Question

DeSoto Tools Inc. is planning to expand production. The expansion will cost \(300,000, which can be financed either by bonds at an interest rate of 14 percent or by selling 10,000 shares of common stock at \)30 per share. The current income statement before expansion is as follows:

DeSOTO TOOLS, INC.
Sales		\(1,500,000
Less: Variable cost	\)450,000
Fixed cost	550,000	1,000,000
Earning before interest and taxes		\(500,000
Less: Interest expenses		100,000
Earning before taxes		\)400,000
Less: Taxes @34%		136,000
Earning after taxes		\(264,000
Shares		100,000
Earning per shares		\)2.64

After the expansion, sales are expected to increase by \(1,000,000. Variable costs will remain at 30 percent of sales, and fixed costs will increase to \)800,000. The tax rate is 34 percent.

d. Explain which financing plan you favor and the risks involved with each plan.

Short answer

Alternative 1 is to raise the fund from issue of 14% debt, which involve more risk than Alternative 2 (in which shares are sold). Also, Alternative 1 gives less earning per share than Alternative 2. Hence, Alternative 2 should be selected.

Step-by-step solution

Comparison of degree of leverages

	Alternative 1	Alternative 2
Degree of operating leverage	4.375	4.375
Degree of financial leverage	1.55	1.33
Degree of combined leverage	6.78	5.83

The degree of operating leverage is same under both the alternatives. But the financial leverage and the combined leverage of Alternative1 is more than those of Alternative 2. Hence, Alternative 1 is more risky than Alternative 2.

Comparison of EPS

	Alternative 1	Alternative 2
EPS	1.70	1.80

The EPS of Alternative 2 is more than that of Alternative 1. Hence, Alternative 2 should be favored because it gives more return with a lower level of risk.