Chapter 2: Q25BP-a (page 152)

The Lopez-Portillo Company has $10.6 million in assets, 80 percent financed by debt and 20 percent financed by common stock. The interest rate on the debt is 9 percent and the par value of the stock is $10 per share. President Lopez-Portillo is considering two financing plans for an expansion to $18 million in assets.
Under Plan A, the debt-to-total-assets ratio will be maintained, but new debt
will cost a whopping 12 percent! Under Plan B, only new common stock at $10
per share will be issued. The tax rate is 40 percent.
a. If EBIT is 9 percent on total assets, compute earnings per share (EPS) before
the expansion and under the two alternatives.

Short Answer

Expert verified

The EPS of the company before expansion under the current plan is $0.54, under plan A is $0.244 and under plan B is $0.54.

Step by step solution

Number of shares under the current plan

Total Assets	$10,600,000
Equity = 20% of total assets	$2,120,000 ($10,600,000 x 20%)
No. of shares (Equity/Par value)	212,000 ($2,120,000/$10)

Number of shares under plan A

Total Assets	$18,000,000
Equity = 20% of total assets	$3,600,000 ($18,000,000 x 20%)
No. of shares (Equity/Par value)	360,000 ($3,600,000/$10)

Number of shares under plan B

Total Assets	$18,000,000
Equity (Equity under current plan)	$2,120,000 ($10,600,000 x 20%)
Add: Additional equity issued ($18,000,000-$10,600,000)	$7,400,000
Balance equity	$9,520,000
No. of shares (Equity/Par value)	952,000 ($9,520,000/$10)

EBIT under current plan

$\begin{array}{rcl} EBIT & = & Totalassets \times Returnonassets \\ = & $ 10, 600, 000 \times 9 % \\ = & $ 954, 000 \end{array}$

EBIT under Plan A & B

$\begin{array}{rcl} EBIT & = & Totalassets \times Returnonassets \\ = & $ 18, 000, 000 \times 9 % \\ = & $ 1, 620, 000 \end{array}$

Interest expense under current plan

$\begin{array}{rcl} Interest & = & Longtermdebt \times Interestrate \\ = & ($ 10, 600, 000 \times 0.80) \times 9 % \\ = & $ 763, 200 \end{array}$

Interest expense under plan A

$\begin{array}{rcl} Interest & = & (ExistingLongtermdebt \times Interestrate) + (Newlongtermbondissue \times Interestrate) \\ = & ($ 8, 480, 000 \times 9 %) + ($ 5, 920, 000 \times 12 %) \\ = & $ 1, 473, 600 \end{array}$

Interest expense under plan B

$\begin{array}{rcl} Interest & = & Longtermdebt \times Interestrate \\ = & ($ 10, 600, 000 \times 0.80) \times 9 % \\ = & $ 763, 200 \end{array}$

Calculation of EPS

Particulars	Current Plan	Plan A	Plan B
EBIT	954,000	1,620,000	1,620,000
Less: Interest	763,200	1,473,600	763,200
EBT	190,800	146,400	856,800
Less: Tax @40%	76,320	58,560	342,720
Net Income (A)	114,480	87,840	514,080
No. of shares (B)	212,000	360,000	952,000
EPS (A/B)	0.54	0.244	0.54

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Stud Clothier
Balance sheet 20X1
Assets		Liabilities and Equity
Cash	\)60,000	Account payable	\(220,000
Account receivable	240,000	Accrued taxes	30,000
Inventory	350,000	Bonds payable (long term)	150,000
Plant and equipment	410,000	Common stock	80,000
		Paid in capital	200,000
		Retained earnings	380,000
Total assets	\)1,060,000	Total LIbilities and Equity	$1,060,000

Stud Clothier
Balance sheet 20X1
Assets		Liabilities and Equity
Cash	\)60,000	Account payable	\(220,000
Account receivable	240,000	Accrued taxes	30,000
Inventory	350,000	Bonds payable (long term)	150,000
Plant and equipment	410,000	Common stock	80,000
		Paid in capital	200,000
		Retained earnings	380,000
Total assets	\)1,060,000	Total LIbilities and Equity	$1,060,000

	20X1	20X2
Sales	\(3,230,000	\)3,370,000
Cost of goods sold	2,130,000	2,850,000
Gross profits	\(1,100,000	\)520,000
Selling and administrative expenses	298,000	227,000
Operating profits	\(802,000	\)293,000
Interest expense	47,200	51,600
Income before taxes	\(754,800	\)241,400
Taxes (35%)	264,180	84,490
Income after tax	\(490,620	\)156,910

Short Answer

Step by step solution

Number of shares under the current plan

Number of shares under plan A

Number of shares under plan B

EBIT under current plan

EBIT under Plan A & B

Interest expense under current plan

Interest expense under plan A

Interest expense under plan B

Calculation of EPS

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