Question: The Hurricane Lamp Company forecasts that next
The Hurricane Lamp Company forecasts that next year’s sales will be $6 million. Fixed operating costs are estimated to be $800,000, and the variable cost ratio (that is, variable costs as a fraction of sales) is estimated to be 0.75. The firm has a $600,000 loan at 10 percent interest. It has 20,000 shares of $3 preferred stock and 60,000 shares of common stock outstanding. Hurricane Lamp is in the 40 percent corporate income tax bracket.
a. Forecast Hurricane Lamp’s earnings per share (EPS) for next year. Develop a complete income statement using the revised format illustrated in Table 14.1. Then determine what Hurricane Lamp’s EPS would be if sales were 10 percent above the projected $6 million level.
b. Calculate Hurricane Lamp’s degree of operating leverage (DOL) at a sales level of $6 million using the following:
i. The definitional formula (Equation 14.1)
Equation 14.1:
ii. The simpler, computational formula (Equation 14.2)
Equation 14.2:
iii. What is the economic interpretation of this value?
c. Calculate Hurricane Lamp’s degree of financial leverage (DFL) at the EBIT level corresponding to sales of $6 million using the following:
i. The definitional formula (Equation 14.3)
Equation 14.3:
ii. The simpler computational formula (Equation 14.4)
Equation 14.4:
iii. What is the economic interpretation of this value?
d. Calculate Hurricane Lamp’s degree of combined leverage (DCL) using the following:
i. The definitional formula (Equation 14.5)
Equation 14.5:
ii. The simpler computational formula (Equation 14.7)
Equation 14.7:
iii. The degree of operating and financial leverage calculated in Parts b and c
iv. What is the economic interpretation of this value?
Table 14.1:
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AEBIT EBIT ASales Sales DOL at X Sales – Variable costs DOL at X : EBIT ΔΕPS EPS AEBIT DFL at X = EBIT EBIT DFL at X EBIT – | – Dp/(1 – T) Dp/(1 – T) AEPS DCL at X =_EPS ASales Sales Sales – Variable costs DCL at X : EBIT – I – Dp/(1 – T) TABLE 14.1 Traditional and Revised Income Statements Allegan Manufacturing Company Year Ending December 31, 2016 Traditional Income Statement Format Sales $ 5,000,000 Less. Cost of sales $ 2,500,000 Operating costs Selling, general, and administrative expenses Total operating costs Earnings before interest and taxes (EBIT) Less. Interest expense Earnings before taxes (EBT) Less. Income taxes (40% rate) Earnings after taxes (EAT) 1,500,000 4,000,000 1,000,000 250,000 750,000 Financial costs 300,000 450,000 150,000 $ 300,000 Less. Preferred stock dividends Earnings available to common stockholders Earnings per share (EPS)-100,000 shares 300 Allegan Manufacturing Company Year Ending December 31, 2016 Revised Income Statement Forma $ 5,000,000 Sales Less. Variable operating costs $3,000 Operating leverage Fixed operating costs Total operating costs Earnings before interest and taxes (EBIT) Less. Fixed capital costs (interest) Earnings before taxes (EBT) Less: Income taxes (variable), 40% rate Earnings after taxes (EAT) Less: Fixed capital costs (prefered stock dividends) 1,000,000 4,000,000 1,000,000 250,000 750,000 300,000 450,000 Financial leverage 150,000 $ 300,000 Earnings available to common stockholders Earnings per share (EPS)-100,000 shares 300
> Referring to Table 13.2, calculate the market value of firm L (without a corporate income tax) if the equity amount in its capital structure decreases to $5,000 and the debt amount increases to $5,000. At this capital structure, the cost of equity is 15
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> Explain the difference between business risk and financial risk.
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