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Strategic Financial Management: Subject

The David Ding Baseball Bat Company is considering three financing alternatives to fund a $4 million expansion: additional debt at 14%, preferred stock with a 12% dividend, or issuing common stock at $16 per share. With current EBIT of $1.5 million, EPS would be highest under common stock at $0.000651. An indifference point between debt and common stock is an EBIT of $2.712 million. Common stock is preferred currently due to its higher EPS and lower degree of financial leverage of 1.32 compared to 2.59 for debt and 4.41 for preferred stock. EBIT would need to increase by $1.212 million for debt to become preferable.

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103 views7 pages

Strategic Financial Management: Subject

The David Ding Baseball Bat Company is considering three financing alternatives to fund a $4 million expansion: additional debt at 14%, preferred stock with a 12% dividend, or issuing common stock at $16 per share. With current EBIT of $1.5 million, EPS would be highest under common stock at $0.000651. An indifference point between debt and common stock is an EBIT of $2.712 million. Common stock is preferred currently due to its higher EPS and lower degree of financial leverage of 1.32 compared to 2.59 for debt and 4.41 for preferred stock. EBIT would need to increase by $1.212 million for debt to become preferable.

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Vijay Singh
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© © All Rights Reserved
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MBA FA IV 'A'

SUBJECT : Strategic Financial Management

Submitted to: Submitted by :


Dr. Vidya Telang Aman Malviya
Amey Sinnarkar
Amol Gupta
Anamika Mahajan
Aniket Rajput
CASE STUDY
David Ding Baseball Bat Company currently has $3 million in debt outstanding, bearing an interest rate of 12 percent. It wishes
to finance a $4 million expansion program and is considering three alternatives: additional debt at 14 percent interest (option 1),
preferred stock with a 12 percent dividend (option 2), and the sale of common stock at $16 per share (option 3). The company
currently has 800,000 shares of common stock outstanding and is in a 40 percent tax bracket.

• If earnings before interest and taxes are currently $1.5 million, what would be earnings per share for the three alternatives,
assuming no immediate increase in operating profit?
• Develop a break-even, or indifference, chart for these alternatives. What are the approximate indifference points? To check
one of these points, mathematically determine the indifference point between the debt plan and the common stock plan. What
are the horizontal axis intercepts?
• Compute the degree of financial leverage (DFL) for each alternative at the expected EBIT level of $1.5 million.
• Which alternative do you prefer? How much would EBIT need to increase before the next alternative would be "better" (in
terms of EPS)?
(In Millions)

Column1 DEBT PREFERRED STOCK COMMON STOCK

Operating Profit (EBIT) $ 1.5 $ 1.5 $ 1.5

Interest on existing debt 0.36 0.36 0.36

Interest on new debts 0.56 - -

Profit before taxes (PBT) $ 0.580 $ 1.140 $ 1.140

Taxes 0.232 0.456 0.456

Profit after taxes $ 0.348 $ 0.684 $ 0.684

Preferred Stock Dividend - 0.48 -

Earning available to common shareholders $ 0.348 $ 0.204 $ 0.684

No. of Shares 800 800 1050

Earning per share $ 0.000435 $ 0.000255 $ 0.000651


c) Degree of Financial Leverage (DFL) = EBIT/EBT

(1) Debt
DFL EBIT of $ 1.5 million = 1.5/(1.5- 0.36- 0.56) = 2.59

(2) Preferred Stock


DFL EBIT of $ 1.5 million = 1.5/(1.5- 0.36- [0.480(1-0.40)]) = 4.41

(3) Common Stock


DFL EBIT of $ 1.5 million = 1.5/(1.5- 0.36) = 1.32
d) For the present EBIT level, common stock is clearly preferable.
EBIT would need to increase by $ 2.712 million - $ 1.5 million = $ 1.212 million
before an indifference point with debt is reached. One would want to be comfortably
above this indifference point before a strong case for debt should be made.
The lower the probability that actual EBIT will fall below the indifference point, the
stronger the case that can be made for debt, all other things remain the same.

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