Question

The Lopez-Portillo Company has $10 million in assets, 80 percent financed by debt and 20 percent financed by common stock. The interest rate on the debt is 15 percent, and the stock book value is $10 per share. President Lopez-Portillo is considering two financing plans for an expansion to $15 million in assets. Under Plan A, the debt-to-total-assets ratio will be maintained, but new debt will cost 18 percent! New stock will be sold at $10 per share. Under Plan B, only new common stock at $10 per share will be issued. The tax rate is 40 percent.

a. If EBIT is 15 percent on total assets, compute earnings per share (EPS) before the expansion (current) and under the two alternatives after expansion. (Round the final answers to 2 decimal places.) EPS Current $ Plan A $ Plan B $
b. What is the DFL under each of the three plans? (Round the final answers to 2 decimal places.) DFL Current X Plan A X Plan B X
c. Using the formula provided in the chapter, calculate the EBIT/EPS indifference point between Plan A and Plan B. (Enter the answers in dollars not in millions.) EBIT $
d. If shares could be sold at $20 each due to increased expectations for the firm’s sales and earnings, what impact would this have on EPS for the two expansion alternatives? Compute EPS for each. (Round the final answers to 2 decimal places.) EPS Plan A Shares $ Plan B Shares $ e. Calculate the EBIT/EPS indifference point at the new share price. (Enter the answers in dollars not in millions.) EBIT $

Answer 1

The current EPS is $0.15 and under Plan A it is $0.135, while it remains $0.15 under Plan B. The DFL is 1.5 for the current plan, 1.38 for Plan A, and 1 for Plan B. The EBIT/EPS indifference point between Plan A and Plan B is $0.14 million. If the shares are sold at $20 each, the EPS for Plan A would be $0.09, and for Plan B it would be $0.15.

Step-by-step explanation:

The calculation of earnings per share (EPS), degree of financial leverage (DFL), and the EBIT/EPS indifference point are fundamental to comparing different financing plans for a company's expansion. In the given scenario, Lopez-Portillo Company is considering two different financing plans to expand its assets. Plan A involves maintaining the debt-to-total-assets ratio while incurring higher interest rates and issuing new stock at the original price. Plan B focuses solely on issuing new common stock. These financial metrics help assess the impact of financing decisions on a company's profitability and financial risk.

a. EPS Current: $0.15, Plan A: $0.135, Plan B: $0.15

b. DFL Current: 1.5, Plan A: 1.38, Plan B: 1

c. EBIT/EPS indifference point between Plan A and Plan B: $0.14 million

d. EPS Plan A Shares: $0.09, Plan B Shares: $0.15

e. EBIT/EPS indifference point at the new share price: $0.1667 million