Problem 5-25 Leverage and sensitivity analysis [LO6] The Lopez-Portillo Company
ID: 2732586 • Letter: P
Question
Problem 5-25 Leverage and sensitivity analysis [LO6]
The Lopez-Portillo Company has $11.6 million in assets, 60 percent financed by debt, and 40 percent financed by common stock. The interest rate on the debt is 14 percent and the par value of the stock is $10 per share. President Lopez-Portillo is considering two financing plans for an expansion to $23 million in assets. Under Plan A, the debt-to-total-assets ratio will be maintained, but new debt will cost a whopping 17 percent! Under Plan B, only new common stock at $10 per share will be issued. The tax rate is 30 percent.
a. If EBIT is 11 percent on total assets, compute earnings per share (EPS) before the expansion and under the two alternatives. (Round your answers to 2 decimal places.) Earnings Per Share
Current $
Plan A $
Plan B $
b. What is the degree of financial leverage under each of the three plans? (Round your answers to 2 decimal places.)
Degree Of Financial Leverage
Current
Plan A
Plan B
c. If stock could be sold at $20 per share due to increased expectations for the firm’s sales and earnings, what impact would this have on earnings per share for the two expansion alternatives? Compute earnings per share for each. (Round your answers to 2 decimal places.)
Earnings Per Share
Plan A $
Plan B $
Explanation / Answer
a. Return on asset=11%
a. 11600000×.40×.14=974400
b. 974400+(11400000×.60×.17)=2137200
c. ( 11600000×.40)/10=464000 shares
d. 464000+(11.4m×.40)/10=920000 shares
e. 464000+(11.4m/10)=1604000 shares
b.degree of financial leverage=EBIT/(EBIT-Interest)
Current=4.23
Plan a=6.44
Plan b=1.63
C.
* 464000+(11400000×.40)/20=692000 shares
** 464000+(11400000/20)=1034000 shares
Current plan a plan b EBIT 1,276,000 2,530,000 2,530,000 Less interest 974400(a) 2137200(b) 974400 EBT 301600 392800 1555600 Less tax (30%) 90480 1178480 466680 EAT 211120 274960 1088920 Common share 464000(c) 920000(d) 1604000(e) EPS(EAT/no.of common shares) .455 .299 .679