Mr. Gold is in the widget business. He currently sells 1 million widgets a year

Question

Mr. Gold is in the widget business. He currently sells 1 million widgets a year at $5 each. His variable cost to produce the widgets is $3 per unit, and he has $1,500,000 in fixed costs. His sales-to-assets ratio is five times, and 40 percent of his assets are financed with 8 percent debt, with the balance financed by common stock at $10 par value per share. The tax rate is 40 percent. His brother-in-law, Mr. Silverman, says he is doing it all wrong. By reducing his price to $4.50 a widget, he could increase his volume of units sold by 40

Explanation / Answer

Sales = $5,000,000 Assets (at 5:1) = $1,000,000 Bonds (40%) = $400,000 Stock = $600,000 = 60,000 shares Contribution margin (at $2 per widget) = $2,000,000 Fixed cost = $1,500,000 EARNINGS BEFORE INTEREST + TAXES (EBIT) = $500,000 Bond payments (8%) = $32,000 Taxes = ($500,000 - $32,000) * 0.40 = $187,200 NET INCOME = $280,800 EARNINGS PER SHARE = $280,800/60,000 shares = $4.68

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