"5-20. (Continued)EBIT DFL = EBIT - I $950,000 $950,000 DFL (Debt) = = =1.18x $950,000-$142,000 $808,000 $950,000 $950,000 DFL (Equity) = = =1.12x $950,000-$100,000 $850,000 $2,500,000 - $750,000 DCL (Debt) = $2,500,000- $750,000- $800,000- $142,000 $1,750,000 = = 2.17x $808,000 $2,500,000 - $750,000 DCL (Equity) = $2,500,000-- $750,000 $800,000- $100,000 $1,750,000 = = 2.06x $850,000 d. The debt financing plan provides a greater earnings per shareat the new sales level, but provides more risk because of theincreased use of debt. However, the interest coverage ratio inboth cases is certainly satisfactory and interest expense iswell protected. The crucial point is expectations for futuresales. If sales are expected to decline, the debt plan will notprovide higher EPS at sales of less than about $2 million socyclical swings in sales, earnings, and profit margins need tobe considered in choosing the financing plan.S5-28 21. Using Standard & Poor’s data or annual reports, compare the financial and operatingleverage of Exxon, Eastman Kodak, and Delta Airlines for the most current year. Explainthe relationship between operating and financial leverage for each company and theresultant combined leverage. What accounts for the differences in leverage of thesecompanies?5-21. Solution:The results for this problem change every year. This is primarilya library assignment to facilitate class discussion.22. Dickinson Company has $12 million in assets. Currently half of these assets are financedwith long-term debt at 10 percent and half with common stock having a par value of $8.Ms. Smith, vice-president of finance, wishes to analyze two refinancing plans, one withmore debt (D) and one with more equity (E). The company earns a return on assets beforeinterest and taxes of 10 percent. The tax rate is 45 percent.Under Plan D, a $3 million long-term bond would be sold at an interest rate of12 percent and 375,000 shares of stock would be purchased in the market at $8 per shareand retired.Under Plan E, 375,000 shares of stock would be sold at $8 per share and the $3,000,000in proceeds would be used to reduce long-term debt. a. How would each of these plans affect earnings per share? Consider the current planand the two new plans. b. Which plan would be most favorable if return on assets fell to 5 percent? Increased to15 percent? Consider the current plan and the two new plans. c. If the market price for common stock rose to $12 before the restructuring, which planwould then be most attractive? Continue to assume that $3 million in debt will beused to retire stock in Plan D and $3 million of new equity will be sold to retire debtin Plan E. Also assume for calculations in part c that return on assets is 10 percent.S5-29 5-22. Solution:Dickinson CompanyIncome Statementsa. Return on assets = 10% EBIT = $ 1,200,000 Current Plan D Plan EEBIT $1,200,000 $1,200,000 $1,200,0001 2 3 Less: Interest 600,000960,000300,000EBT 600,000 240,000 900,000Less: Taxes (45%) 270,000108,000405,000EAT 330,000132,000495,0004 Common shares 750,000 375,000 1,125,000EPS $.44 $ .35 $ .441$6,000,000 debt @ 10%2$600,000 interest + ($3,000,000 debt @ 12%)3($6,000,000 – $3,000,000 debt retired) × 10%4($6,000,000 common equity)/($8 par value) = 750,000sharesPlan E and the original plan provide the same earnings pershare because the cost of debt at 10 percent is equal to theoperating return on assets of 10 percent. With Plan D, thecost of increased debt rises to 12 percent, and the firm incursnegative leverage reducing EPS and also increasing thefinancial risk to Dickinson.S5-30 5-22. (Continued)b. Return on assets = 5% EBIT = $600,000Current Plan D Plan EEBIT $600,000 $600,000 $ 600,000Less: Interest 600,000 960,000 300,000EBT 0(360,000) 300,000Less: Taxes @ 45% ---(162,000) 135,000EAT0 $(198,000) $ 165,000Common shares 750,000 375,000 1,125,000EPS 0 $(.53) $ .15Return on assets = 15% EBIT = $1,800,000Current Plan D Plan EEBIT $1,800,000 $1,800,000 $1,800,000Less: Interest600,000960,000300,000EBT 1,200,000 840,000 1,500,000Less: Taxes @45% 540,000 378,000675,000EAT $660,000 $462,000 $ 825,000Common shares 750,000 375,000 1,125,000EPS $.88 $1.23 $ .73If the return on assets decreases to 5%, Plan E provides thebest EPS, and at 15% return, Plan D provides the best EPS.Plan D is still risky, having an interest coverage ratio of lessthan 2.0.S5-31 5-22. (Continued)c. Return on Assets = 10% EBIT = $1,200,000Current Plan D Plan EEBIT $1,200,000 $1,200,000 $1,200,000EAT330,000132,000495,0001 2 Common shares 750,000 500,000 1,000,000EPS $ .44 $ .26 $ .501750,000 – ($3,000,000/$12 per share) = 750,000 – 250,000 = 500,000 shares2750,000 + ($3,000,000/$12 per share) = 750,000 + 250,000 = 1,000,000 sharesAs the price of the common stock increases, Plan E becomesmore attractive because fewer shares can be retired underPlan D and, by the same logic, fewer shares need to be soldunder Plan E.23. Johnson Grass and Garden Centers has $20 million in assets, 75 percent financed by debtand 25 percent financed by common stock. The interest rate on the debt is 12 percent andthe par value of the stock is $10 per share. President Johnson is considering two financingplans for an expansion to $30 million in assets.Under Plan A, the debt-to-total-assets ratio will be maintained, but new debt will cost awhopping 15 percent! New stock will be sold at $10 per share. Under Plan B, only newcommon stock at $10 per share will be issued. The tax rate is 40 percent. a. If EBIT is 12 percent on total assets, compute earnings per share (EPS) before theexpansion and under the two alternatives. b. What is the degree of financial leverage under each of the three plans? c. If stock could be sold at $20 per share due to increased expectations for the firm’ssales and earnings, what impact would this have on earnings per share for the twoexpansion alternatives? Compute earnings per share for each. d. Explain why corporate financial officers are concerned about their stock values!S5-32 "