Reference no: EM132558487

Wired Communications Corporation (WCC) supplies headphones to airlines for use with movie and stereo programs. The headphones sell for $288 per set, and this year's sales are expected to be 45,000 units. Variable production costs for the expected sales under current production methods are estimated at $10,200,000, and fixed (operating) costs are currently $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. WCC pays out 70% of earnings and is in the 40% marginal tax bracket. The company is considering investing $7,200,000 in new equipment. Sales would not increase, but variable costs per unit decline by 20%. Also fixed operating costs would increase to $1,800,000. WCC could raise the required capital by borrowing $7,200,000 at 10% or by selling 240,000 additional shares 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 financing?

b. Calculate the DOL, DFL and DTL under the existing setup and under the new setup with each type of financing. Assume that the expected sales level 45,000 units or $12,960,000.

c. At what unit sales level would WCC have the same EPS, assuming it undertakes the investment and finances with debt or with stock?

d. At what unit sales level would EPS=0 under the three production/financing setupsthat is under the old plan, the new plan with debt financing and the new plan with stock financing? (worth 5 bonus points)

e. On the basis of the analysis in parts a through c, which plan is the riskiest, which has the highest expected EPS, and which would you recommend? Assume here that there is fairly high probability of sales falling as low as 25,000 units, and determine EPS under debt and stock financing options at 25,000 units of sales level to help assess the riskiness of the two financing plans.