chapter5 hw answers

Chapter 05: Opcnuing and Financial Leverage

Chapter 5 Operating and Financial Leverage

Discussion Questions 5- 1. Discuss the various uses for break-even analysis.

Such analysis :1llows the firm to determine at what level of operations it will break even (earn zero profit) and to explore the relationship between voJurne, costs1 and proJJts.

5-2. Whal l'acrors would cause a difference in the use of linancia l lcverage for a mi Uty company and an amomobile company?

A mility is in a stable, predictable indus1ry and therefore can afford 10 use more linancial leverage than an auromobile company, which is generally subjec11o the inlluences of Lhe business cycle. An automobile manufaciUrer may no1 be able to service a large amount of deb1 when there is a downturn in the economy.

5-3. Explain how the break-even point and opemling leverage are affected by the choice of manufacturing facilities (labor intensive versus capital intensive).

A Jabor-iniCnsive company wlll have low fixed costs and a concsponding.ly low break-even poinl. However, the impact of operating leverage on the finn is small and Lhere will be lirlle magnification of profits as volume

incr~ases. A capital-intensive fi rm, on rhe other hand, will have a higher break-even poim and enjoy the positive influences of operating leverage as voJume increases.

5-4. Whm role does depreciation play in break-even analysis based on accounting flows? Based 0 11 cash flows? Vlhich perspective-is 1onger term io nature'!

For break-eveo analysis based on accouming flows, dcprecial ion is considered part of fixed costs. For cash flow purposes, it is eli minated from fixed COStS.

The accounting flows perspective is longer-lerm in nantre because we must consider the problems of equipmem replacemenl.

5-1

Chapter 05: Opcnlli(lg and Financial le\'cr:tge

5-S.

5-6.

5-7.

5-8.

5-9.

What does risk taking have to do with !he use of operating and financial leverage>

Both operating and financial leverage imply that the linn wi ll employ a heavy component of fixed cost resources. This is inherently risky because the obligation to make pa)'ITlents re mains regardless of the condition of the company or the economy.

Discuss the limitations of iinancial leveral!e. -

Debt can only be used up to a point. Beyond that, financial leverage tends to increase the overall costs of financing to the firm as well as encourage cred itors to place restrictions on the tirm. The limitations of using l'inaocial leverage tend to be greatest in indus tries that are highly cyclical in nature.

How does the interest rate on new debt inlluencc the use of tinancial leverage'?

The higher U1e illlerest rate on new debt, the less attractive financial leverage is to the linn.

Explain how combined leverage brings together operating income and earnings per shme.

Operating leverage primarily affects the operating income of the firm. At this point, fi nancial leverage takes over and determines the overall impact on earnings per share. A delineation of the combined effect of operating and financial levemge is presented in Table 5-6 and Figure 5-5.

Explain why operating leverage decreases as a company increases sales aoc.J shifts away from the break-even point.

At progressively higher levels of operations 1han 1he break-even poi111, !he percemage change in operating income as a result of a percentage change in unit volume diminishes. The reason is primarily mathematical - as we move to increasingly higher levels of operating income, the percentage change from the higher base is likely to be less.

5-2


5-10. When )'OU are considering two di fferent financing plans, does being at the level where eamings per slmre are equal between the two plans always rroeao you arc indifferent as to which plan is selected?

Problems

The point of equality only measures indifference based on earnings per share. Since ow ultimate goal is market v~~ue maximization, we must also be concerned with how these earnings are valued. Two pl

Chaptu 0.5: Opc:-~taling a.od Fin:wcial Le\e . age

b. Sales - Fixed costs - Total variable costs Net profit (loss)

$300,000 (12,000 uni ts x $25) 96,000

204,000 (12,000 units x $17) $ 0

2. Break-even analysis (L02) The Hal'lneu Corporation manuJitclures baseball bats with Pudge Rodriguez's autograph stamped on them. Each bal sells for $13 and has a variable cos! of $8. There are $20,000 in lixed costs involved in the production process. a. Compute the break-even poinl in units. b. Find the sales ( in units) needed to earn a prolit of $15,000.

5-2. Solution:

Hartnett Corporation

a. BE $20,000 4 000 . = = , umts $13-$8

b. Q = Profit + FC = $15,000 + $20,000 (P- VC) $ 13-$8

= $35000 = 7,000 units $5

3. Break-even analysis (L02) Therapeutic Systems sells ils products for $8 per unit h has lhc following cosls:

Rent ... ............................... ......... . $120,000

Factory laOOr ..... ..... ................... . $1.50 per unit

Executives under contract ......... . $112,000

Raw mmcrial ........ ......... ... ........ .. $.70 per unit

54

Chaptu 0.5: Opc:-~taling a.od Fin:wcial l.e\'e . age

Separate the expenses berwcen fixed and variable costs per uuil. Using tbis information and I he ~ales plicc per unit of $8 compute the break-even point.

S-3. Solution:

Therapeutic Systems

Rent Factory labor Executive under contract Raw materials

Fixed Costs $120,000

$112,000

$232,000

Variable Costs (per unit)

$1.50

70 $2.20

BE = FC P-VC

$232, 000 = $23 2, 000 = 40 000 units $8.00-$2.20 $5.80 ,

4. Break-even analysis (L02) Draw 1wo break-even graphs- me for a conservative ftrm using labor-intensive production and another for a capital-intensive fi rm. Assuming these companies compete within the same industry and have identical sales, explai11 the impact of changes in sales volume on both finns profits.

S-4. Solution:

Labor-Intensive and capital-intensive break-even graphs

55

Chapter 05: OpcraLing and Fioa.nd al Le\\-:rage

Labor-intensive Capital-Intensive

The company having the high fixed costs will have lower variable costs than its competitor s ince it has substituted capital for labor. With a lower variable cost, the high fixed cost company will have a larger contribution margin. Therefore, when sales rise, its profits will increase faster than the low fixed cost firm and when the sales decline, the reverse will be true.

5. Break-even a nalys is (L02) Eaton Toot Company has fixed costs o r $200,000, sells its units for $56, and has variable costs of $3 I per unit. a. Compute the break-even point. b. Ms. Eaton comes up with a new plan to cut fixed costs to $150,000. However, more

labor will now be required, which will increase variable costs per tmit to $34. The sales price will remain at $56. What is the new break-even point?

c. Under the new plan, what is likely to happen to protitability at very high volume levels (compared to the old plan)?

5-5. Solution:

56


a.

b.

Eaton Tool Company

Fixed costs BE= -----------------Price - variable cost per unit

= $200,000 = $200,000 = 8 000 units $56 -$31 $25 '

Fixed costs BE= ------------------Pr ice- variable cost per unit

$150,000 $ 150,000 6 818 -= = = umts

$56 - $34 $22 '

The breakeven level decreases.

c. With less operating leverage and a smaller contribution margin, profitability is likely to be less than it would have been at very h igh volume levels.

6. 8reak-e,en analysis (L02) Jay linoleum Company has fixed costs of $70,000. Jls product currently sells for $4 per uni1m1d has variable costs per unit of $2.60. Mr. Thomas, the head of manufacturing, proposes 10 buy new equipment that will cost $300,000 and drive up fixed costs 10$105,000. Ahhough lhe price will remain al $4 per unil, !he increased amomation will reduce variable costs per unit 10 $2.25.

As a resull of Thomas's suggestion, will Lhe break-even poinl go up or down? Compme the necessary numbers.

S-6. Solution: Jay Linoleum Company

BE (b f. ) $70,000 $70,000 50 000 -e ore = = = muts $4.00 - $2.60 $1.40 ,

5-7


BE (after)= $105000 _ = $!05000 = 60,000 units $4.00-$2.2.) $1.75

T he break-even point wil l go up.

