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:

e. What can we learn from the answer to part d about the advisability of the

three methods of financing the expansion?

Short answer

	Plan 1	Plan 2	Plan 3
EPS when sale is $6,500,000	0.96	1.16	1.15
EPS when sales is $10,500,000	5.46	4.16	4.90

When the sale is $6,500,000, Plan 2 is seems to be a better alternative in comparison of plan 1 and 3 because it give highest EPS.

When the sale is $10,500,000, Plan 1 is seems to be a better alternative in comparison of plan 2 and 3 because it give highest EPS.

Step-by-step solution

EPS @ sales of 6,500,000

	100% Debts	100% Equity	50% Debts and 50% Equity
EBIT	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	400,000	725,000	575,000
Taxes (40%)	160,000	290,000	230,000
EAT (A)	240,000	435,000	345,000
Shares (Old)	250,000	250,000	250,000
Shares (new)	0	125,000	50,000
Total shares (B)	250,000	375,000	300,000
EPS (A/B)	0.96	1.16	1.15

EPS @ sales of 10,500,000

	100% Debts	100% Equity	50% Debts and 50% Equity
Sales	10,500,000	10,500,000	10,500,000
Less: Variable cost (50% of sales)	5,250,000	5,250,000	5,250,000
Less: Fixed cost	2,350,000	2,350,000	2,350,000
EBIT	2,900,000	2,900,000	2,900,000
Less: Interest (Old debts)	300,000	300,000	300,000
Less: Interest (New debts)	325,000	0	150,000
EBT	2,275,000	2,600,000	2,450,000
Taxes (40%)	910,000	1,040,000	980,000
EAT (A)	1,365,000	1,560,000	1,470000
Shares (Old)	250,000	250,000	250,000
Shares (new)	0	125,000	50,000
Total shares (B)	250,000	375,000	300,000
EPS (A/B)	5.46	4.16	4.90