The firm was considering buying back 625,000 shares of stock outstanding at $16 per share. This would represent $10 million in total. The funds to purchase the shares would be acquired from a new bond issue that would carry an interest rate of 11.25 percent. The bond would have a 15-year life. The firm was in a 34 percent tax bracket.Figure 1 Earnings per share for the last five yearsYear 1st Qtr 2nd Qtr 3rd Qtr 4th Qtr Yearly total2003 $.23 $.25 $.19 $.34 $1.012004 .26 .28 .27 .41 1.222005 .34 .36 .33 .48 1.512006 .35 .37 .34 .49 1.552007 .35 .36 .36 .49 1.56Figure 2 Glen Mount Furniture Company Current Balance Sheet Dec.31,2008 AssetsCurrent assets: Cash $350,000Marketable securities 90,000Accounts receivable 5,000,000Inventory 7,000,000Total current assets 12,440,000Other assets:Investments 5,000,000Fixed assets:Plant and equipment 27,060,000Less: Accumulated depreciation 4,000,000Net plant and equipment 23,060,000Total assets 40,500,000 Liabilities and Stockholders' EquityCurrent liabilities Accounts payable $4,400,000Wages payable 150,000Accrued expenses 950,000Total current liabilities 5,500,000Long term liabilitiesBonds payable,10.625% 12,000,000Stockholders' equityCommon stock, $1 par value, 2,000,000 shares 2,000,000Capital in excess of par 8,000,000Retained earnings 13,000,000Total stockholders' equity 23,000,000Total liabilities and Stockholders' equity 40,500,000Figure 3 Glen Mount Furniture Company Abbreviated Income Statement For the Year Ended Dec. 31,2008Sales $45,000,000Less: Fixed costs 12,900,000Less: Variable costs (58% of sales) 26,100,000Operating income (EBIT) $6,000,000Less: Interest 1,275,000Earnings before taxes (EBT) $4,725,000Less: Taxes (34%) 1,606,500Earnings after taxes (EAT) $3,118,500Shares 2,000,000Earnings per share $1.56Required1. Project earnings per share for 2009 assuming that sales increase by $500,000. Use Figure 3 as the model for the calculation. Further assume that the capital structure is not changed.2. By what percent did earnings per share increase from 2008 to 2009?3. Now assume that $10 million of debt replaces 625,000 shares of common stock as described in the case. The interest on the new debt will be 11.25 percent. What will projected earnings per share be for 2008 based on the anticipated sales increase of $500,000?4. Based on your answer to question 3, by what percent would earnings per share increase from 2008 to 2009?5. Compute the degree of financial leverage (DFL) for the answer to question 1 and for the answer to question 3.6. Compute degree of combined leverage (DCL) for the answer to question 1 and the answer to question 3.7. What is the total debt to assets ratio as shown in the 2008 balance sheet (Figure 2)? What will it be if $10 million worth of stockholders' equity is replaced with debt?8. What do you think might happen to the stock price as a result of replacing $10 million worth of stockholders' equity with debt? Consider any relevant factors.
Subject: Financial Management
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