7. Cash break-even analysis (L02) Calloway Cab Company oetermioes its break-even s trictly on tbc basis of cash cxpcnd.imres related to fixed costs. Its Lotallixed costs arc $400,000, but 20 percem of this value is represemed by depreciation. lis comribution margin (price minus variable cost) for each unit is $3.60. How many units does the lirm need to sell to reach the cash break -even poinr?

S-7. Solution:

Calloway Cab Company

Cash related fixed costs= Total Fixed Costs - Depreciation = $400,000 - 20% ($400,000) = $400,000 - $80,000 = $320,000

Cash BE = $320000 = 88 889 $3.60 ,

8. Cash break-even analysis (L02) Air Purifier, l.nc., computes its break-even poiJJL sLrictJy on the basis of cash expendirures related to fixed costs . Its total li xed costs arc $2,400,000, but 15 percent of this value is represented by depreciation. hs contribution margin (price minus variable cost) for each unit is $30. How many units docs the firm need 10 sell to reach the cash break-e ven point?

S-8. Solution: Air Purifier, Inc.

Cash related fixed costs= Total Fixed Costs- Depreciation

5-8


= $2,400,000- 15% (2,400,000) = $2,400,000- $360,000 = $2,040,000

BE 2,040,000 68 000 . = = , UllllS $30 9. Cash break-even an~~ lysis (L 02) Boise Timber co. computes its break-even point strictly

on the basis of cash expenditures related to fixed costs. Its total fixed costs are $6,000,000, bur 25 percent of Lbi s value is represented by depreciation. Tis cooti bution margin (price minus var.iabJe cosL) for each unit is $4. How many units does the firm need to sell to reach the cash break-even point?

S-9. Solution:

Boise Timber Co.

Cash related fixed costs = Total Fixed Cosr.s - Depreciation = $6,000,000 - 25% ($6,000,000) = $6,000,000 - $1,500,000 = $4,500,000

B. E - $4,500,000 - 1 125 000 . - - , . , muts $4 I 0. Degree of leverage (L02 & 5) The Sterl ing Tire Company's income state ment for 2010 is

as fo Llows:

STERLING TIRE COMPANY Income Statement

For the Year Ended December 31, 2010 Sales (20,000 tires at $60 cacb) ........... ......... . Less: Variable costs (20,000 tires at $30l .... .

Fixed COSL~ ........ ... ... ... ... ... ... ... .......... ... ... ... . Earnings before interest and taxes (EBIT) .. .. Interest expense ......................... ................... . Eamings before taxes (EBT) .. ...................... . Income tax expense (30%) ......................... ...

5-9

$1,200,000 600,000 400000 200,000

50000 150,000 45,000

Omptcr 05: Opernling :ind Fin:mci:JI Leverage

Earning~ after !aXes (EAT) ........................... . s 105,000

Gi ven thi~ income Matcrrn:m, COmpulc the following: " Degr~e of operating leverage. b. Degree or llnancial leverage. c. Degr~e of combined leverage. d. Break-even poinl in units.

5-10. Solution:

Sterling Tire Company

Q = 20,000, P = $60, VC = $30, FC = $400,000, I= $50,000

DOL = Q(P - VC) a. Q(P - VC) - FC

20, 000($60-$30) - ----~--~----~----20, 000($60 - $30) - $400,000

- __ 20....:.,_00_0_,_($_30....:.) __ 20, 000($30) - $400,000

_ $600,000 = $600,000 = 3.00x $600,000 - $400, 000 $200, 000

5-10. (Continued) b. DFL = EBIT _ $200,000

EBIT - J $200,000 - $50,000

= $200,000 = l .33x $150,000

5- lO

Chaptu 05: O)x'~tating a.Jld Fin:wcial l.e\'twage

c. DCL= Q (P - VC) Q(P-VC)- FC-I

20, 000($60 - $30) 20, 000($60-$30)-$400,000-$50,000

$600,000 = $600,000 = 4x $600,000-$400,000-$50,000 $150,000

d. BE= $400,000 = $400,000 = 13 333 units $60-$30 $30 , J I. Degree of leverage (L02 & 5) The Harding Compiuly manufactures skates. The

company's income stateme.nt for 20 I 0 is as follows:

HARDING COMPANY Income Statement

For tbe Year Ended December Jl, 2010 Sales ( 10,000 skates @$50 each) ................................ . Less: V ruiable costs ( I 0,000 skates at $20) ............ ..... ..

Fixed costs ................................................................ . Earnings before interest and taxes (EBIT) .................. .. Interest expense ..... ............................ ............................ . &lrnjngs before t~\xes (EBT) ... .. .... ......................... ...... . Income tax expense (40%) ......... ............................ ..... .. Earnings alter taxes (EAT) .......................................... ..

Given this income statement, compute the following:

a. Degree of operating leverage. b. Degree of linancial levcrage. c. Degree of combined leverage. d. Break-even point in units (number of skates).

5-J I. Solution :

5- tt

$500,000 200,000 150.000 150,000 60,000 90,000 36,000

$ 54,000

Ou1prcr 05: Opcr.u.ing and Fina.uc-i:ll Le\'el'age

Harding Company

Q = 10,000, P =$50, VC = $20, FC = $ 150,000, I = $60,000 Q(P- VC) a. DOL = _ .:::..:.._ _ ___.:__

Q(P - VC) - FC

_ ___ 10~,0_0_0~($_50_-_$_2~0) __ _ I 0, 000($50 - $20)-$150,000

I 0, 000( $30) - ___ ___;_..:..___

10, 000($30) - $ 150, 000

_ $300,000 = $300,000 = 2 .00x $300,000 - $ 150,000 $ 150,000

5-11. (Continued) b. DFL= EBIT = $ 150,000

EBIT - I $ 150,000-$60,000 = $150,000 = l.6?x $90,000

Q (P - VC) c. DCL = _.....o....::..___....:......_ Q(P - VC) - FC- 1

- ------~1 0~,0~0~0(~$5~0~$~20~) ____ __ 10, 000($50 - $20) - $ 150,000 -$60,000

_ $ 10,000($30) = $300,000 = 3.33x $10, 000($30)-$21 0, 000 $90,000

S-12

Chaptel' 05: O)x'~tating a.od Fin:wcial l.e\'e . age

d. BE = $150,000 = $ 150,000 = 5 000 skates $50-$20 $30 , J 2. Break -even point. a nd degree of leverage (L02 & 5) Mo & Chris's Del icious Burgers,

Inc., sells food to Military Cafeterias for $ 15 a box. The fixed costs of this operation are $80,000, while the variable cost per box is $10. a. What is the break-e ven point ill boxes? b. Calculate the prol'it or loss on 15,000 boxes and on 30,000 boxes. c. What is the degree of operating leverage at 20,000 boxes and at 30,000 boxes?

Why does the degree of operating leveragt: change as the quamity sold increases? d. l f the firm has an annual imcrest expense of$10,000, calculate the degree of

financial leverage at both 20,000 and 30,000 boxes. c. What is the degree of combin.ed leverage at both sales leve ls?

5-12. Solution:

Moe & Chris' Delicious Burgers, Inc.

a. BE = $80,000 = $80,000 = 16 000 boxes $ 15 - $10 $5 '

b. 15,000 30,000 boxes boxes

Sales @ $15 per box $225,000 $450,000 Less: Variables Costs ($ 1 0) ($1 50,000) ($300,000) Fixed Costs ($ 80,000} ($ 80,000} Profit or Loss (EBIT) ($ 5,000) $70,000

c. DOL = Q(P- VC) Q(P -VC)-FC

DOL at 20 000= 20,000($ l 5 - $ IO) , 20,000 ($15 - $ 10) - $80,000

= $100,000 = 5.0x $20,000

5-13

Chapter 05: OpcraLing and Financial Le\\-:rage

DOL at 30 000 = 30000 ($! 5- $LO) ' 30, 000($15-$ 1 0)-$80,000

= $J 50,000 = 2_14x $70,000 Leverage goes down because we are further away from the break-even point, thus the firm is operating on a larger profit base and leverage is reduced.

