Q:2

Mr. Jamshed is an entrepreneur and has recently set up manufacturing unit of Pens. He currently sells 1 million pen a year at Rs.5 each. His variable cost to produce the pen is Rs.3 per pen and he has Rs.1,500,000 in fixed costs. His sales to assets ratio is 5 times, and 40 percent of his assets are financed with 8% debt, with the balance being financed by ordinary shares of Rs.10 per share. The tax rate is 35%. His newly appointed finance manager, Mr. Impression feels that Mr. Jamshed is doing it all wrong. By reducing his price to Rs.4.50 per pen, he could increase his sales volume of pens by 40%. Fixed costs would remain constant, and variable costs would remain Rs.3 per unit. His sales to asset ratio would be 6.3times. Furthermore, he could increase his debt to assets ratio to 50%, with the balance in shares. It is assumed that the interest rate would go up 1 percent and that the price of shares would remain constant.

Required:

a) Compute the EPS under the Jamshed and Impression plans. Is Mr. Impressions perception, right? (Marks 5)

b) Mr. Jamsheds partner does not think that fixed costs would remain constant under the Impression plan but they would go up by 15% percent. If this is the case, should Mr. Jamshed shift to the Impression plan, based on earnings per share. (Marks 3)

c) What is the effect on the total risk of the firm on switching from one plan to another? (Marks 2)