16. In Problem 15, compute the stock price for Hall Pharmaceuticals if it sells at 13 times earnings per share and EBIT is $80,000.

17. Pulp Paper Company and Holt Paper Company are each able to generate earnings before interest and taxes of $150,000.
The separate capital structures for Pulp and Holt are shown below:
Pulp Holt
Debt @ 10% $ 800,000 Debt @ 10% $ 400,000
Common stock, $5 par 700,000 Common stock, $5, par 1,100,000
Total $1,500,000 Total $1,500,000
Common shares 140,000 Common shares 220,000
a. Compute earnings per share for both firms. Assume a 40 percent tax rate.
b. In part a, you should have the same answer for both companies' earnings per share. Assuming a P/E ratio of 20 for each company, what would each company's stock price be?
c. Now as part of your analysis, assume the P/E ratio would be 15 for the riskier company in terms of heavy debt utilization in the capital structure and 26 for the less risky company. What would the stock prices for the two firms be under these assumptions? (Note: Although interest rates also would likely be different based on risk, we hold them constant for ease of analysis).
d. Based on the evidence in part c, should management only be concerned about the impact of financing plans on earnings per share or should stockholders' wealth maximization (stock price) be considered as well?

18. Firms in Japan often employ both high operating and financial leverage because of the use of modern technology and close borrower-lender relationships. Assume the Susaki Company has a sales volume of 100,000 units at a price of $25 per unit; variable costs are $5 per unit and fixed costs are $1,500,000. Interest expense is $250,000. What is the degree of combined leverage for this Japanese firm?

19. Glynn Enterprises and Monroe, Inc., both produce fluid control products. Their financial information is as follows:
Capital Structure
Glynn Monroe
Debt @ 10% $ 1,500,000 0
Common stock, $10 per share 500,000 $2,000,000
$ 2,000,000 $2,000,000
Common shares 50,000 200,000
Operating Plan
Sales (200,000 units at $5 each) $ 1,000,000 $ 1,000,000
Less: Variable costs 600,000 200,000
($3 per unit) ($1 per unit)
Fixed costs 0 400,000
Earnings before interest and taxes (EBIT) $ 400,000 $ 400,000
a. If you combine Glynn's capital structure with Monroe's operating plan, what is the degree of combined leverage?
b. If you combine Monroe's capital structure with Glynn's operating plan, what is the degree of combined leverage?
c. Explain why you got the results you did in parts a and b.
d. In part b, if sales double, by what percent will EPS increase?.

20. DeSoto Tools, Inc., is planning to expand production. The expansion will cost $300,000, which can be financed either by bonds at an interest rate of 14 percent or by selling 10,000 shares of common stock at $30 per share. The current income statement before expansion is as follows:
DESOTO TOOLS, INC.
Income Statement
200X
Sales $1,500,000
Less: Variable costs $450,000
Fixed costs 550,000 1,000,000
Earnings before interest and taxes 500,000
Less: Interest expense 100,000
Earnings before taxes 400,000
Less: Taxes @ 34% 136,000
Earnings after taxes $ 264,000
Shares 100,000
Earnings per share $ 2.64
After the expansion, sales are expected to increase by $1,000,000. Variable costs will remain at 30 percent of sales, and fixed costs will increase to $800,000. The tax rate is 34 percent.
a. Calculate the degree of operating leverage, the degree of financial leverage, and the degree of combined leverage before expansion. (For the degree of operating leverage, use the formula developed in footnote 2; for the degree of combined leverage, use the formula developed in footnote 3. These instructions apply throughout this problem.)
b. Construct the income statement for the two alternative financing plans.
c. Calculate the degree of operating leverage, the degree of financial leverage, and the degree of combined leverage, after expansion.
d. Explain which financing plan you favor and the risks involved with each plan.