5-12. (Continued)

d. DFL = EBIT EBIT-1

First determine the profit or loss (EBIT) at 20,000 boxes. As indicated in part b, the profit (EBlT) at 30,000 boxes is $70,000:

Sales @ $15 per bag Less: Variable Costs ($10) Fixed Costs Profit or Loss (EBTT) DFL at 20 000 = $20,000

, $20,000 - $10,000 = $20,000 = 2_0x $10,000

DFL at 30 000 = $70,000 , $70,000 - $10,000

= $70,000 = 1.17 X $60,000

5-1 4

20,000 boxes $300,000 (200,000)

80,000 $ 20,000


e. DCL = __ Q.::c..(P.:..__-_V_C-'-)-Q(P - VC) - FC - I

DCLat20000= 20,000($15 - $10) ' 20,000($15-$10)-$80,000-$10,000

= $100,000 = JO.Ox $10,000

5-12. (Continued)

DCLat30000= 30,000 ($ 15 - $10) , 30,000($15- $10) -$80,000-$10,000

= $150,000 = 2_50x $60,000 13. Break-even point and degree of leverage (L02 & 5) United Snack Company sells

50-pound bags or pe


12,000 ba~s Sales @ $10 per bag I $120,000 Less: Variables Costs ($5) (60,000) Fixed Costs (80,000) Profit or Loss (EBIT) ($ 20,000)

5-13. (Continued)

c. DOL = Q(P- VC) Q(P-VC)-FC

25,000 ba~s $250,000 (125,000)

(80,000) $45,000

D0Lat20000= 20,000($10-$5) ' 20,000 ($10 - $5) - $80,000

= $100,000 = 5.00x $20,000

DOL at 25 000 = 25000 ($I O-$5) ' 25, 000($ 10-$5)-$80,000

= $125,000 = 2_78x $45,000 Leverage goes down because we are further away from the break-even point, thus the finn is operating on a larger profit base and leverage is reduced.

5-1 6


5-13. (Continued)

d. DFL= EBIT EBIT -1

First determine the profit or loss (EBIT) at 20,000 bags. As indicated in part b, the profit (EBIT) at 25,000 bags is $45,000:

20,000 ba2s Sales@ $10 per bag $200,000 Less: Variable Costs ($5) 100,000

Fixed Costs 80,000 Profit or Loss (EBIT) $20,000

DFL at 20 000 = $20,000 , $20,000 - $10, 000

= 2.0x

DFL at 25 000 = $45000 , $45,000 - $10,000

= l.29x

e. DCL= Q (P-VC) Q(P- VC) - FC-1

DCL at 20 000 = 20000 ($I0 - $5) , 20,000($10-$5) -$80,000-$10,000

= $100,000 =IO.Ox $10,000

DCLat25000= 25,000($I0 - $5) ' 25, 000($1 0-$5)-$80,000-$ I 0, 000

= $125,000 = 3_57x $35,000

5-1 7


J 4. Nonlinear breakeven analysis (L02) International Data Syste ms inlormation on re venue and costs is only relevant up to a sales volume of 100,000 un its . After 100,000 units, the market becomes saturated and the ptice per unit falls from $4.00 to $3.80. Also, there are cost overruns at a production volume of ov~r 100,000 units, and variable cost per unit goes up from $2.00 to $2.20. Fixed costS remain the same at $50,000. a. Compute operating income at I 00,000 units. b. Compute operating income m 200,000 units.

5-14. Solution:

International Data Systems

a. Sales ( 100,000 x $4) ......... .............. .............. ... . $400,000

Total variable costs (I 00,000 x $2) ................. . 200,000

Fixed costs ................ ....................................... . 50,000

Operating income ............................................. . $J 5.0J){lQ

b. Sales (200,000 x $3.80) ... .......... ...................... . $760,000

Total variable costs (200,000 x $2.20) ......... ... . 440,000

Fixed costs ......... .. ............ ........ ...... .. ................ . 50,000

0 . . peratmg tncome ...... ............................ ........ ... . $270,000

5- 18


15. Use of different formulas for operating leverdge (LOJ) U.S. S teal has the following income statement data:

Units Sold 40,000 60,000

a.

b.

Tol

Chaptu 0.5: O)x'~taling a.od Fin:wcial l.e\'e . age

Q =40,000

p = Total revenue = $160,000 = $4 Units sold 40,000

VC = Total variable costs = $80,000 = $2 Unils sold 40,000

FC = $50,000

DOL = 40,000 ($4 - $2) $80,000 40, 000($4 - $2) - $50,000 $80,000 - $50,000

= $80,000 = 2.67 $30,000

16. Earnings per sha re and linancialleverage (L04) Cain Auto Supplies and Able Auto Pan s are competitors in the aftermarket for amo supplies. The separate capital structures for Cai n and Able are presented below.

Cain Debt @ I 0% .... ... ................. $ 50,000 Common s tock, $ 10 par .. ... . 100,000

Total................................ $ 150 1(){)() Common shares .. ................. I 0,000

Able Debt @ 10% .... ...... ... ... .. . Common s tock, $ 10 par. Tolal ...................... .. .... .. . Common shares ........... .. .

$ 100,000 50,000

$150,000 5,000

a. Compute earnings per share if eamiogs before interest and taxes arc $10,000, $15,000, and $50,000 (a.ssume a 30 perce nt tax rate).

b. Explain the relationship between earnings per share and the level of EBIT. c. If the cost of debt went up to 12 percent and all other factors remained equal, what

would be the break-even level for EBIT/

5-20


5-16. Solution:

a. Cain Auto Supplies and Able Auto Parts

Cain Able EBTT $10,000 $10,000 Less: Interest 5,000 I 0,000 EBT 5,000 0 Less: Taxes @ 30% 1,500 0 EAT 3,500 0 Shares 10,000 5,000 EPS $.35 0 EBIT $15,000 $15,000 Less: Interest 5,000 I 0,000 EBT 10,000 5,000 Less: Taxes @ 30% 3,000 I ,500 EAT 7,000 3,500 Shares 10,000 5,000 EPS $.70 $.70 EBIT $50,000 $50,000 Less: Interest 5,000 10,000 EBT 45,000 40,000 Less: Taxes @ 30% 13,500 12,000 EAT 31,500 28,000 Shares 10,000 5,000 EPS $3.15 $5.60

521


5-16. (Continued) b. Before-tax return on assets = 6.67%, 10% and 33% at Lhe

respective levels of EBIT. When the before-tax return on assets (EBIT!fotal AsseLS) is less than the cost of debt (10%), Cain does better with less debt than Able. When before-tax return on assets is equal to the cost of debt, both firms have equal EPS. This would be where the method of financing has a neutral effect on EPS. As return on assets becomes greater than tbe interest rate, financial leverage becomes more favorable for Able.

c. 12% x $150,000 (debt & equity)= $18,000 break-even level

17. PIE Ratio (L06) In Problem 16, compute the stock pl'ice for Cain if it sells at 18 times earnings per share and EBIT is $40,000.

5-17. Solution :

Cain Supplies and Able Auto Parts (Continued) Cain

EBIT $40,000 Less: Interest 5,000 EBT $35,000 Less: Taxes @ 30% 10,500 EAT $24,500 Shares 10,000 EPS $2.45 PIE J8x Stock Price $ 44.10

18. Leverage and stockholder weallb (L04) Sterling Optical and Royal Optical botb make glass frames and each is able to generate earnings before interest and taxes of $ 120,000. The separate capital structures for Sterling and Royal are shown below:

5-22


Sterling Debt @ 12% . . .. ..... . ...... :. Common stock, $5 par ..... . Total. ... .. ....... . . ........... . Common shares .. ..... ..... ..

