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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 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.
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