Asked by: shemrob-ga
List Price: $25.00
20 Jul 2005 12:48 PDT
Expires: 19 Aug 2005 12:48 PDT
Question ID: 545910
mr gold is in the widget businesd. He currently sells 1 million widgets a year at $5 each. His variable cost to produce the widgets is $3 per unit, and he has $1,500,000 in fixed cost. His sales-to-assets ratio is five times, and 40 percent of his assets are financed with 8 percnet debt, with the balance financed by common stock at $10 per share. The tax rate is 40 percent. Mr. silverman, says he is doing it all wrong. By reducing hIS price to $4.50 a widget, he could increase his volume of units sold by 40 percent. Fixed costs would remain constant and variable costs would remain $3 per unit. His sales-to-asset ratio would be 6.3 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. Compute earnings per share under the Silverman plan. Mr Gold's wife, 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? I HAVE TO ANSWER BEFORE 5PM TODAY!!!!!!
Answered By: omnivorous-ga on 20 Jul 2005 13:09 PDT
SILVERMAN PLAN Sales = 1.4 million units @ $4.50 = $6.3 million Assets (at 6.3:1) = $1,000,000 Bonds (50%) = $500,000 Stock = $500,000 = 50,000 shares Contribution margin (at $1.50 per widget) = $2,100,000 Fixed cost = $1,725,000 (15% increase over $1.5 million) EARNINGS BEFORE INTEREST + TAXES (EBIT) = $375,000 Bond payments (9%) = $45,000 Taxes = ($375,000 - $45,000) * 0.40 = $132,000 NET INCOME = $198,000 EARNINGS PER SHARE (EPS) = $198,000/50,000 shares = $3.96 Though there are fewer shares outstanding, EPS declines from the original $4.68 ? not a good thing. Note that the critical assumption made late in the problem ? that fixed costs increase by 15% or $225,000 is what kills this proposition. If Silverman were correct and fixed costs DID remain constant, EBIT would be $600,000; and net income would be $333,000 or $6.66. Best regards, Omnivorous-GA
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