$ 600,000 400.000

$ 1,000,000 80,000

Royal Debt @ 12% ............. .. Common stock, $5 par Total .. ... ........... . ...... . Common shares .... ...... ..

a. Compme earnings per share for both firms. Assume a 25 percent t.ax rate.

$ 200,000 800,000

$1,000,000 160,000

b. In part a, you should have gonen the same answer for both companies' earnings per share. Assuming a P/E ratio of 20 for each company, what would its stock price be?

c. Now as part of your analysis , assume the PIE ratio would be 16 for the riskier company in terms of heavy debt utilization in the capital structure and 25 for the less risky company. What would the stock prices for the two lirms be under these assumptions? (Note: Although interest rates also would likely be different based on risk, we will hold them constant for ease of analysis.)

d. Based on the evidence in pan c, should management on ly be concerned about the impact of linancing plans on earnings per share or should stockholders' we


c. Sterling Royal 16 X $.45 = $7.20 25 X $.45 = $11.25

d. Clearly, the ultimate objective should be to maximize the stock price. While management would be indifferent between the two plans based on earnings per share, Royal Optical, with the less risky plan, has a higher stock price.

19. .Japanese firm and combined leverage (LOS) Firms in Japan onen employ both high operating and Jintmcialleverage because of the use of modern technology and close bonower-lender relationships. Assume the Mitaka Company has a sales volume of 125,000 units at a price of $25 per unit; vali able costs are $5 per un it and fixed costs are $ J ,800,000. Interest expense is $400,000. What is the degree of combined leverage for this J apanesc li.rm '!

5-19. Solution:

Mitaka Company

DCL= Q(P - VC) Q(P- VC)- FC-1

125,000 ($25 - $5) 125,000 ($25 - $5) - $1,800,000 - $400,000

125,000 ($20) 125,000 ($20)-$2,200,000

$2, 500,000 $2, 500,000-$2,200,000

= 8.33x

5-24


20. Combining operating and f'inancialle\'erage (LOS) Sinclair Manufacttuing and Boswell Brothers Inc. are both involved in the production of brick for the homebuilding industry. Their Jjnancial information is as follows:

Capital Structure

Debt @ 12% .... ......... ....... ....... .. ....... ......... ......... ..... . Common s tock, $ I 0 per share ... ............................ .

Tota l... ................................................................. . Common shares ...................................................... . Operating Plan Sales (50,000 units at $20 each) ........... .. .. ......... ..... .

Less: Variable costs .......................... ...... .... ........ .

Fixed costs ...... . Eamings before interest and taxes (EBlT) .......... .... .

Sinclai.r $ 600,000

400,000 $ 1,000,000

40,000

$ 1,000,000 800,000

($16 per un it) 0

$ 200,000

Boswell 0

$ I ,(l()Q.QOO $ I ,000,000

100,000

$ I ,000,000 500,000

($1 0 per unit) 300,000

$ 200,000

a. lf you combine Sinclair's capi t:d structure wi th Boswell's operating plan, what is the degree of combined leverage? (Round 1o 1wo places to 1hc light of the decimal point.)

b. If you combine Boswell's capital srrucrurc wilh S.incJair's operating plan, what is 1hc degree of combined leverage?

c. Explain why you got lhe resuhs you did in part b. d. In part b, if sales double, by what percentage will EPS increase?

5-20. Solution:

Sinclair Manufacturing and Boswell Brothers

525

Omptcr 05: Opernling :ind Fin:mci:JI Leverage

a.

DCL = Q(P - V C) Q(P - VC) - FC - T

- ------~50~~00~0~($~2~0~$1~0~) ____ __ 50,000 ($20 - $ 10) - $300,000-$72,000

500,000 ---------~---------

500,000 - $300,000-$72,000

$500,000 - $128,000

= 3.9Ix b.

DCL = Q(P - VC) Q(P- VC)- FC - 1

_ ___ so..:.., o_o_o..:..:($_20_ -_ $;_1_6):....__ 50,000($20 - $16) -0-0

50,000($4) -

50,000($4)

$200,000 - $200,000

=lx

5-26

C1lo'lptcr- 05: Opemljng ;lnd Finnncial Leverage

5-20. (Continued) c. The leverage factor is only lx because Boswell has no financial

leverage and Sinclair has no operating leverage.

d. BPS will increase by 100 percent. However, there is no leverage involved. BPS merely grows at the same rate as sales.

21 . Expansion and leverage (LOS) n1e Norman Automatic Mailer Machine Company is planning to expand production because of the increased volume of mailouts. n 1e increased m.ailout capacity wi ll cost $2,000,000. The expansion can be linanccd either by bonds at an interest rate of 12 percent or by selling 40,000 shares of com.mon stock at $50 per share. The current income statement (before expansion) is as follows:

NORMAN AUTOMATIC MAILER Income Statement

201X Sales.

Less: Variable costs (40%) . .... .. .... ................ . Fixed COStS . . ..... . .. .... ...... ...... ... . ..... . .. ... ...... .

Eantings before interest and taxes ......... ......... . . Less: lote,cst expense ................ ... ............... . .

Earnings before taxes ................ ....................... . Less: Taxes(@ 35%) .................................... .

Earnings after taxes ....... ................................... . Shares ............................................................... . Eamings per share .. ............. ......... ................... . .

$1,200,000 800.000

$3,000,000

l.OOO,OOO 400,000 600,000 210,QOQ

$ 390,000 100,000

$ 3.90 Assume thai after expansion, sales are expected to increase by $1,500,000. Variable costs will remain at 40 percent of st\les, and fixed costs will increase by $550,000. The U\x rate is 35 percent. a. Calculate the degree of operating leverage, the degree of l'inancial leverage, and the

del,>rCC of combined leverage before expansion. (For the degree of operating leverage, use the formula developed in footnote 2 of this chapter; for the degree of combined leverage, use the formula developed in footnote 3. These instructions apply throughout this problem.)

b. Construct the income statement for the two financial plans. c. Calculate the de&>ree of operating leverage, the degree of linancialleverage, and l11e

de&>ree of combined leverage, after expallsion, for the two linancing plans. d. Explain which linancing plan you favor and the risks involved.

527


5-2 1. Solution:

Norman Automatic Mailer Machine

a. DOL = S-TVC S - TVC - FC

$3,000,000 - $ 1,200,000 -----~--~--~--~----$3,000,000 - $ 1,200,000 - $800,000

= $1,800,000 = I.Bx $1,000,000

DFL = EBJT EBIT - T

$ 1,000,000 - ----'-'-----''----

$1, 000,000-$400,000

= $1,000,000 = l.6?x $600,000

S- TVC DCL = ----------S-TVC-FC- T

----~$~3,~00~0~,000~-~$~1~,2~002,~000~---$3,000,000 - $ 1,200,000 - $800,000 - $400,000

= $1,800,000 = 3x $600,000

S-28


5-21. (Continued) b. Income Statement After Expansion

Debt Equity Sales $4,500,000 $4,500,000 Less: Variable Costs (40%) 1,800,000 I ,800,000 Fixed Costs 1.350,000 I .350.000 EBJT I ,350,000 I ,350,000 Less: Interest 640,0001 400,000 EBT 710,000 950,000 Less: Taxes @ 35% 248,500 332,500 EAT (Net Income) 461,500 617,500 Common Shares 100,000 ] 40,000! BPS $ 4.62 $ 4.41

(1) New interest expense level if expansion is fmanced with debt. $400,000 + 12% ($2,000,000) = $400,000 + $240,000 = $640,000

(2) Number of conunon shares outstanding if expansion is financed with equity. 100,000 + 40,000 = 140,000


5-21. (Continued) c.

