Problem 1

Packages Inc. sells 900,000 containers per year. Each container sells for $2.05. At this level of sales, the fixed operating costs are $0.156 per container and the variable operating costs are $1.635 per container. The firm has $125,000 in 9% coupon bonds issued and outstanding and the firm has preferred shares outstanding that require a dividend payment of $5,000 per year. The firm has a tax rate of 35 percent. The firm has 105,000 common shares issued and outstanding

a. Prepare an analytical income statement for Packages Inc. from the above information.

b. Prepare an analytical income statement for Packages Inc. if the firm experiences a 10 percent decrease in sales.

c. At a 900,000 level of output, what is the degree of operating leverage for the firm?

d. At a 900,000 level of output, what is the degree of financial leverage for the firm?

e. At a 900,000 level of output, what is the degree of combined or total leverage for the firm?

f. If sales were to decrease by 10 percent from the 900,000 level, by what percentage would the earnings before interest and taxes change?

g. If sales were to increase by 10 percent from the 900,000 level, by what percentage would the earnings per share change?

h. Using the analytical income statement you prepared in part b, calculate the percentage change in the earnings before interest and taxes. Does this verify your answer in part f?

i. If interest costs increase, what will happen to the degree of operating leverage and degree of financial leverage?

Problem 2

ADA Inc., an all equity firm, needs $6,000,000 to finance new equipment. Firm currently has 250,000 common shares outstanding and its tax rate is 35%. The firm is considering the following two mutually exclusive options to finance the new equipment.

I. Raise the required funds by selling bonds with a 12% coupon rate.

II. Raise $ 4,000,000 by issuing 200,000 shares of common stock and remaining $ 2,000,000 by issuing preferred stock at 5% dividend.

a) What level of EBIT would yield the same EPS for options I and II?

b) What EPS corresponds to this level of EBIT calculated in part a?

c) If you expect the EBIT to be $2.5 million, which option would you recommend for the expected EBIT level?

d) If you learn that after expansion there is a 50% probability of EBIT being $3 million, a 50% probability of it being $1 million, which option would you recommend for the expected EBIT level?