Leverage and EPS

Mr. Katz is in the widget business. He currently sells 2 million widgets
a year

at $4 each. His variable cost to produce the widgets is $3 per unit, and
he has

$1,500,000 in fixed costs. His sales-to-assets ratio is four times, and
40 percent

of his assets are financed with 9 percent debt, with the balance
financed by

common stock at $10 per share. The tax rate is 30 percent.

His brother-in-law, Mr. Doberman, says Mr. Katz is doing it all wrong.
By

reducing his price to $3.75 a widget, he could increase his volume of
units sold

by 40 percent. Fixed costs would remain constant, and variable costs
would

remain $3 per unit. His sales-to-assets ratio would be 5 times.
Furthermore, he

could increase his debt-to-assets ratio to 50 percent, with the balance
in

common stock. It is assumed that the interest rate would go up by 1
percent and

the price of stock would remain constant.

Instructions

a. Compute earnings per share under the Katz plan.

b. Compute earnings per share under the Doberman plan.

c. Mr. Katz’s wife does not think that fixed costs would remain
constant under

the Doberman plan but that they would go up by 20 percent. If this is
the

case, should Mr. Katz shift to the Doberman plan, based on earnings per

share?