S - TVC . DOL = (Sameundereitherplan) S - TVC - FC

DOL (D b /E . ) $4,500,000 - $1,800,000 . e t qtuty = . . .. $4,500,000-$1,800,000-$1,350,000

= $2, 700,000 = 2x $ 1,350,000 DFL= EBIT

EBJT-T

DFL (Debt)= ~$1,350,000 = $1,350,000 = 1.90x $1,3:>0,000-$640,000 $710,000 D FL (E uit ) = $1,350,000 = $1,350,000 = I .4lx

q y $1,350,000-$400,000 $950,000

DCL (Debt)= $4,500,000-$1,800,000 $4,500,000 - $ 1,800,000 - $ 1,350,000 - $640,000

= $2,700,000 = 3.80x $710,000

DCL (E . ) $4,500,000 - $1,800,000 quJty = --~ ----'-'-----'------''----....:.._----$4,:>00,000-$1,800,000-$1,350,000-$400,000

= $2,700,000 = 2_84x $950,000

5-30

Chapter 05: OpcraLing and Fioa.ndal Le\\-:rage

5-21. (Continued) d. The debt financing plan provides a greater earnings per share

level, but provides more risk because of the increased use of debt and higher DFL and DCL. The crucial point is expectations for future sales. If sales are expected to decline or advance very slowly, the debt plan will not perfonn well in comparison to the equity plan. Conversely, with increasing sales, the debt plan becomes more attractive. Based on projected overall sales of $4,500,000, tbe debt plan should probably be favored.

22. Leverage analysis with actual companies (L06) Using Slandard & Poor's dala or annual reports, compare lhe llnancial and operating leverage of Chevron, Eastman Kodak, and Della Airlines for 1he most cunem year. Explain 1he relationship between operating and llnancial leverage for each company and the resuhant combined leverage. What accounts for the di fferences in leverage of these companies?

5-22. Solution: The results for this problem change every year. This is primarily an Internet/library assignment to facilitate class discussion.

23 . Leverage and sensitivity analysis (L06) Dickinson Company has $12 million in assets. Cu1Tenrly hal f of these assets are linanced with long-term debt at 10 percem and half with common stock having a par value of $8. Ms. Smith, vice-president of finance, wishes to analyze two refinancing plans, one with more debt (D) and one with more equity (E). TI1e company earns a return on assets before interest and taxes of 10 percent. TI1e tax rate is 45 percent. Under Pl

Chapter OS: Operating and Financial Leverage

5-23. Solution:

Dickinson Company Income Statements

a. Return on assets= 10%

Current

EBIT = $ 1,200,000 PlanD PlanE

EBIT $) ,200,000 $) ,200,000 $1,200,000 Less: Interest 600,000' 960,000! 300,000-' EBT 600,000 240,000 900,000 Less: Taxes (45%) 270,000 108,000 405,000 EAT 330,000 132,000 495,000 Common shares 750,000q 375,000 l, 125,000 EPS $ .44 $ .35 $

(I) $6,000,000 debt @ 10% (2) $600,000 interest+ ($3,000,000 debt@ 12%) (3) ($6,000,000- $3,000,000 debt retired) @ I 0%

.44

(4) ($6,000,000 common equity)/($8 par value)= 750,000 shares

Plan E and the original plan provide the same earnings per share because the cost of debt at 10 percent is equal to the operating return on assets of 10 percent. With Plan D, the cost of increased debt rises to 12 percent, and the firm incurs negative leverage reducing EPS and also increasing the financial risk to Dickinson.

5-32


5-23. (Continued) b. Return on assets = 5% EBIT = $600,000

Current Plan D PlanE EBJT $600,000 $ 600,000 $600,000 Less: Interest 600,000 960,000 300,000 EBT 0 (360,000) 300,000 Less: Taxes (45%) --- ( 162,000) I 135,000

-

EAT 0 $(198,000) $ 165,000 Conunon shares 750,000 375,000 1,125,000 EPS 0 $ (.53) $ .15

Remm on assets = 15% EBIT = $1,800,000 Current PlanD PlanE

EBIT $1 ,800,000 $1,800,000 $1,800,000 Less: Interest 600,000 960,000 300,000 EBT 1,200,000 840,000 I ,500,000 Less: Taxes (45%) 540,000 378,000 675,000 EAT $ 660,000 $ 462,000 $ 825,000 Common shares 750,000 375,000 1,125,000 EPS $ .88 $ 1.23 $ .73

If the return on assets decreases to 5%, Plan E provides the best EPS, and at 15% return, Plan D provides the best EPS. Plan D is still risky, having an interest coverage ratio of less than 2.0.

5-33


c. Retum on Assets= 10% EBIT = $1,200,000

Current Plan D EBIT $1,200,000 $ 1,200,000 EAT 330,000 132,000 Common shares 750,000 500,000' EPS $. 44 $ .26

(l ) 750,000 - ($3,000,000/$12 per share) = 750,000- 250,000 = 500,000

(2) 750,000 + ($3,000,000/$12 per share) = 750,000 + 250,000 = 1,000,000 shares

Plan E $1,200,000

495,000 I ,OOO,OOO-

$ .50

As the price of the common stock increases, P lan E becomes more attractive because fewer shares can be retired under Plan D and, by the same logic, fewer shares need to be sold under Plan E.

24. Leverage and sensithity analysis (L06) Edsel Research Labs has $24 million in assets. Cunem.ly half o f these assets are linanced with long-term debt at 8 percent and half with common stock having a par Vl~ue of $10. Ms. Edsel, the vice-presidem of finance, wishes to analyze two relinancing plans, one with more debt (D) and one with more equi ty (E). The company eams a return on assets before interest and !

Chaptet 0.5: O)x'~tating aod Fin:wcial Levetagc

5-24. Solution: Edsel Research Labs

Income Statement

a. Return on assets = 8% EBIT = $1,920,000 Current Plan D Plan E

EBIT $1,920,000 $1,920,000 $1,920,000 Less: Interest 960,0001 ? 1,560,000" 480,0003 EBT 960,000 360,000 1,440,000

.ess: Taxes (40%) 384,000 1.44 000 576,000 EAT 576,000 216,000 864.000 Common shares I ,200,0004 600,0005 1,800,0006 EPS $.48 $.36 $.48

1 $12,000,000 debt@ 8% 2 $960,000 interest+ ($6,000,000 new debt@ 10%) 3 ($12,000,000- $6,000,000 debt retired) x 8% 4 ($12,000,000 common equity I $10 par value) = 1,200,000

shares 5 ($6,000,000 common equity I $10 par value)= 600,000

shares 6 ($18,000,000 common equity I $ 10 par value) = 1,800,000

shares

The current plan and Plan E provide the highest return of $.48.

535

Chaplet 05: Ope-raLing and Financial Lever:lge

5-25. (Continued) b. Reuun on assets= 12% EBIT = $2,880,000

Current PlanO Plan E

EBIT $2,880,000 $2,880,000 $2,880,000 Less: lnLerest 960,000 I ,560,000 480,000 EBT 1,920,000 1,320,000 2,400,000 Less: taxes (40%) 768,000 528,000 960,000 EAT 1,152,000 792.000 1,440,000 Common shares 1,200,000 600,000 1,800,000 EPS $.96 $1.32 $.80 Pan D provides the highest return. The % EBIT (12%) is higher than the interest rate (8% and 10% ). The more debt the better.

c. Return on assets = 8%

EBIT Less: Interest EBT Less: taxes (40%) EAT Common shares EPS

Current $1,920,000

960,000 960,000 384,000 576,000

I ,200,000 $.48

I $960,000 + (6,000,000 X 6%)

EBIT = $1 ,920,000

PlanO $1,920,000

1,320,00)1 600,000 240,000 360,000 600,000 $.60

Plan E $1,920,000

480,000 1,440,000

576,000 864,000

I ,800,000 $.48

Plan 0 provides the highest return. The% EBIT (8%) is higher than the cost of new debt ( 6% ).

