Chapter 5, Problem 26P

Mr. Gold is in the widget business. He currently sells 1.5 million widgets a year at $\text{\$6}$ each. His variable cost to produce the widgets is $\text{\$4}$ per unit, and he has $\text{\$1,550,000}$ in fixed costs. His sales-to-assets ratio is six times, and 30 percent of his assets are financed with 10 percent debt, with the balance financed by common stock at $\text{\$10}$ par value per share. The tax rate is

35 percent.

His brother-in-law, Mr. Silverman, says he is doing it all wrong. By reducing his price to $\text{\$5}\text{.00}$ a widget, he could increase his volume of units sold by 60 percent. Fixed costs would remain constant, and variable costs would remain $\text{\$4}$ per unit. His sales-to-assets ratio would be 7.5 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 Gold plan.

b. Compute earnings per share under the Silverman plan.

c. Mr. Gold’s wife, the chief financial officer, does not think that fixed costs would remain constant under the Silverman plan but that they would go up by 15 percent. If this is the case, should Mr. Gold shift to the Silverman plan, based on earnings per share?