Laurel Street, president of Uvalde Manufacturing Inc. is preparing a proposal to present to

her board of directors regarding a planned plant expansion that will cost $10 million.

At issue is whether the expansion should be financed with debt (a long-term note at First

National Bank of Uvalde with an interest rate of 15%) or through the issuance of common

stock (200,000 shares at $50 per share).

Uvalde Manufacturing currently has a capital structure of:

Debt (12% interest) 40,000,000

Equity 50,000,000

The firm's most recent income statement is presented next:

Sales $100,000,000

Cost of goods sold 65,000,000

Gross profit 35,000,000

Operating expenses 20,000,000

Operating profit 15,000,000

Interest expense 4,800,000

Earnings before tax 10,200,000

Income tax expense (40%) 4,080,000

Net income $ 6,120,000

Earnings per share (800,000 shares) $ 7.65

Laurel Street is aware that financing the expansion with debt will increase risk but could

also benefit shareholders through financial leverage. Estimates are that the plant expansion

will increase operating profit by 20%. The tax rate is expected to stay at 40%. Assume

a 100% dividend payout ratio.

Laurel Street is aware that financing the expansion with debt will increase risk but could

also benefit shareholders through financial leverage. Estimates are that the plant expansion

will increase operating profit by 20%. The tax rate is expected to stay at 40%. Assume

a 100% dividend payout ratio.

Required

a. Calculate the debt ratio, time interest earned, earnings per share, and the financial

leverage index under each alternative, assuming the expected increase in operating

profit is realized.

b. Discuss the factors the board should consider in making a decision.