536


25. L-everage and sensitivity analysis The Lopez-Portillo Company has $10 million in assets, 80 percent financed by debt and 20 percent rmanced by cor'rlmon stock. The interest rate on the debt is J 5 percent and the par value of the stock is $10 per share. President Lopez Portillo is considering two financing plans for an expansion to $15 million in assets.

Under Plan A, the debt-to-total-assets ratio will be maimained, bm new debt wi ll cost a whopping 18 percent! Under Plan B, only new common stock at $10 per share will be issued. The tax rate is 40 percenL a. IJ EB IT is 15 percent on Lolal :tssels, compute eamings per share (EPS) before the

expansion and under the two ithematives. b. What is the degree of ilnancialleverage under each of the tluee plans'/ c. u stock could be sold al $20 per sbarc due 10 increased expectations for the l'imo's

sales and earnings, what impact would this have on cam.ings per share for the two expansion a.llcmati ves? Compute earnings per share for each.

d. Explain why corporate financial off'iccrs are concerned about tbeir stock values.

5-25. Solution:

Lopez-PortiUo Company

a. Rerum on Assets= 12%

Current Plan A EBIT $1,500,000 $2,250,000 Less: Interest 1 200000(a) 1 920000(c EBT 300,000 330,000 Less: Taxes (40%) 120,000 132,000 EAT $ 1.80 000 $ 198 000 Common shares 200,000(b) 300,000(d) EPS $.90 $.66

Plan B $2,250,000

1 200000(e\ 1,050,000

420,000 $630 000

700,000([) $.90

(a) (80% X $1 0,000,000) X 15% = $8,000,000 X 15% = $1,200,000

(b) (20% x $1 0,000,000)/$10 = $2,000,000/$10 = 200,000 shares (c) $1,200,000 (current) + (80% x $5,000,000) x 18% =

$1,200,000 + $720,000 = $1,920,000 (d) 200,000 shares (current)+ (20% x $5,000,000)/$10 =

200,000 + 100,000 = 300,000 shares (e) unchanged (t) 200,000 shares (current)+ $5,000,000/$10 = 200,000 +

500,000 = 700,000 shares

537


5-25. (Continued)

b. DFL = EBIT EBIT - 1

c.

DFL (CuJTent) = $I '500000 = 5.00x $1,500,000- $1,200,000

DFL (Plan A)= $2,250,000 = 6.82x $2,250,000 - $1,920,000

DFL (Plan B)= $2,250000 . = 2.14x $2,250,000-$1,200,000

Plan A PlanB EAT $198,000 $630,000 Common Shares 250,0001 450,0002 EPS $. 79 $ 1.40 1 200,000 shares (current)+ (20% x $5,000,000)/$20

= 200,000 + 50,000 = 250,000 shares 2 200,000 shares (current) + $5,000,000/$20

= 200,000 + 250,000 = 450,000 shares Plan B would continue to provide the higher earnings per share. The difference between plans A and B is even greate r than that indicated in part (a).

d . Not only does the price of the common stock c reate wealth to the shareholder, which is the major objective of the financial manager, but it greatly influences the abili ty to finance projects at a high or low cost of capital. Cost of capital will be discussed in Chapter 10, and one will see the impact that the cost of capital has on capital budgeting decisions.

5-38

Chapter 05: OpcraLing and Fioa.ndal Le\\-:rage

26. Operating leverage and ratios (L06) Mr. Gold is in the widget business. He currently sells I mi Ilion widgets a year at $5 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 live times, and 40 percent of his assets are financed with 8 percent debt, with the balance financed by common stock at $10 par value per share. The tax rate is 40 percent.

His brother- in-law, Mr. Silverman, says he is doing it all wrong. By reducing his price to $4 .50 a widget, he could increase his volume of units sold b) 40 percent. Fixed costs would remain constant, and variable costs would remain $3 per unit. His sales-to-assets ratio would be 6.3 times. Furthermore, he could increase his debt-to-assets ratio to 50 percent, with t.hc balance in common stock. It is assumed that the interest. rate would go up by I percent and the price of stock wou ld remain constant. a. Compute earnings per share under the Go.ld plan. b. CompUie earnings per share under the Silw.rrnan plan. c. Mr. Gold's wife, the chief financial officer, does not think that lixed costs would

remain constamunder the Silverman plan but that they would go up by 15 percent. lf this is the case, should Mr. Gold shift to the Si lverman plan , based on earnings per share'?

5-26. Solution:

Gold-Silverman a. Gold Plan

Sales ($1,000,000 units x $5) I $5,000,000 - Fixed costs - 1,500,00) - Variable costs - 3,000,000 Operating income (EBIT) $500,000 - Jnterest1 32,000 EBT $468,000 -Taxes@ 40% 187,200 EAT $280,800 SharesL 60,000 Earnings Per Share $ 4.68

Sales $5 000 000 Assets = = ' ' = $ 1,000,000

AssetTW11over 5

Debt = 40% of Assets = 40% x $1,000,000 = $400,000

5-39


Interest= 8% x $400,000 = $32,000 2 Stock = 60% of $1,000,000 = $600,000

Shares = $600,000/$10 = 60,000 shares

5-26. (Continued) b. Silverman Plan

Sales ($1,400,000 units at $4.50) - Fixed costs -Variable costs (l 400 000 units x $3) Operating income (EBIT) - Interest3 EBT - Taxes@ 40% EAT Shares4 Earnings Per Share

$6,300,000 1,500,000 4,200,000

$ 600,000 45 000

$ 555,000 222.000

$ 333,000 50,000

$ 6.66

Assets= Sales = $6300000 = $ 1 000 000 . ' ' AssetTumover 6.3

3 Debt = 50% of Assets = 50% x $1,000,000 = $500,000 Interest= 9% x $500,000 = $45,000

4 Stock= 50% of $1 ,000,000 = $500,000 Shares= $500,000/$10 = 50,000 shares

5-40


5-26. (Continued) c. Silverman Plan (based on Mrs. Gold's Assumption)

Sales ($1,400,000 units at $4.50) $6,300,000 -Fixed costs ($1,500,000 x 1.15) 1,725,000 - Variable costs (I ,400,000 units x $3) 4,200,000 Operating income (EBIT) $375,000 -Interest 45,000 EBT $ 330,000 - Taxes@ 40% 132,000 EAT $ 198,000 Shares 50,000 Earnings Per Share $ 3.96

No! Gold should not shift to the Silverman Plan if Mrs. Gold's assumption is coiTect.

27. Expansion, break-even analysis, and leverage (L02, 3 & 4) Delsing Canning Company is consideli ng an expansion or its facilities. hs current income statement is as follows:

Sales ................................................................. . Less: Variable expense (50% or sales) .......... .

Fixed expense ............................................. . Eamings before imerest and taxes (EBIT) ... .... . Interest (10% cost) .. .......... ... ............... .... ..... .... . Eamings before taxes (EBT) ........................ .... . Tax (30%) .... ............................... ...................... . Earnings after taxes (EAT) ......... ......... .... ...... ... . Shan:s of common stock- 200,000 .... ......... .... . Earnings p~r share ............................................ .

$5,000,000 2,500,000 I ,&OQ.OOO

700,000 200,000 500,000 150,000

$ 350.000

$ 1.75

The company is currently financed with 50 percem debt and 50 percent equity (common stock, par value of$10). In order to expand the facilities, Mr. Delsing estimates a need for $2 million in addition


2. Sell $2 milli on of common s tock ~t $20 per share. 3. Sell $1 million of debt at 12 percent and $ 1 million of common s tock ~t $25 per

share. Variable costs arc expected to stay at 50 percent of sales, wh.ilc fixed expenses will increase lO $2,300,000 per year. Dclsing is not sure how much this expansion will add to sale's, but he estimates that sales will rise by $ 1 mi llion per year for the next live years.

