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Mutiara Auto Parts is considering expanding its Penang factory at Bayan Lepas Industrial area
Mutiara Auto Parts is considering expanding its Penang factory at Bayan Lepas Industrial area. The expansion would be financed by the sale of common stock or a bond issue. The financial manager needs to evaluate how the two alternative financing plans will affect the earnings potential of the firm.
The total financing required is $10 million. The firm currently has $10 million of 10% coupon bonds and 1,000,000 common stocks outstanding. The firm has a 40% tax rate.
The firm can arrange financing of the $10 million through:
Plan 1: 12% coupon bond issue
Plan 2: Sale of 500,000 new shares of common stock
a. The new interest cost under Plan 1 is $?
b. The existing interest cost under Plan 1 is $?
c. The total interest cost under Plan 1 is $?
d. The existing number of common shares outstanding is?
e. The existing interest cost under Plan 2 is $?
f. The number of additional shares issued under Plan 2 is?
g. The total number of common shares outstanding under Plan 2 is?
h. The degree of final leverage (DFL) for Plan 1 at $4,600,000 of EBIT is?
i. The degree of final leverage (DFL) for Plan 2 at $4,600,000 of EBIT is?
j. The financial break-even point under Plan 1 is $?
k. The financial break-even point under Plan 2 is $?
l. The EPS under Plan 1 is $_per share.
m. The EPS under Plan 2 is $_ per share.
n. Based on the analysis in part (a) to part (m) above which plan should Mutiara Auto Parts choose and why? Plan (choose from Plan 1/Plan 2) because it is ( choose from more/equally/less) risky and gives the (choose from same/higher/lower) EPS.
Expert Solution
Answer :
| - | Parameter | Linkage | Value ($) |
| Current debt | A | 10,000,000 | |
| Current interest rate | B | 10% | |
| Current number of shares outstanding | C | 1,000,000 | |
| Total new financing required | D | 10,000,000 | |
| Plan 1 | - | - | |
| Interest rate | E | 12% | |
| Plan 2 | - | - | |
| New shares | F | 500,000 | |
| (a) | The new interest cost under plan 1 is | G= E * D | 1,200,000 |
| (b) | The existing interest cost under plan 1 is | H = A * B | 1,000,000 |
| (c) | The total interest cost under plan 1 is | I = G + H | 2,200,000 |
| (d) | The existing number of common shares outstanding is | J = C | 1,000,000 |
| (e) | The existing interest cost under plan 2 is | K = H = A*B | 1,000,000 |
| (f) | The number of additional shares issued under 2 is | L = F | 500,000 |
| (g) | The total number of common shares outstanding under plan 2 is | M = C + L | 1,500,000 |
| EBIT | N | 4,600,000 | |
| (h) | The degree of final leverage (DFL) for plan 1 at $4,600,000 of EBIT is | O = N/(N-I) | 1.92 |
| (i) | The degree of financial leverage (DFL) for plan 2 at $4,600,000 of EBIT is | P = N/(N-K) | 1.28 |
| (j) | The financial break-even point under plan 1 is | I (See above) | 2,200,000 |
| (k) | The financial break -even point under plan 2 is | k (See above) | 1,000,000 |
| Tax rate | Q | 40% | |
| (l) | The EPS under plan 1 is | - | 1.44 |
| (m) | The EPS under plan 2 is | - | 1.44 |
(n). Both the plan result in same EPS. However plan 1 has higher degree of financial leverage. This is because it has higher debt and hence higher interest cost.
A firm should choose a plan with lower degree of financial leverage. Hence, Mutiara auto parts should choose plan 2
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