Page 155 - DMGT405_FINANCIAL%20MANAGEMENT

Unit 8: Concept of Leverages

In his analysis regarding the new product proposals, George Lee recognized that, the firm Notes
would have to build new facilities to produce each product. The lounges would require an
investment of $3.8 million which would include the purchase and installation of
manufacturing and packaging machinery. The umbrellas, although a relatively simple
concept, would require an investment of $6 million for efficient production. For both
products, it would take 80 days to install the equipment. This means that production could
begin by January 1st.
Len haton, the firm’s vice-president of sales, has prepared sales estimates for the two
products. He forecasts $4 million in sales for the lounges and $ 4.3 million in sales for the
umbrellas on annual basis. The report from the cost accounting department estimates
variable costs of two-third of the sales value for the lounge unit and 61 per cent for the
umbrellas. Fixed costs would be $400,000 and $ 650,000, respectively.
To finance the new projects, Lee has been working with Lucid’s investment bankers. At a
recent meeting, Lee was told that the firm could raise money from two sources under the
current market conditions. First, it could borrow on an 11 year note at 12 per cent for either
or both the projects in an amount not exceeding $ 8.5 million. Second, the investment
bankers felt confident that they could underwrite a preferred stock issue with a 12 per cent
dividend upto a dollar amount of $6 million. The issue would have to be cumulative with
respect to dividends. Common stock financing would not be a possibility at present.
RKV Balance Sheet (Projected through December 31 this Year)

Cash $ 425,000
Accounts receivables 750,000
Inventory 500,000
Fixed Assets 7,650,000
$ 9,325,000
Current liabilities $ 600,000
Long-term debt (10%) 3,800,000
Common stock ($3 par) 1,500,000
Retained earnings 3,425,000
$ 9,325,000

Question
What would be the effect of acceptance of each project on leverages? Would it give a
favourable financial leverage to RKV?
RKV Income Statement (Projected through December 31 this Year)

EBIT 1,926,520
EBT 1,536,520
Fixed Costs 1,043,480
Interest 390,000
Marginal contribution 2,970,000
Net Income 1,027,303
Sales $ 8,000,000
Taxes 509,217
Variable Costs 5,030,000

LOVELY PROFESSIONAL UNIVERSITY 149