The Norman Automatic Mailer Machine Company is planning to expand production because of the increased volume of mailouts. The increased mailout capacity will cost $2,000,000. The expansion can be financed either by bonds at an interest rate of 12 percent or by selling 40,000 shares of common stock at $50 per share. The current income statement (before expansion) is as follows:
NORMAN AUTOMATIC MAILER
Income Statment
201X
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
Earning before expense 600,000
Less: Taxes (35% 210,000
Earning after taxes 390,000
shares 100,000
Earning per share 390
Assume that after expansion, sales are expected to increase by $1,500,000. Variable costs will remain at 40 percent of sales, and fixed costs will increase by $550,000. The tax rate is 35 percent.
a. Calculate the degree of operating leverage, the degree of financial leverage, and the degree of combined leverage before expansion. (For the degree of operating leverage, use the formula developed in footnote 2 of this chapter; for the degree of combined leverage, use the formula developed in footnote 3. These instructions apply throughout this problem.)
b. Construct the income statement for the two financial plans.
c. Calculate the degree of operating leverage, the degree of financial leverage, and the degree of combined leverage, after expansion, for the two financing plans. d. Explain which financing plan you favor and the risks involved.