPS FORMULA FORMULA FORMULA

EPS at sales of $10,000,000 under all three scenarios

50% Debt +
100% Equity
100% Debt (1) 50% Equity
(2)
(3)
Sales $10,000,000 $10,000,000 $10,000,000
- TVC FORMULA FORMULA FORMULA
- FC 2,300,000 2,300,000 2,300,000
EBIT #VALUE! #VALUE! #VALUE!
Total Interest (I) #VALUE! #VALUE! #VALUE!
EBT #VALUE! #VALUE! #VALUE!
Taxes (34%) #VALUE! #VALUE! #VALUE!
EAT FORMULA FORMULA FORMULA
Shares (old) CELL REF CELL REF CELL REF
Shares (new) 0 CELL REF CELL REF
Total shares #VALUE! #VALUE! #VALUE!
EPS FORMULA FORMULA FORMULA

e. Which is the best financing method to suit Mr. Phelps' objectives? And why?

Problem 5-20 Copyright © 2012 McGraw-Hill Ryerson