Using the financial statements above, determine the following: a)Rosebush’scurre
ID: 2787523 • Letter: U
Question
Using the financial statements above, determine the following:
a)Rosebush’scurrent degree of operating leverage (DOL).
b)Rosebush’s current degree of financial leverage (DFL).
c)The impact of a 15%decrease in sales would have on EPS(in %).
Show your work.
d)Rosebush is considering expanding at a cost of $250,000. In order to finance the expansion, Rosebush has been presented with the following options:
Option #1: Finance the $250,000expansion with new bonds. The bonds will have a call feature so will be riskier than the company’s current debt; they will have a coupon rate of 9.5%.
Option #2: Finance the $250,000expansion with new common shares at $10 per share.
i.Calculate the level of EBIT that will produce the same EPS under both plans.
ii.What level of EPS corresponds to this level of EBIT.
iii.If EBIT is expected to be $175,000, which plan would maximize EPS? Explain. iv.Should the plan selected in part (iii) be unconditionally chose nor should other factors be considered in selecting the financing option? Explain.
Rosebush Flowers Inc. Balance Sheet Liabilities Assets Cash A/R Invento $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 Equipemer $139,600 $1000 par, 15 years to maturity) Preferred Shares (Par $50, dividend 7%) $50,000 Common Stock (44,000 shares outstanding) Retained Earnings $100,000 $100,000 Total Assets $400,000 Total Liabilities & Owers Equit $400,000 Rosebush Flowers Inc. Income Statement Sales Cost of Goods Sold Gross Margin $739,100 $494,100 Fixed Costs Depreciation Earnings before interest and taxes Interest Earnings before taxes Taxes (35%) Net Income $320,000 $6,000 $168,100 $8,000 $160,100 $56,035 $104,065 Dividends -Preferred $3,500Explanation / Answer
a) Degree of operating Leverage = Contribution / EBIT = $494,100 / $168,100 = 2.94
b) Degree of Financial Leverage = EBIT / EBT = $168,100 / $160,100 = 1.05
c)
Current EPS = (104,065 - 3,500) / 44,000 = $2.29 per share
Decrease in EPS = (2.29 - 0.65) / 2.29 = 71.62%
d) i. For both the options to be indifferent -
EPS under option 1 = EPS under Option 2
Now, Equalising both EPS's, we have -
(0.65 EBIT - 24137.50) / 44000 = (0.65 EBIT - 8700) / 69000
Or, (0.65 EBIT - 24137.50) x 69000 = (0.65 EBIT - 8700) x 44000
Or, EBIT = 78,934.6153846 or $78,934.62
ii. Put the above calculated EBIT under any option and calculate the EPS. As this is indifference point, the answer would be same in botht the situations -
EPS = (0.65 x 78,934.62 - 8700) / 69000 = 0.62
iii. If EBIT is expected to be $175,000, i.e., more than the indifference point, then EPS will be maximum under Option 1 or bond option. This is because the denominator under option 1, i.e, no. of shares is less than the denominator under option 2. Less no of share and more earnings equals more earnings per share for the shareholders.
EPS (Option 1) = (0.65 x 175000 - 24137.50) / 44000 = 2.04
EPS (Option 2) = (0.65 x 175000 - 8700) / 69000 = 1.52
iv. The company should not decide unconditionally. It should also check whether it will able to pay the high amounts of interest and principal payments from its earnings in its future. In case not, this may lead to non-payment and in turn bankruptcy. The company should also decide how much leverage is adequate for the firm to provide an adequate return on investments made.
EPS if Sales decreases by 15% Particulars If sales decrease($) Sales (739,100 - 15%) 628,235 Less: Cost of goods Sold 245,000 Contribution / Gross Margin 383,235 Less: Fixed Cost 320,000 Less: Depreciation 6,000 EBIT 57,235 Less: Interest 8,000 EBT 49,235 Less: Tax @35% 17,232.25 Net Income 32,002.75 Less: Preferred Dividend 3,500 Earnings available to equity shareholders 28,502.75 No. of equity share outstanding 44,000 EPS 0.65Related Questions
Navigate
Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.