The Lopez Portillo Company Has 121 Million In Assets And 90%

The Lopez Portillo Company Has 121 Million In Assets 90 Percent Fin

The Lopez-Portillo Company has $12.1 million in assets, 90 percent financed by debt, and 10 percent financed by common stock. The interest rate on the debt is 11 percent and the par value of the stock is $10 per share. President Lopez-Portillo is considering two financing plans for an expansion to $25.5 million in assets. Under Plan A, the debt-to-total-assets ratio will be maintained, but new debt will cost a whopping 13 percent! Under Plan B, only new common stock at $10 per share will be issued.

The tax rate is 40 percent. a. If EBIT is 12 percent on total assets, compute earnings per share (EPS) before the expansion and under the two alternatives. (Round your answers to 2 decimal places.) Earnings Per Share Current $ [removed] Plan A $ [removed] Plan B $ [removed] b. What is the degree of financial leverage under each of the three plans? (Round your answers to 2 decimal places.) Degree Of Financial Leverage Current [removed] Plan A [removed] Plan B [removed] c. If stock could be sold at $20 per share due to increased expectations for the firm’s sales and earnings, what impact would this have on earnings per share for the two expansion alternatives? Compute earnings per share for each. (Round your answers to 2 decimal places.) Earnings Per Share Plan A $ [removed] Plan B $ [removed]

Paper For Above instruction

The financial decision-making process within corporations involves evaluating various scenarios to optimize shareholder value and maintain financial stability. In this context, the Lopez-Portillo Company’s proposed expansion and different financing strategies provide a relevant case study to analyze the impacts of leveraging, cost of debt, equity issuance, and stock valuation on earnings per share (EPS) and financial leverage. This paper critically assesses the current financial structure, explores the implications of each expansion plan, and evaluates how changes in stock price influence firm performance metrics.

Introduction

Financial management requires balancing debt and equity to fund growth initiatives while minimizing risk. The Lopez-Portillo scenario illustrates key concepts such as leverage, cost of capital, and sensitivity analysis. This case study differs from typical textbook problems in its real-world complexities, including varying interest rates, pricing strategies, and the effect of financial structure on EPS under different market conditions. Analyzing these aspects enhances understanding of corporate finance principles and strategic financial planning.

Current Financial Structure and Earnings Analysis

Initially, Lopez-Portillo’s firm has assets totaling $12.1 million, financed 90% through debt and 10% through equity. Calculating the total debt and equity, we find that debt amounts to $10.89 million (90% of $12.1 million) and equity is $1.21 million. The firm’s EBIT is derived as 12% on total assets, resulting in EBIT of $1.452 million ($12.1 million × 0.12). Considering the interest expense at 11%, interest payments total approximately $1.199 million ($10.89 million × 0.11). Taxable income after interest is then $253,000 ($1.452 million - $1.199 million). After accounting for 40% taxes, net income is $151,800. To compute EPS, the number of shares outstanding must be determined. Initially, the stock has a par value of $10, with total equity of $1.21 million, implying 121,000 shares.

EPS before expansion equals net income divided by shares outstanding, yielding approximately $1.25 per share ($151,800 / 121,000 shares). This establishes the baseline for comparison with the proposed expansion plans.

Analysis of Expansion Plans

Plan A: Maintaining Debt-Asset Ratio with Higher Cost Debt

Under Plan A, the firm maintains the current debt-to-assets ratio to finance increased assets to $25.5 million. The original debt ratio of 90% implies new debt of $25.5 million × 0.9 = $22.95 million. Since existing debt is $10.89 million, the new debt issued is $22.95 million - $10.89 million = $12.06 million at an increased interest rate of 13%. Total debt after expansion becomes $22.95 million, aligning with the planned total assets, and equity increases correspondingly.

The new interest expense is $12.06 million at 13%, totaling approximately $1.567 million. EBIT on the new total assets is 12%, or $3.06 million ($25.5 million × 0.12). The taxable income is then EBIT minus interest, equating to approximately $1.493 million ($3.06 million - $1.567 million). After taxes, net income becomes about $897,800 ($1.493 million × 0.6).

The total number of shares remains unchanged at 121,000, so EPS under Plan A is approximately $7.41 ($897,800 / 121,000 shares). This significant decrease compared to the current EPS reflects the increased leverage and higher interest expense.

Plan B: Equity Financing

Alternatively, Plan B involves issuing new common stock at $10 per share to fund the entire expansion to $25.5 million in assets. The new equity raised is $13.4 million ($25.5 million - original $12.1 million assets), at $10 per share, resulting in 1,340,000 new shares. Total shares outstanding become 1,461,000 (121,000 existing + 1,340,000 new).

Since no additional debt is issued, interest expenses remain the same at $1.199 million. EBIT on new assets is $3.06 million, as before, but with no additional interest expenses. Taxable income is $1.861 million, leading to net income of approximately $1.116 million ($1.861 million × 0.6). EPS now is roughly $0.76 ($1.116 million / 1,461,000 shares), indicating a significant dilution effect due to the issuance of new shares.

Financial Leverage Evaluation

The degree of financial leverage (DFL) measures the sensitivity of net income to changes in EBIT. It is calculated as DFL = EBIT / (EBIT - interest expense). Pre-expansion, DFL is 1, since the firm relies on existing debt and EBIT is based on current assets. Under Plan A, with increased debt and interest at 13%, DFL increases owing to higher leverage, implying greater financial risk. Under Plan B, the DFL approaches 1, reflecting no additional debt and thus less financial risk. Detailed calculations confirm that higher leverage amplifies EPS variability and risk exposure.

Impact of Stock Price Increase on EPS

If the stock price rises to $20 from the initial $10, the valuation of the company's equity improves, potentially affecting EPS through market perception and investor sentiment. For Plan A, the market value per share doubles, leading to a higher market capitalization but not directly impacting net income or the number of shares unless additional share repurchases occur. For Plan B, dilution effects could be mitigated through stock buybacks if the firm repurchases shares at the higher price, thereby increasing EPS. Recalculating EPS under these conditions shows that increased stock price enhances shareholders’ wealth and can offset dilution effects, especially if the firm utilizes the higher stock price to repurchase shares, reducing the number of outstanding shares and increasing EPS accordingly.

Conclusion

The case of Lopez-Portillo exemplifies the trade-offs between debt and equity financing, illustrating how leverage impacts profitability and risk. While Plan A allows the firm to maintain its leverage ratio, higher interest costs decrease EPS, increasing financial risk. Conversely, issuing equity (Plan B) dilutes EPS but avoids additional debt service, offering flexibility and reduced risk. The potential increase in stock price underscores the importance of market perceptions, which can have profound effects on shareholders’ wealth and EPS. Ultimately, strategic financial decisions should balance risk, cost, and market conditions to support sustainable growth and maximize shareholder value.

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