Question

Delsing Canning Company is considering an expansion of its facilities. Its Current income statement is as follows:

Sales	\(5,500,000
Less: variable expenses (50% of sales)	2,750,000
Fixed expenses	1,850,000
Earnings before interest and taxes (EBIT)	\)900,000
Interest (10% cost)	300,000
Earning before taxes (EBT)	\(600,000
Tax @40%	240,000
Earning after tax (EAT)	\)360,000
Share of common stock-250,000
Earning per share	\(1.44

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 \(2.5 million in additional financing. His investment banker has laid out three plans for him to consider:

1. Sell \)2.5 million of debt at 13 percent.

2. Sell \(2.5 million of common stock at \)20 per share.

3. Sell \(1.25 million of debt at 12 percent and \)1.25 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 \)2,350,000 per year. Delsing is not sure how much this expansion will add to sales, but he estimates that sales will rise by \(1.25 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:

c. The degree of financial leverage before expansion and for all three methods of financing after expansion. Assume sales of \)6.5 million for this question.

Short answer

	Before expansion	After expansion
		Plan 1	Plan 2	Plan 3
Degree of financial leverage	1.50	2.56	1.41	1.78

Step-by-step solution

Degree of financial leverage before expansion

$$\begin{gathered} \mathbf{DFL}\mathbf{=}\frac{\mathbf{EBIT}}{\mathbf{EBT}} \\ \mathbf{=}\frac{\mathbf{\$}\mathbf{900}\mathbf{,}\mathbf{000}}{\mathbf{\$}\mathbf{600}\mathbf{,}\mathbf{000}} \\ \mathbf{=}\mathbf{1}\mathbf{.}\mathbf{50} \end{gathered}$$

Degree of financial leverage after expansion

	100% Debts	100% Equity	50% Debts and 50% Equity
Sales	6,750,000	6,750,000	6,750,000
Less: Variable cost	3,375,000	3,375,000	3,375,000
Less: Fixed cost	2,350,000	2,350,000	2,350,000
EBIT (A)	1,025,000	1,025,000	1,025,000
Less: Interest (Old debts)	300,000	300,000	300,000
Less: Interest (New debts)	325,000	0	150,000
EBT (B)	400,000	725,000	575,000
DFL (A/B)	2.56	1.41	1.78