De lsing is imerested in a thorough analys is of his expansion plans and methods of financing. He would like you to analyze the following: a. The break-even point for operating expenses before and after expansion (in sales

dollars). b. The degree of operating levemge before and after expansion . Assume sales of $5

million before expansion and $6 million after expansion. Use the formula in footnote 2 o f the chapte r.

c. The degree of financial leverage before cxpans.ion and for all three methods of Jinancing afler expansion. Assume sales of $6 rnillion for this question.

d. Compute EPS under al l three methods of linanciog the expansion at $6 mil.lion in sales (first year) and $ 10 million in sales (last year).

e. What can we learn from the answer to part d about the advisabi li ty of the three methods of linancing the expansion)

5-27. Solution:

Delsing Canning Company

a. AI break-even before expansion:

PQ = FC + VC

Sales

Sales

where PQ equals sales volume at break-even point

=Fixed costs+ Vatiable costs (Variable costs= 50% of sales)

= $1,800,000 +.50 Sales .50 Sales= $1,800,000 Sales = $3,600,000

AI break-even after expansion:

5-42


Sales = $2,300,000 +.50 Sales .50 Sales = $2,300,000 Sales = $4,600,000

b. Degree of operating leverage, before expansion, at sales of $5,000,000 DOL= Q(P - VC) _ S- TVC

Q(P-YC)-FC S-TYC-FC $5,000,000-$2,500,000 - ------~~----~--~------

$5, 000,000 - $2, 500,000 - $1' 800, 000 = $2,500,000 = 3.57 x $700,000

5-27. (Continued) Degree of operating leverage after expansion at sales of $6,000,000 DOL= $6,000,000 - $3,000,000

$6,000,000-$3,000,000-$2,300,000 = $3,000,000 = 4.29x $700,000

This could also be computed for subsequent years. c. DFL before expansion:

DFL= EBIT EBIT-l

543


$700,000 - -----'----

$700, 000 - $200,000

= $700,000 = 1.40x $500,000

DFL after expansion: Compute EBIT and I for all three plans:

(100% Debt)

Sales - TVC (.50) - FC EBIT I - Old Debt I - New Debt Total Interest

5-27. (Continued)

DFL= EBIT EBIT- T

(l)

(1) $6,000,000

3,000,000 2,300,000

$ 700,000 200,000 260,000

$ 460,000

(2)

(100% Equity) (2) $6,000,000

3,000,000 2,300,000

$ 700,000 200,000

0 $ 200,000

(50% Debt and 50%

Equity) (3) $6,000,000

3,000,000 2,300.000

$ 700,000 200,000 120,000

$320,000

(3) $700,000 $700,000 $700,000

( $700,000 - $460,000) ( $700,000 - $200,000) ( $700,000 - $320,000)

DFL = 2.92x l.40x 1.84x d. EPS @ sales of $6,000,000


(refer back to part c to get the values for EBIT and Total I)

(50% Debt (100% (100% and 50%

Debt)(l) E uity) (2) E uity) (3) EBIT $700,000 $700,000 $700,000 Total I 460,000 200,000 320,000 EBT $240,000 $500,000 $380,000 Taxes (30%) 72,000 150,000 114,000 EAT $168,000 $350,000 $266,000 Shares (old) 200,000 200,000 200,000 Shares (new) 0 100,000 40,000 Total Shares 200,000 300,000 240,000 EPS (EATtrotal shares) $.84 $L17 $Lll

EPS @ sales of $10,000,000 (50% Debt

(100% (100% and 50% Debt) (1) Equity) (2) Equitv) (3)

Sales $10,000,000 $10,000,000 $10,000,000 -TVC 5,000,000 5,000,000 5,000,000 -FC 2,300,000 2,300,000 2300,000 EBIT $2,700,000 $2,700,000 $ 2,700,000 Total I 460,000 200,000 320,000 EBT $2,240,000 $2,500,000 $2,380,000 Taxes (30%) 672,000 750,000 714,000 EAT $] ,568,000 $1,750,000 $1,666,000 Total Shares 200,000 300,000 240,000 EPS (EAT/Total Shares) $7.84 $5.83 $6.94

5-45


e. In the first year, when sales and profits are relatively low, plan 2 (100% equity) appears to be the best alternative. However, as sales expand up to $10 mill ion, financial leverage begins to produce results as EBIT increases and Plan J (100% debt) is the highest yielding alternative.

COMPREHENSIVE PROBLEM

Comprehensive Problem 1. Ryan Boot Company (review of Chapters 2 through 5) (multiple LO's from Chap ters 2 through 5)

Assets Cash .. .......... ............. ................. . Marketable sectuilies ....... ........ . Accounls rece ivable ................. . lnvemory ............. .................... .. Gross plant and equipment

Less ............................... ........ .

RYAN BOOT COMPANY Balance Sheet

December 31, 2010

$ 50,000 80,000

3,000,000 1,000,000 6,000,00

Liabilities and Stockholders' Equity Accounls payable....... ............ $2,200,000 Accrued expenses ..... ... ... ... .... J 50,000 Noles payable (currenl) .... ... ... 400,000 Bonds (I 0%) .......... ... ... ...... .... 2,500,000 Corrunon slock ( 1.7 million 1,700,000

shares, par v;\lue $1) .. ....... .. Accumulaled deprecialion .. 2.000.000 Retained earnjngs ................ .. . 1,180,000

$8, 130,000 To1al liabili1ies and Total assets .............. ...... ........... . $8, 130,000 slocknolders' equily ............ .

Income Statemen t- 2010 Sates (credit) ..... .................................................................... .. Fixed costs* .......................................................................... .. Variable coSLS (0.60) ............................................. ................ . Earnings before interest and taxes.. ....................... ............... ..

Less: lnteresl ...................... ............................... ................. . Earnings before taxes ............... ................................ ...... ...... ..

.Less: Taxes@ 35% ....... ... ... .. .... ......................... ...... .......... . Earnings after t~1xes .......... ......... ............................ .. .............. .

Dividends (40% payout) ..................................................... . Increased rc1aiocd earnings ................................................... .

546

$7,000,000 2,100,000 4,200,000

700,000 250.000 450,000 157,500

$ 292,500 117,000

$ 175,500


*Fixed costs include (a) lease expense of $200,000 and (b) depreciation of $500,000.

Note: Ryan Boots also has $65,000 per )'ear in sinking fund obligations associated with its bond issue. The sinking fund represents an annual repayment of the principal amount of the bond. ll is not tax -deductible.

Comprehenshe Problem I (Continued)

Profit margin ................................. .. Return on assets ......... .................. . .. Return on equity ........................... .. Receivables turnover ........... .......... . inventory turnover .. ....................... . Fixed-asset turnover ..................... .. Total-asset turnover ................... .... . Current ralio ................................... . Quick ratio ..................................... . Debt to total assets ......................... . lnteresL coverage ............................ . Fixed charge coverage .................. ..

Ratios Ryan Boot

(to be filled in) Industry 5.75% 6.90% 9.20% 4.35X 6.50X 1.85X 1.20X 1.45X l.lOX

2505% 5.35X 4 .62X

a. Analyze Ryan Boot Company, using ralio analysis . Compute the ratios on the prior page for Ryan and compare them to the industry data that is given. Discuss the weak points, strong points, and what you think should be done to improve the company's perfonn ance.

b. ln your analysis, calculate the overall break-even point in sales dollars and the cash break-even point. Also compute the de&'Tee of operating leverage, degree of financial leverage, and de&'Tee of combined leverage. (Use footnote 2 for DOL and footnote 3 in the chapter for DCL.)

c. Use the iofom1atioo in parts " and b to discuss the risk associated with thls company. Given the ri.s.k, decide whether a bank should loan funds to Ryan .Boot.

