Problem 13-12 Breakeven and leverage Wingler Communications Corporation (WCC) pr
ID: 2734604 • Letter: P
Question
Problem 13-12
Breakeven and leverage
Wingler Communications Corporation (WCC) produces premium stereo headphones that sell for $28.60 per set, and this year's sales are expected to be 440,000 units. Variable production costs for the expected sales under present production methods are estimated at $10,100,000, and fixed production (operating) costs at present are $1,560,000. WCC has $4,800,000 of debt outstanding at an interest rate of 7%. There are 240,000 shares of common stock outstanding, and there is no preferred stock. The dividend payout ratio is 70%, and WCC is in the 40% federal-plus-state tax bracket.
The company is considering investing $7,200,000 in new equipment. Sales would not increase, but variable costs per unit would decline by 20%. Also, fixed operating costs would increase from $1,560,000 to $1,800,000. WCC could raise the required capital by borrowing $7,200,000 at 10% or by selling 240,000 additional shares of common stock at $30 per share.
What would be WCC's EPS (1) under the old production process, (2) under the new process if it uses debt, and (3) under the new process if it uses common stock? Round your answers to the nearest cent.
1. $
2. $
3. $
At what unit sales level would WCC have the same EPS, assuming it undertakes the investment and finances it with debt or with stock? {Hint: V = variable cost per unit = $8,080,000/440,000, and EPS = [(PQ - VQ - F - I)(1 - T)]/N. Set EPSStock = EPSDebt and solve for Q.} Round your answer to the nearest whole.
units
At what unit sales level would EPS = 0 under the three production/financing setups - that is, under the old plan, the new plan with debt financing, and the new plan with stock financing? (Hint: Note that VOld = $10,100,000/440,000, and use the hints for Part b, setting the EPS equation equal to zero.) Round your answers to the nearest whole.
Old plan units
New plan with debt financing units
New plan with stock financing units
On the basis of the analysis in parts a through c, and given that operating leverage is lower under the new setup, which plan is the riskiest, which has the highest expected EPS, and which would you recommend? Assume here that there is a fairly high probability of sales falling as low as 250,000 units, and determine EPSDebt and EPSStock at that sales level to help assess the riskiness of the two financing plans. Round your answers to two decimal places.
EPSDebt = $
EPSStock = $
Explanation / Answer
Details Amt $ Under old system: Unit selling price 28.60 Variable cost at 440,000 units level= 10,100,000 Unit variable cost 22.95 Unit Contribution Margin at this level =(28.60-22.95)= 5.65 1 EPS calculation under old system: Units 440,000 Unit Contribution Margin 5.65 Total Contribution 2,486,000 Less Fixed cost 1,560,000 Less ,Interest@7% on $4,800,000= 336,000 Taxable Income 590,000 Tax @40% 236,000 Post Tax Income 354,000 Common stock outstanding 240,000 EPS =Post Tax Income/No of common stock= $ 1.48 2 Under new process :When debt Issued: Unit selling price 28.60 Unit variable cost (20% lower) 18.36 Unit Contribution Margin(for 440,000 units) 10.24 Total Contribution Margin(for 440,000 units) 4,504,000 Less Fixed cost 1,800,000 Interest ( 7% on 4800000 +10% on 7200000) 1,056,000 Taxable Income 1,648,000 Tax @40% 659,200 Post Tax Income 988,800 Outstanding Common Stock = 240,000 EPS =988800/240000= $ 4.12 3 Under new process :When Equity Issued: Unit selling price 28.60 Unit variable cost (20% lower) 18.36 Unit Contribution Margin(for 440,000 units) 10.24 Total Contribution Margin(for 440,000 units) 4,504,000 Less Fixed cost 1,800,000 Interest ( 7% on 4800000 ) 336,000 Taxable Income 2,368,000 Tax @40% 947,200 Post Tax Income 1,420,800 Outstanding Common Stock =(240000+240000) 480,000 EPS =1420800/480000 $ 2.96 4 Assume At unit k , EPS will be same for both options (10.24*k-1800000-1056000)*0.60/240000=(10.24*k-1800000-336000)*0.60/480000 2*(10.24*k-1800000-1056000)=(10.24*k-1800000-336000) 20.48k-3600000-2112000=10.24k-1800000-336000 10.24k=3576000 k=349219 So at unit level 349219 , the EPS would be same. 5 Assume at unit level k , EPS =0 So in Option with Debt : so, 10.24k-1800000-1056000=0 k=278906 units 6 Assume at unit level k , EPS =0 So in Option with Equity : so, 10.24k-1800000-336000=0 k=208594