Chapter 5, Problem 25P

a.

Summary Introduction

To calculate: The EPS of Lopez-Portillo Company before the expansion, if EBIT is 9% on total assets.

Introduction:

Earning per share (EPS):

It is the profit per outstanding share of a public company. A higher EPS indicates higher value of the company because investors are ready to pay higher price for one share of the company.

Answer to Problem 25P

The calculation of EPS of current plan, plan D, and plan E of Lopez-Portillo Company is shown below.

Explanation of Solution

The formulae used for the computation of EPS of current plan, plan D, and plan E are shown below.

Working notes:

Calculation of interest on current plan:

$\begin{array}{c}\text{Interest on Current Plan}=\left(\text{Debt Percentage}\times \text{Assets}\right)\times \text{Interest Rate}\\ =\left(80\%\times \$10,600,000\right)\times 9\%\\ =\$8,480,000\times 9\%\\ =\$763,200\end{array}$

Calculation of common shares of current plan:

$\begin{array}{c}\text{ Common Shares of Current Plan}=\frac{\left(\text{Common Stock Percentage}\times \text{Assets}\right)}{\text{Par Value of the stock}}\\ =\frac{\left(20\%\times \text{\$}10,600,000\right)}{\$10}\\ =\frac{\$2,120,000}{\$10}\\ =212,000\text{ shares}\end{array}$

Calculation of interest of plan A:

$\begin{array}{c}\text{ Interest of Plan A}=\text{Interest on Current Plan}+\\ \left[\text{Debt Percentage}\times \left(\text{Increased Assets}-\text{Previous Assets}\right)\right]\\ \times \text{New Debt Percentage}\\ =\$763,200+\left[80\%\times \left(\$18,000,000-\$10,600,000\right)\right]\times 12\%\\ =\$763,200+\left[80\%\times \$7,400,000\right]\times 12\%\\ =\$1,473,600\end{array}$

Calculation of common shares of plan A:

$\begin{array}{c}\text{Common Shares of Plan A}=\text{Common shares of Current plan}+\\ \left[\text{Common stock Percenatge}\times \frac{\left(\text{Increased Assets}-\text{Previous Assets}\right)}{\text{Share Price}}\right]\\ =\$212,000+\left[\frac{20\%\times \left(\$18,000,000-\$10,600,000\right)}{\$10}\right]\\ =\$212,000+\left[\frac{\left(20\%\times \$7,400,000\right)}{\$10}\right]\\ =360,000\text{ shares}\end{array}$

Calculation of common shares of plan B:

$\begin{array}{c}\text{Common Shares of Plan B}=\text{Common shares of current Plan}+\\ \left(\frac{\text{Increased Assets}-\text{Previous Assets}}{\text{Price per share}}\right)\\ =\$212,000+\frac{\left(\$18,000,000-\$10,600,000\right)}{\$10}\\ =\$212,000+\frac{\$7,400,000}{\$10}\\ =952,000\text{ shares}\end{array}$

Note : The interest of plan B is unchanged.

b.

Summary Introduction

To calculate: The DFL of Lopez-Portillo company of each plan.

Introduction:

Degree of Financial Leverage (DFL):

It refers to the leverage ratio that evaluates the company’s EPS to the variations in its operating income. This ratio indicates that higher DFL leads to the higher earnings of the firm.

Answer to Problem 25P

The DFL of current plan is 5 times , plan A is 11.07 times, and plan B is 1.89 times.

Explanation of Solution

Computation of DFL of current plan:

$\begin{array}{c}\text{DFL}\left(\text{Current}\right)=\frac{\text{Earning before interest and tax}}{\text{Earning before interest and tax}-\text{Interest}}\\ =\frac{\$954,000}{\$954,000-\$763,200}\\ =\frac{\$954,000}{\$190,800}\\ =5\end{array}$

Computation of DFL of plan A:

$\begin{array}{c}\text{DFL}\left(\text{PlanA}\right)=\frac{\text{Earning before interest and tax}}{\text{Earning before interest and tax}-\text{Interest}}\\ =\frac{\$1,620,000}{\$1,620,000-\$1,473,600}\\ =\frac{\$1,620,000}{\$146,400}\\ =11.07\end{array}$

Computation of DFL of plan B:

$\begin{array}{c}\text{DFL}\left(\text{PlanB}\right)=\frac{\text{Earning before interest and tax}}{\text{Earning before interest and tax}-\text{Interest}}\\ =\frac{\$1,620,000}{\$1,620,000-\$763,200}\\ =\frac{\$1,620,000}{\$856,800}\\ =1.89\end{array}$

c.

Summary Introduction

To calculate: The EPS of each Plan and also determine the impact of each plan of Lopez-Portillo company.

Introduction:

Earning per share(EPS):

It is the profit per outstanding share of a public company. A higher EPS indicates higher value of the company because investors are ready to pay higher price for one share of the company.

Answer to Problem 25P

The calculation of EPS of plan A and plan B of Lopez-Portillo Company is shown below.

Explanation of Solution

The formula used for the computation of EPS of Plan A and Plan B are shown below.

Plan B will provide a higher EPS on a constant basis.

Working notes:

Calculation of common shares of plan A:

$\begin{array}{c}\text{Common Shares of Plan A}=\text{Common Shares of current plan}+\\ \left[\frac{\text{Common stock percentage}\times \left(\text{Increased Asset}-\text{Previous Asset}\right)}{\text{Selling Price per Share}}\right]\\ =\$212,000+\left[\frac{20\%\times \left(\$18,000,000-\$10,600,000\right)}{\$20}\right]\\ =\$212,000+\frac{\left(20\%\times \$7,400,000\right)}{\$20}\\ =286,000\end{array}$

Calculation of common shares of plan B:

$\begin{array}{c}\text{Common Shares of Plan B}=\text{Common Shares of current plan}+\frac{\left(\text{Increased Asset}-\text{Previous Asset}\right)}{\text{Selling Price per Share}}\\ =\$212,000+\frac{\left(\$18,000,000-\$10,600,000\right)}{\$20}\\ =\$212,000+\frac{\$7,400,000}{\$20}\\ =582,000\end{array}$

d.

Summary Introduction

To explain: The reason behind the concern of CFO about the stock values of Lopez-Portillo Company.

Introduction:

Share price:

The highest price of one share of a company that an investor is willing to pay is termed as the share’s price. It is the current price used for the trading of such shares.

Answer to Problem 25P

The CFO of the company is concerned about the value of the stock because it impacts capital budgeting decisions and it also influences the ability to finance projects.

Explanation of Solution

The reason behind CFO’s concern about the common stock values are as follows:

(a) Common stock creates shareholder’s wealth.

(b) It impacts the capital budgeting decisions.

(c) It also influences the potential of financing any undertaken projects either at a high or low cost of capital.