"5-23. Solution:Johnson Grass and Garden Centersa. Return on Assets = 12% Current Plan A Plan BEBIT $2,400,000 $3,600,000 $3,600,0001 3 5 Less: Interest 1,800,0002,925,0001,200,000EBT 600,000 675,000 1,800,000Less: Taxes @240,000 270,000720,00040%EAT $360,000 $405,000 $1,080,000Common 2 4 6 500,000 750,000 1,500,000 sharesEPS $.72 $.54 $ .721(75% × $20,000,000)× 12% = $15,000,000 × 12% = $1,800,0002(25% × $20,000,000)/$10 = $5,000,000/$10 = 500,000 shares3$1,800,000 (current) + (75% × $10,000,000) × 15% = $1,800,000 + $1,125,000 = $2,925,0004500,000 shares (current) + (25% × $10,000,000)/$10 = 500,000 + 250,000 = 750,000 shares5unchanged6500,000 shares (current) + $ 10,000,000/$10 =500,000 + 1,000,000 = 1,500,000 sharesS5-33 5-23. (Continued)EBIT DFL = b.EBIT - I $2,400,000 DFL (Current) = = 4.00x $2,400,000 - $1,800,000 $3,600,000 DFL (Plan A) = = 5.33x $3,600,000 - $2,925,000 $3,600,000 DFL (Plan B) = = 2x $3,600,000 - $1,800,000 c. Plan A Plan B EAT $405,000 $1,080,0001 2Common Shares 625,000 1,000,000 EPS $.65 $1.081500,000 shares (current) + (25% × $10,000,000)/$20 = 500,000 + 125,000 = 625,000 shares2500,000 shares (current) + $10,000,000/$20 = 500,000 + 500,000 = 1,000,000 sharesPlan B would continue to provide the higher earnings pershare than Plan A. The difference between plans A and B iseven greater than that indicated in part (a).d. Not only does the price of the common stock create wealth tothe shareholder, which is the major objective of the financialmanager, but it greatly influences the ability to raise capitalto finance projects at a high or low cost. Cost of capital willbe discussed in Chapter 10, and one will see the impact thatthe cost of capital has on capital budgeting decisions.S5-34 24. Mr. Katz is in the widget business. He currently sells 2 million widgets a year at $4 each. Hisvariable cost to produce the widgets is $3 per unit, and he has $1,500,000 in fixed costs. Hissales-to-assets ratio is four times, and 40 percent of his assets are financed with 9 percent debt,with the balance financed by common stock at $10 per share. The tax rate is 30 percent.His brother-in-law, Mr. Doberman, says Mr. Katz is doing it all wrong. By reducing hisprice to $3.75 a widget, he could increase his volume of units sold by 40 percent. Fixedcosts would remain constant, and variable costs would remain $3 per unit. His sales-to- assets ratio would be 5 times. Furthermore, he could increase his debt-to-assets ratio to 50percent, with the balance in common stock. It is assumed that the interest rate would go upby 1 percent and the price of stock would remain constant. a. Compute earnings per share under the Katz plan. b. Compute earnings per share under the Doberman plan. c. Mr. Katz’s wife does not think that fixed costs would remain constant under theDoberman plan but that they would go up by 20 percent. If this is the case, should Mr.Katz shift to the Doberman plan, based on earnings per share?5-24. Solution:Katz-Dobermana. Katz PlanSales ($2,000,000 units × $4) .....................$8,000,000–Fixed costs ................................................–1,500,000–Variable costs (2,000,000 units × $3) .......–6,000,000Operating income (EBIT) ...........................$500,0001 –Interest .....................................................72,000EBT .............................................................$428,000–Taxes @ 30% ............................................128,400EAT .............................................................$ 299,6002 ......................................................................................Shares 120,000Earnings Per Share ......................................$ 2.50Sales $8,000,000 Assets = = =$2,000,000Asset Turnover 4 1Debt = 40% of Assets40% × $2,000,000 = $800,000Interest = 9% × $800,000 = $72,0002Stock = 60% of $2,000,000 = $1,200,000Shares = $1,200,000/$10 = 120,000S5-35 5-24. (Continued)b. Doberman PlanSales ($2,800,000 units at $3.75) .............$10,500,000–Fixed costs ..............................................1,500,000–Variable costs (2,800,000 units × $3) .....8,400,000Operating income (EBIT) .........................$600,0003 ..............................................................................–Interest 105,000EBT ...........................................................$495,000–Taxes @ 30% ..........................................148,500EAT ...........................................................$346,5004 ...................................................................................Shares 105,000Earnings Per Share ....................................$3.30Sales $10,500,000 Assets = = =$2,100,000Asset Turnover 5 3Debt = 50% of Assets50% × $2,100,000 = $1,050,000Interest = 10% × $1,050,000 = $105,0004Stock = 50% of $2,100,000 = $1,050,000Shares = $1,050,000/$10 = 105,000c. Doberman Plan (based on Mrs. Katz’s Assumption)Sales ..........................................................$10,500,000–Fixed costs ($1,500,000 × 1.20) .............1,800,000–Variable costs ..........................................8,400,000Operating income (EBIT) .........................$ 300,000–Interest ..................................................... 105,000EBT ...........................................................$195,000–Taxes @ 30% ..........................................58,500EAT ...........................................................$136,500Shares ........................................................105,000Earnings Per Share ....................................$1.30No! Mr. Katz should not shift to the Doberman plan if Mrs.Katz’s assumption is correct.S5-36 25. Highland Cable Company is considering an expansion of its facilities. Its current incomestatement is as follows:Sales .............................................................................................. $4,000,000 Less: Variable expense (50% of sales)....................................... 2,000,000 Fixed expense ................................................................... 1,500,000Earnings before interest and taxes (EBIT) .................................... 500,000Interest (10% cost) ........................................................................ 140,000Earnings before taxes (EBT) ......................................................... 360,000Tax (30%)...................................................................................... 108,000Earnings after taxes (EAT)............................................................ $252,000Shares of common stock ............................................................... 200,000Earnings per share ......................................................................... $1.26Highland Cable Company is currently financed with 50 percent debt and 50 percentequity (common stock, par value of $10). To expand the facilities, Mr. Highland estimatesa need for $2 million in additional financing. His investment banker has laid out three plansfor him to consider: 1. Sell $2 million of debt at 13 percent. 2. Sell $2 million of common stock at $20 per share. 3. Sell $1 million of debt at 12 percent and $1 million of common stock at $25 pershare.Variable costs are expected to stay at 50 percent of sales, while fixed expenses willincrease to $1,900,000 per year. Mr. Highland is not sure how much this expansion willadd to sales, but he estimates that sales will rise by $1 million per year for the next fiveyears.Mr. Highland is interested in a thorough analysis of his expansion plans and methods offinancing. He would like you to analyze the following: a. The break-even point for operating expenses before and after expansion (in salesdollars). b. The degree of operating leverage before and after expansion. Assume sales of$4 million before expansion and $5 million after expansion. Use the formula infootnote 2. c. The degree of financial leverage before expansion at sales of $4 million and for allthree methods of financing after expansion. Assume sales of $5 million for the secondpart of this question. d. Compute EPS under all three methods of financing the expansion at $5 million insales (first year) and $9 million in sales (last year). e. What can we learn from the answer to part d about the advisability of the threemethods of financing the expansion?S5-37 "