Ryan Boot Company is trying to plan the funds needed for 2011. The management anticipates an increase in sales of 20 percem, which can be absorbed wilhout im:reasi11g fixed assets. d. What would be Ryan's needs for external funds based on the current balance sheet'?

Compute RNF (required new funds). Notes payable (current) and bonds are not pru1 or the liabilit)' calculation .

5-47


e. What would be the required new funds if the company b1ings its ratios into line with the industry average during 2011'? Specilical ly examine receivables tumover, inventory turnover, and the profit mmgin. Use the new values to recompute the factors in RNF (assume liabilities stay the same).

f Do not calculate, only comment on these questions. How would required new funds change if the company: (J) Were at full capacity') (2) Raised the dividend payout ratio? (3) Suffered a decreased g.-owth in sales? (4) Faced an accelerated inflatioo rate?

CP 5-l. Solution:

Ryan Boot Company

a. Ratio analysis Profit margin $292,500/$7,000,000 Return on assets $292,500/$8,130,000 Return on equity $292,500/$2,880,000 Receivable turnover $7,000,000/$3 000,000 Inventory turnover $7,000,000/$1,000,000 Fixed asset turnover $7,000,000/$4,000,000 Total asset ntrnover $7,000,000/$8,130,000 Current ratio $4,130,000/$2,750,000 Quick ratio $3,130,000/$2,750,000 Debt to total assets $5,250,000/$8,130,000 Interest coverage $700,000/$250,000 Fixed charge coverage see calculation below*

Ryan 4.18% 3.60%

10.16% 2.33x 7.00x l.75x .86x

l.50x l.14x

64.58% 2.80x 1.64x

* $700,000+200,000(Lease) = 1.64x $250,000+200,000 + 65,000/ (1 - .35)

Industry 5.75% 6.90% 9.20% 4.35x 6.50x l.85x l.20x 1.45x I. !Ox

25.05% 5.35x 4.62x

Lease expense of $200,000 and sinking fund of $65,000

5-48


a. The company has a lower profit margin than the industry and the problem is further compounded by the slow turnover of assets (.86x versus an i_ndustry norm of I .20x). Thjs leads to a much lower return on assets. The company has a higher remrn on equity than the industry, but this is accomplished through the firm's heavy debt rat.io rather than through superior profitabihty.

The slow turnover of assets can be djrectly traced to the unusually high level of accounts receivable. The firm's accounts receivable mrnover ratio is only 2.33x, versus an industry norm of 4.35x. Actually the firm does quite well with inventory turnover and it is only slightly below the industry in fixed asset turnover.

The previously mentioned heavy debt position becomes more apparent when we examine times interest earned and fi xed charge coverage. The latter is particularly low due to lease expenses and sinking fund obligations.

b. Break-even in sales Sales = Fixed Costs + Variable costs (variable costs are expressed as a percentage of sales) Sales8 11 = $2,100,000 + .60 Sales .40 s = $2, 100, 000

s - $2,100,000/.40 s - $5,250,000

5-49


Cash break -even Sales = (Fixed costs - Non cash expenses*) +Variable costs Sales8E = ($2,100,000 - $500,000) + .60 Sales Sales8E = $1,600,000 + .60 Sales .40 s = $1,600,000

s = $1,600,000/.40 s = $4,000,000

*Depreciation

DOL= S- TVC S-TVC-FC

$7' 000,000- $4,200,000 - ----~--------~--------$7, 000,000 - $4,200,000 - $2,100,000

= $2,800,000 = 4x $700,000

DFL = EBIT = $700,000 EBIT - I $700,000 - $250,000

= $700,000 = 1_56x $450,000

DCL = ___ S_ T_V_C_' _ S-TVC-FC- T

$7,000,000- $4,200,000 - --------~--~--~--~---------

$7,000,000 - $4,200,000 - $2,100,000 - $250,000

= $2,800,000 = 6_22x $450,000

5-50


c. Ryan is operating at a sales volume that is $1,750,000 above the traditional break-even point and $3,000,000 above the cash break-even point. This can be viewed as somewhat positive.

However, the firm has a high degree of leverage, which indicates any reduction in sales volume could have a very negative impact on profitability. The DOL of 4x is associated with heavy fixed assets and relatively high fixed costs. The DFL of 1.56x is attributed to high debt reliance. Actually, if we were to include the lease payments of $200,000 with the interest payments of $250,000, the DFL would be almost 3x. The banker would have to question the potential use of the funds and the firm's ability to pay back the loan. AcUlally, the fl.l'lll aheady appears to have an abundant amount of assets, so hopefully a large expansion would not take place here. There appears to be a need tO reduce accounts receivable rather than increase the level.

One possible use of the ftmds might be to pay off part of the current notes payable of $400,000. This might be acceptable if the firm can demonstrate the ability to meet its future obligations. The banker should request to see pro forma financial statements and projections of future cash flow generation. The loan might only be acceptable if the firm can bring down its accounts receivable position back in line and improve its profitability.

55 1


d. Required new funds = A (6S) - L (6S) -PS2 (1 - D) s s Change in Sales = 20% x $7 ,000,000= $ 1 ,400,000

RNF = $4,l30,000 ($ 1,400,000) - $2'350000 ($1 ,400,000) $7,000,000 $7,000,000

-4.18% ($8,400,000)(1 - .4)

RNF = .590($1 ,400,000) - .336($1,400,000) - $351, 120(.6) =$826,000 -$470,400 - $2 10,672 =$144,928

e. Required funds if selected industry ratios were applied

Receivables= Sales/Receivable turnover

Receivables= $7,000,()()()/4.35 Receivables = $1 ,609, 195 Revised A (assets) =$50,000+$80,000 + $1,609, 195 + $1,000,000 =$2, 739,195 Profit Margin= 5.75%

A L RNF = s(6S) - S(6S) - PS2 ( 1- D)

SS2


RNF= $2739195 ($1 400 000)- $2350000 ($1 400 000) $7,000,000 , , $7,000,000 ' '

-5.75%($8,400,000)(1 -.4)

RNF= .391($1 ,400,000)- .336($1,400,000) -$483,000 (.6) =$547,400 - $470,400 - $289,800 = - $212,800

Required new funds (RNF) is negative, indicating there will actually be an excess offunds equal to $212,180. This is due to the much more rapid turnover of accounts receivable and the higher profit margin.

f. ( 1) If Ryan Boots were at full capacity, more funds would be needed to expand plant and equipment.

(2) More funds would be needed to offset the larger payout of earnings to dividends.

(3) Fewer funds would be required as sales grow less rapidly. Fewer new assets would be needed to support sales growth.

(4) As inf1ation increased so would the cost of new assets, especially inventory and plant and equipment Even if sales prices could be increased, more assets would be required to support the same physical level of sales. Increased profits alone would not make up for the higher level of assets required and more funds would be needed.

5-53


WEB EXERC I SE

I. At the stan o r the chapter, we talked about how risky and volatile airlines' operations were. Let's examine this further. Go to iinance.vahoo.com.

Enter AMR for American Airlines in the "Gel Quotes" box. Go to "Company Proiile'" along the left-hand margin.

2 . Click 0 11 profile in the left-hand column and write a one-paragraph description or the company.

3 Scroll down and cl ick on the "Income Statement" Describe the pattern of change tor "'Total Revenue" and "Net Income from Continuing Operations" in one paragraph.

4. Next go to the "Balance Sheet." In one sentence, describe the pattern of change in Stockholders' Equit)' and indicate whether this does or does not appear to be a mauer or concern.

5. Click on "Analyst Estimates." Do AMR's earnings estimates appear to be more or less promising for the rumre?

6 . Finally, c lick on "CompeliLrs." How does AMR compare to the other airlines and the industry in terms of Operating Margin?

Note: Occasion:dly a ropic we h~vc Jjs1cd may h:wc been dclelcd. upd:ucd. or m

chapter5 hw answers

Documents