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The firm was considering buying back 625,000 shares of stock

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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 years
Year 1st Qtr 2nd Qtr 3rd Qtr 4th Qtr Yearly total
2003 $.23 $.25 $.19 $.34 $1.01
2004 .26 .28 .27 .41 1.22
2005 .34 .36 .33 .48 1.51
2006 .35 .37 .34 .49 1.55
2007 .35 .36 .36 .49 1.56

Figure 2 Glen Mount Furniture Company
Current Balance Sheet
Current assets:
Cash $350,000
Marketable securities 90,000
Accounts receivable 5,000,000
Inventory 7,000,000
Total current assets 12,440,000

Other assets:
Investments 5,000,000

Fixed assets:
Plant and equipment 27,060,000
Less: Accumulated depreciation 4,000,000
Net plant and equipment 23,060,000
Total assets 40,500,000

Liabilities and Stockholders' Equity
Current liabilities
Accounts payable $4,400,000
Wages payable 150,000
Accrued expenses 950,000
Total current liabilities 5,500,000

Long term liabilities
Bonds payable,10.625% 12,000,000

Stockholders' equity
Common stock, $1 par value, 2,000,000 shares 2,000,000
Capital in excess of par 8,000,000
Retained earnings 13,000,000
Total stockholders' equity 23,000,000
Total liabilities and Stockholders' equity 40,500,000

Figure 3 Glen Mount Furniture Company
Abbreviated Income Statement
For the Year Ended Dec. 31,2008

Sales $45,000,000
Less: Fixed costs 12,900,000
Less: Variable costs (58% of sales) 26,100,000
Operating income (EBIT) $6,000,000
Less: Interest 1,275,000
Earnings before taxes (EBT) $4,725,000
Less: Taxes (34%) 1,606,500
Earnings after taxes (EAT) $3,118,500
Shares 2,000,000
Earnings per share $1.56

1. 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.

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