Breakeven and leverage

Wingler Communications Corporation (WCC) produces premium stereo headphones that sell for
$28.90 per set, and this year's sales are expected to be 440,000 units. Variable production costs
for the expected sales under present production methods are estimated at $10,500,000, and fixed
production (operating) costs at present are $1,560,000. WCC has $4,800,000 of debt outstanding
at an interest rate of 8%. There are 240,000 shares of common stock outstanding, and there is no
preferred stock. The dividend payout ratio is 70%, and WCC is in the 40% federal-plus-state tax
bracket.

The company is considering investing $7,200,000 in new equipment. Sales would not increase,
but variable costs per unit would decline by 20%. Also, fixed operating costs would increase
from $1,560,000 to $1,800,000. WCC could raise the required capital by borrowing $7,200,000
at 10% or by selling 240,000 additional shares of common stock at $30 per share.

a. What would be WCC's EPS (1) under the old production process, (2) under the new
process if it uses debt, and (3) under the new process if it uses common stock? Round
your answers to the nearest cent.
2.04
1. $
2. $
3. $

b. At what unit sales level would WCC have the same EPS, assuming it undertakes the
investment and finances it with debt or with stock? {Hint: V = variable cost per unit =
$8,400,000/440,000, and EPS = [(PQ - VQ - F - I)(1 - T)]/N. Set EPSStock = EPSDebt and
solve for Q.} Round your answer to the nearest whole.
units

c. At what unit sales level would EPS = 0 under the three production/financing setups - that
is, under the old plan, the new plan with debt financing, and the new plan with stock
financing? (Hint: Note that VOld = $10,500,000/440,000, and use the hints for Part b,
setting the EPS equation equal to zero.) Round your answers to the nearest whole.
Old plan units
New plan with debt financing units
New plan with stock financing units
d. On the basis of the analysis in parts a through c, and given that operating leverage is
lower under the new setup, which plan is the riskiest, which has the highest expected
EPS, and which would you recommend? Assume here that there is a fairly high
probability of sales falling as low as 250,000 units, and determine EPSDebt and EPSStock at
that sales level to help assess the riskiness of the two financing plans. Round your
answers to two decimal places.
EPSDebt = $
EPSStock = $