Problem:
Blackwell Company is planning to expand production because of the increased volume of sales. The CFO estimates that the increased capacity will cost $2,000,000. The expansion can be financed either by bonds at an interest rate of 12% or by selling 40,000 shares of common stock at $50 per share. The current income statement (before expansion) is as follows:
Blackwell Company
Income Statement
200X
Sales
$3,000,000
Less: Variable costs (40%)
$1,200,000
Fixed costs
800,000
Earnings before interest and taxes
1,000,000
Less: Interest expense
400,000
Earnings before taxes
600,000
Less: Taxes (@ 35%)
210,000
Earnings after taxes
390,000
Shares
100,000
Earnings per share
$3.90
Assume that after expansion, sales are expected to increase by $1,500,000. Variable costs will remain at 40% of sales, and fixed costs will increase by $550,000. The tax rate is 35%.
Based on the data provided, answer to the following questions:
a. Calculate the degree of operating leverage using the following formula:
DC=S-TVC/S-TVC-FC-I
b. Calculate the degree of financial leverage using the following formula:
DCL = S-TVC/S-TVC-FC-I
c. Calculate the degree of combined leverage before expansion using the following formula:
DCL = S-TVC/S-TVC-FC-I
d. Construct the income statement for the two financial plans.
e. Calculate the degree of operating leverage, the degree of financial leverage, and the degree of combined leverage, after expansion, for the two financing plans.
f. Explain which financing plan you favor and the risks involved.