Problem 1 (36 marks) Rosebush Flowers Inc. operates a number of flower shops in

Question

Problem 1 (36 marks) Rosebush Flowers Inc. operates a number of flower shops in Halifax. The firm is considering an expansion project in Dartmouth Crossing. Below is their most recent set of financial statements. Rosebush Flowers Inc. Balance Sheet Assets Cash A/R Inventory Liabilities $69,921 Accounts Payable $52,818 Accrued Liabilities $31,333 $18,667 $137,661 Long Term Debt (8% coupon,semiannual pmts $100,000 Net Property, Plant and Equipemen $139,600 $1000 par, 15 years to maturity) Preferred Shares (Par $50, dividend 7%) $50,000 Common Stock (44,000 shares outstanding)$100,000 $100,000 Retained Earnings Total Assets $400,000 Total Liabilities&Owers; Equity $400,000 Rosebush Flowers Inc. Income Statement Sales Cost of Goods Sold Gross Margin $739,100 $245·00 $494,100 $320,000 $6.000 Fixed Costs Depreciation Earnings before interest and taxes Interest Earnings before taxes Taxes (35%) Net Income $168,100 $8.000 $160,100 $56.035 $104,065 Dividends -Preferred $3,500

Explanation / Answer

a) Degree of operating leverage = Contribution Margin/EBIT = 494100/168100 = 2.94 [Gross margin is taken as Contribution margin) b) Degree of Financial leverage with preference dividend = EBIT/[EBIT-Interest-((Preferred dividend/(1-t))] = 168100/(160100-8000-3500/0.65) = 1.15 c) Increase in EPS = Increase in sales*Degree of combined leverage Degree of combined leverage=Degree of operating leverage*Degree of financial leverage. Therefore, % increase in EPS for 15% increase in sales = 0.15*2.94*1.15= 50.72% d) i) EPS under Option 1: = [(EBIT-8000-250000*9.5%)*(1-0.35)-3500]/44000 EPS under Option 2: = [(EBIT-8000)*(1-0.35)-3500]/(44000+250000/10) If the EPS is the same the above two equations should be eaual. [(EBIT-31750)*0.65-3500]/44000 = [(EBIT-8000)*0.65-3500]/69000 Solving for EBIT 69*(0.65EBIT-20637.5-3500)=44*(0.65EBIT-5200-3500) 44.85EBIT-1665487.5=28.6EBIT-382800 16.25EBIT = 1282687.50 EBIT = $88,411.54 (Answer) ii) Option 1 Option 2 EBIT $ 78,934.62 $    78,934.62 Interest [8000+250000*9.5% for Option 1 and 8000 for Option 2] $ 31,750.00 $      8,000.00 EBT $ 47,184.62 $    70,934.62 Tax at 35% $ 16,514.62 $    24,827.12 EAT $ 30,670.00 $    46,107.50 Preference dividend $    3,500.00 $      3,500.00 NI available for common shareholders $ 27,170.00 $    42,607.50 # of common shares outstanding $ 44,000.00 $    69,000.00 EPS $            0.62 $               0.62 Answer iii) If expected level of EBIT is more than the indifference level of EBIT of $78934.62, then higher financial leverage would magnify EPS more. Hence, the Option 1 of using more debt is preferable. iv) It should not be unconditionally selected. The impact of the higher risk due to higher debt content on the price should be considered. Due to higher risk the P/E ratio may go down, which has to be considered.

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