d. Not only does the price of the common stock create wealth to the shareholder, which is the major objective of the financial manager, but it greatly influences the ability to finance projects at a high or low cost of capital. Cost of capital will be discussed in Chapter 10, and one will see the impact that the cost of capital has on capital budgeting decisions. 5-40
Chapter 05: Operating and Financial Leverage 26.Operating leverage and ratios (LO6)Mr. Gold is in the widget business. He currently sells 1 million widgets a year at $5 each. His variable cost to produce the widgets is $3 per unit, and he has $1,500,000 in fixed costs. His sales-to-assets ratio is five times, and 40 percent of his assets are financed with 8 percent debt, with the balance financed by common stock at $10 par value per share. The tax rate is 40 percent.His brother-in-law, Mr. Silverman, says he is doing it all wrong. By reducing his price to $4.50 a widget, he could increase his volume of units sold by 40 percent. Fixed costs would remain constant, and variable costs would remain $3 per unit. His sales-to-assets ratio would be 6.3 times. Furthermore, he could increase his debt-to-assets ratio to 50 percent, with the balance in common stock. It is assumed that the interest rate would go up by 1 percent and the price of stock would remain constant.a.Compute earnings per share under the Gold plan.b.Compute earnings per share under the Silverman plan.c.Mr. Gold's wife, the chief financial officer, does not think that fixed costs would remain constant under the Silverman plan but that they would go up by 15 percent. If this is the case, should Mr. Gold shift to the Silverman plan, based on earnings per share?5-26. Solution:
Chapter 05: Operating and Financial Leverage Interest = 8% × $400,000 = $32,000 2 Stock = 60% of $1,000,000 = $600,000 Shares = $600,000/$10 = 60,000 shares 5-26. (Continued) b. Silverman Plan Sales ($1,400,000 units at $4.50) $6,300,000 - Fixed costs 1,500,000 - Variable costs (1,400,000 units $3) 4,200,000 Operating income (EBIT) $ 600,000 - Interest 3 45,000 EBT $ 555,000 - Taxes @ 40% 222,000 EAT $ 333,000 Shares 4 50,000 Earnings Per Share $ 6.66 Sales $6,300,000 Assets $1,000,000 AssetTurnover 6.3 = = = 3 Debt = 50% of Assets = 50% × $1,000,000 = $500,000 Interest = 9% × $500,000 = $45,000 4 Stock = 50% of $1,000,000 = $500,000 Shares = $500,000/$10 = 50,000 shares 5-42
Chapter 05: Operating and Financial Leverage 5-26. (Continued) c. Silverman Plan (based on Mrs. Gold’s Assumption) Sales ($1,400,000 units at $4.50) $6,300,000 - Fixed costs ($1,500,000 1.15) 1,725,000 - Variable costs (1,400,000 units $3) 4,200,000 Operating income (EBIT) $ 375,000 - Interest 45,000 EBT $ 330,000 - Taxes @ 40% 132,000 EAT $ 198,000 Shares 50,000 Earnings Per Share $ 3.96 No! Gold should not shift to the Silverman Plan if Mrs. Gold’s assumption is correct.
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