Wingler Communications Corporation (WCC) produces premium stereo headphones that

Question

Wingler Communications Corporation (WCC) produces premium stereo headphones that sell for $29.00 per set, and this year's sales are expected to be 460,000 units. Variable production costs for the expected sales under present production methods are estimated at $10,500,000, 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.

Explanation / Answer

Variable cost / unit = 10,500,000 / 460,000 = $ 22.83 / unit

1. 1. Under the old production process, net income = (sales - variable costs - fixed costs - debt*interest rate)*(1-tax rate) = (460,000*29-10,500,000-1,560,000-4,800,000*7%)*(1-40%) = 566,400

EPS = net income / total shares = 566,400 / 240,000 = 2.36

1. 2. Under the new production process with debt, new variable cost / unit = old variable cost / unit *(1-20%) = 22.83*(1-20%) = 18.26

Net income = (sales - variable costs - fixed costs - debt 1*interest rate 1 - debt 2*interest rate 2)*(1-tax rate) = (460,000*29-460,000*18.26-1,800,000-4,800,000*7%-7,200,000*10%)*(1-40%) = 1,250,400

New EPS under debt = net income / total shares = 1,250,400 / 240,000 = 5.21

1. 3. Under the new production process with equity, net income = (sales - variable costs - fixed costs - debt*interest rate)*(1-tax rate) = (460,000*29-460,000*18.26-1,800,000-4,800,000*7%)*(1-40%) = 1,682,400

New EPS under stock = net income / total shares = 1,682,400 / (240,000+240,000) = 3.51

2. Assuming the sales units sold = Q, then EPS 1 under debt = ((29-18.26)*Q - 1,800,000 - 4,800,000*7% - 7,200,000*10%) *(1-40%) / 240,000 = (10.74Q - 2,856,000) *0.6 / 240,000

EPS 2 under debt = ((29-18.26)*Q - 1,800,000 - 4,800,000*8%) * (1-40%) / 480,000 = (10.74Q - 2,136,000) *0.6 / 480,000

Equating the 2 EPS, we get (10.74Q - 2,856,000) *0.6 / 240,000 = (10.74Q - 2,136,000) *0.6 / 480,000

Or 2*(10.74Q - 2,856,000) = (10.74Q - 2,136,000)

Solving, we get Q = 332,988 units

3. Under old process, EPS=0 when sales - variable cost = fixed cost + debt * interest rate

Or Q*(29-22.83) = 1,560,000+4,800,000*7% = 1,896,000

Solving, we get Q = 307,099 units (old plan)

Under new process with debt financing, Q*(29-18.26) = 1,800,000+4,800,000*7%+7,200,000*10% = 2,856,000

Solving, we get Q = 265,943 units (new plan with debt)

Under new process with stock financing, Q*(29-18.26) = 1,800,000+4,800,000*7% = 2,136,000

Solving, we get Q = 198,899 units (new plan with stock)

4. As sales may fall to 250,000 units which is below breakeven EPS of 265,943 units under the debt financing plan, this debt financing plan would be the riskiest plan. This is also the plan with the highest EPS. However we should recommend the plan with stock financing as its EPS will be positive under 250,000 units and will also be higher than the current no-financing situation.

Under 250,000 units sales, EPS debt = (250,000*29-250,000*18.26-1,800,000-4,800,000*7%-7,200,000*10%)*(1-40%)/240,000 = -0.43

Under 250,000 units sales, EPS stock = (250,000*29-250,000*18.26-1,800,000-4,800,000*7%)*(1-40%)/480,000 = 0.69

Hope this helped ! Let me know in case of any queries.

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