Resource:Ch. 6 of Understanding Financial Statements
Complete Problem 6.6 on p. 232 (Ch.
Submit your answers to questions A and
6.6.Laurel Street, president of Uvalde
Manufacturing Inc. is preparing a proposal to present to
her board of directors regarding a planned plant expansion that
will cost $10 million.
At issue is whether the expansion should be financed with debt (a
long-term note at First
National Bank of Uvalde with an interest rate of 15%) or through
the issuance of common
stock (200,000 shares at $50 per share).
Uvalde Manufacturing currently has a capital structure of:
Debt (12% interest) 40,000,000
The firmâs most recent income statement is presented next:
Cost of goods sold 65,000,000
Gross profit 35,000,000
Operating expenses 20,000,000
Operating profit 15,000,000
Interest expense 4,800,000
Earnings before tax 10,200,000
Income tax expense (40%) 4,080,000
Net income $ 6,120,000
Earnings per share (800,000 shares) $ 7.65
Laurel Street is aware that financing the expansion with debt will
increase risk but could
also benefit shareholders through financial leverage. Estimates
are that the plant expansion
will increase operating profit by 20%.The tax rate is expected to
stay at 40%.Assume
a 100% dividend payout ratio.
a.Calculate the debt ratio, time
interest earned, earnings per share, and the financial
leverage index under each alternative, assuming the expected
increase in operating
profit is realized.
b.Discuss the factors the board should consider in making a