Problem:
Drake 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:
Drake 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%.
Q1. Calculate the degree of operating leverage, the degree of financial leverage, and the degree of combined leverage, before expansion.
Q2. Construct the income statement for the two financial plans.
Q3. Calculate the degree of operating leverage, the degree of financial leverage, and the degree of combined leverage, after expansion, for the two financing plans.
Q4. Explain which financing plan you favor and the risks involved.