Textbook Problem

BREAKEVEN AND LEVERAGE Wingler Communications Corporation (WCC) produces premium stereo headphones that sell for $28 80 per set, and this year’s sales are expected to be 450,000 units. Variable production costs for the expected sales under present production methods are estimated at $10,200,000, and fixed production (operating) costs at present are $1,560,000. WCC has $4,800,000 of debt outstanding at an interest rate of 8%. There are 240,000 shares of common stock outstanding, and there is no preferred stock. The dividend payout ratio is 70%, and WCC is in the 40% federal-plus-state tax bracket.

The company is considering investing $7,200,000 in new equipment. Sales would not increase, but variable costs per unit would decline by 20%. Also, fixed operating costs would increase from $1,560,000 to $1,800,000. WCC could raise the required capital by borrowing $7,200,000 at 10% or by selling 240,000 additional shares of common stock at $30 per share.

1. a. What would be WCC’s EPS (1) under the old production process, (2) under the new process if it uses debt, and (3) under the new process if it uses common stock?
2. b. At what unit sales level would WCC have the same EPS assuming it undertakes the investment and finances it with debt or with stock? {Hint: V = variable cost per unit $8,160,000 450,000, and EPS =[(PQ – VQ – F – I) (1 – T)]/N. Set EPS_Stock = EPS_Debt and solve for Q.}
3. c. At what unit sales level would EPS 0 under the three production/financing setups— that is, under the old plan, the new plan with debt financing, and the new plan with stock financing?(Hint: Note that V_old $10,200,000 450,000, and use the hints for part b, setting the EPS equation equal to zero.)
4. d. On the basis of the analysis in parts a through c, and given that operating leverage is lower under the new setup, which plan is the riskiest, which has the highest expected EPS, and which would you recommend? Assume that there is a fairly high probability of sales falling as low as 250,000 units. Determine EPS_Debt and EPS_Stock at that sales level to help assess the riskiness of the two financing plans.