21. Using Standard & Poor's data or annual reports, compare the financial and operating leverage of Exxon, Eastman Kodak, and Delta Airlines for the most current year. Explain the relationship between operating and financial leverage for each company and the resultant combined leverage. What accounts for the differences in leverage of these companies?

22. Dickinson Company has $12 million in assets. Currently half of these assets are financed with long-term debt at 10 percent and half with common stock having a par value of $8. Ms. Smith, vice-president of finance, wishes to analyze two refinancing plans, one with more debt (D) and one with more equity (E). The company earns a return on assets before interest and taxes of 10 percent. The tax rate is 45 percent.
Under Plan D, a $3 million long-term bond would be sold at an interest rate of 12 percent and 375,000 shares of stock would be purchased in the market at $8 per share and retired.
Under Plan E, 375,000 shares of stock would be sold at $8 per share and the $3,000,000 in proceeds would be used to reduce long-term debt.
a. How would each of these plans affect earnings per share? Consider the current plan and the two new plans.
b. Which plan would be most favorable if return on assets fell to 5 percent? Increased to 15 percent? Consider the current plan and the two new plans.
c. If the market price for common stock rose to $12 before the restructuring, which plan would then be most attractive? Continue to assume that $3 million in debt will be used to retire stock in Plan D and $3 million of new equity will be sold to retire debt in Plan E. Also assume for calculations in part c that return on assets is 10 percent.

23. Johnson Grass and Garden Centers has $20 million in assets, 75 percent financed by debt and 25 percent financed by common stock. The interest rate on the debt is 12 percent and the par value of the stock is $10 per share. President Johnson is considering two financing plans for an expansion to $30 million in assets.
Under Plan A, the debt-to-total-assets ratio will be maintained, but new debt will cost a whopping 15 percent! New stock will be sold at $10 per share. Under Plan B, only new common stock at $10 per share will be issued. The tax rate is 40 percent.
a. If EBIT is 12 percent on total assets, compute earnings per share (EPS) before the expansion and under the two alternatives.
b. What is the degree of financial leverage under each of the three plans?
c. If stock could be sold at $20 per share due to increased expectations for the firm's sales and earnings, what impact would this have on earnings per share for the two expansion alternatives? Compute earnings per share for each.
d. Explain why corporate financial officers are concerned about their stock values!

24. Mr. Katz is in the widget business. He currently sells 2 million widgets a year at $4 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 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 his price to $3.75 a widget, he could increase his volume of units sold by 40 percent. Fixed costs 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 50 percent, with the balance in common stock. It is assumed that the interest rate would go up by 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 the Doberman 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?

25. Highland Cable Company is considering an expansion of its facilities. Its current income statement is as follows:
Sales $4,000,000
Less: Variable expense (50% of sales) 2,000,000
Fixed expense 1,500,000
Earnings before interest and taxes (EBIT) 500,000
Interest (10% cost) 140,000
Earnings before taxes (EBT) 360,000
Tax (30%) 108,000
Earnings after taxes (EAT) $ 252,000
Shares of common stock 200,000
Earnings per share $ 1.26
Highland Cable Company is currently financed with 50 percent debt and 50 percent equity (common stock, par value of $10). To expand the facilities, Mr. Highland estimates a need for $2 million in additional financing. His investment banker has laid out three plans for 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 per share.
Variable costs are expected to stay at 50 percent of sales, while fixed expenses will increase to $1,900,000 per year. Mr. Highland is not sure how much this expansion will add to sales, but he estimates that sales will rise by $1 million per year for the next five years.
Mr. Highland is interested in a thorough analysis of his expansion plans and methods of financing. He would like you to analyze the following:
a. The break-even point for operating expenses before and after expansion (in sales dollars).
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 in footnote 2.
c. The degree of financial leverage before expansion at sales of $4 million and for all three methods of financing after expansion. Assume sales of $5 million for the second part of this question.
d. Compute EPS under all three methods of financing the expansion at $5 million in sales (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 three methods of financing the expansion?