11. Assuming that all other factors remain unchanged, determine how a firm's breakeven point is affected by each of the following:
a. The firm finds it necessary to reduce the price per unit because of competitive conditions in the market.
A reduction in price per unit (P) reduces the contribution margin per unit (P - V) and hence increases the breakeven output level (Qb).
b. The firm's direct labor costs increase as a result of a new labor contract.
An increase in direct labor costs increases variable cost per unit (V), reduces the contribution margin per unit (P - V), and hence increases the breakeven output level (Qb).
c. The Occupational Safety and Health Administration requires the firm to install new ventilating equipment in its plant. (Assume that this action has no effect on worker productivity.)
The installation of new ventilating equipment increases fixed costs (F) in the form of depreciation on the equipment, and hence increases the breakeven output level (Qb).
4. Albatross Airline’s fixed operating costs are $5.8 million, and its variable cost ratio is 0.20. The firm has$2 million in bonds outstanding with a coupon interest rate of 8 percent. Albatross has 30,000 shares of preferred stock outstanding, which pays a $2 annual dividend? There are 100,000 shares of common stock outstanding. Revenues for the firm are $8 million, and the firm is in the 40 percent corporate income tax bracket.
a. Compute Albatross’ degree of operating leverage.
DOL =
=
= 10.67
b. Compute its degree of financial leverage.
DFL =
=
= 1.36
c. Compute its degree of combined leverage and interpret this value.
DCL = DOL x DFL
= 10.67 x 1.36
= 14.55
The DCL shows that each one percent change in sales results in a 14.55 percent change in EPS, in the same direction as the sales change.
8. A firm has sales of $10 million, variable costs of $5 million, EBIT of $2 million, and a degree of total leverage of 3.0.
a. If the firm has not preferred stock, what are its annual interest charges?
DCL = (Sales - Variable cost)/[EBIT - Interest - Dp/(1-T)]
3.0 = ($10M - $5M) / ($2M - Interest)
Interest = $333,333
b. If the firm wishes to reduce its degree of total leverage to 2.5 by reducing interest charges, what will be the new level of annual interest charges?
2.5 = ($10M - $5M) / ($2M - Interest)
Interest = $0
9. Fastron, Inc. expects sales of silicon chips to be $60 million this year. Because this is a very capital-intensive business, fixed operating costs are $20 million. The variable cost ratio is 40 percent. The firm’s debt obligations consist of a $4 million, 10 percent bank loan and a $20 million bond issue with an 11 percent coupon rate. Fastron has 1 million shares of common stock outstanding, and its marginal tax rate is 40 percent.
a. Compute Fastron’s degree of operating leverage.
DOL =
=
= 2.25
b. Compute Fastron’s degree of financial leverage.
DFL =
=
= 1.19
c. Compute Fastron’s degree of combined leverage
DCL = DOL x DFL
= 2.25 x 1.19
= 2.69
d. Compute Fastron’s EPS if sales decline by 5 percent.
A sales decline to $57,000,000 is a 5 percent decline from $60,000,000
New EPS = $8.04 x (1 - (0.05 x 2.69)) = $6.96
10. McFrugal, Inc. has expected sales of $20 million. Fixed operating costs are $2.5 million, and the variable cost ratio is 65 percent. Mcfrugal has outstanding a $12 million, 8 percent bank loan. The firm also has outstanding 1 million shares of common stock ($1 par value). McFrugal’s tax rate is 40 percent.
a. What is McFrugal’s degree of operating leverage at a sales level of $20 million?
DOL =
=
= 1.556
b. What is McFrugal’s current degree of financial leverage?
DFL =
=
= 1.2712
c. Forecast McFrugal’s EPS if sales drop to $15 million.
DCL= DOL x DFL = 1.5556 x 1.2712
= 1.9775
% change in EPS = DCL x % change in Sales
% change in sales= ($15 million - $ 20 million) / $ 15 million= -25%
Therefore % change in EPS= -49.44% =-0.25x1.9774
EPS at sales of $20 million= $2.124
Therefore EPS at sales of $15 million= ( 1 -0.4944) x $2.124
= $1.074
12. Finance Question
East Publishing Company is doing an analysis of a proposed new
finance textbook. Using the following data, answer (a) through (d).
Fixed Cost per Edition:
Development (reviews, class testing , and so on) $18,000
Copyediting 5,000
Selling and promotion 7,000
Typesetting 40,000
Total $70,000
Variable Cost per Copy:
Printing and binding $4.20
Administrative costs 1.60
Salespeople's commission (2% of selling price) 0.60
Author's royalties (12% of selling price) 3.60
Bookstore discounts (20% of selling price) 6.00
Total $16.00
Projected Selling Price $30.00
The company's marginal tax rate is 40 percent.
a. Determine the company's breakeven volume for this book:
i. in units
FC = $70,000; VC = $16; P = $30
Qb = $70,000/($30 - $16) = 5,000 copies
II. In dollar sales
Sb = Qb x P = 5,000 x $30 = $150,000
b. Develop a breakeven chart for the textbook.
Slope of total revenue line is P = $30; Total revenue line originates from the origin (0,0).
Slope of total cost line is V = $16; Total cost line has a y-intercept of $70,000.
Breakeven units equal 5,000 copies at a total revenue level of $150,000.
c.Determine the number of copies East must sell in order to earn an (operating) profit of $21,000 on this book.
Target profit = $21,000
Target volume = ($70,000 + $21,000)/($30 - $16) = 6,500 books
d. Suppose East feels that $30.00 is too high a price to charge for a new finance textbook. It has examined the competitive market and determined that $24.00 would be a better selling price. What would the breakeven volume be at this new selling point?
Projected selling price $24.00
Variable costs per copy
Printing and binding $ 4.20
Administrative costs 1.60
Sales commissions 0.48*
Author's royalties 2.88*
Bookstore discounts 4.80*
Total $13.96
*These variable costs are reduced because they are a function of
the selling price.
Qb = $70,000 / ($24 - $13.96) = 6,972 copies
15. Rodney Rogers, a recent business school graduate, plans to open a wholesale dairy products firm. The business will be completely financed with equity. Rogers expects first year sales to total $5,500,000. He desires to earn a target pretax profit of $1,000,000 during his first year of operation. Variable costs are 40 percent of sales.
a. How large can Rogers’ fixed operating costs be if he is to meet his profit target?
Sales = $5,500,000
VC = 0.4($5,500,000) = $2,200,000
Target pretax profit = $1,000,000
$5,500,000 - $2,200,000 - FC = $1,000,000
FC = $2,300,000
b. What is Rogers’ breakeven level of sales at the level of fixed operating costs determined in (a)?
Breakeven sales = $2,300,000/ (1 - 0.4) = $3,833,333
6. What is the underlining objective of EBIT-EPS analysis?
Use of EBIT-EPS analysis can determine which financing alternative maximizes EPS. However, it is possible that maximizing EPS results in such a high risk level that the weighted cost of capital is not minimized, and therefore the value of the firm is not maximized.
8. In practice what are the factors managers consider in setting a firm’s target capital structure?
A firm should use more debt if it traditionally has been more profitable than the average firm in the industry, or if its operating income is more stable than the operating income of the average firm in the industry. If the opposite factors (i.e., less profitable and less stable) are true, the firm generally should use less debt. This answer assumes that the average firm in the industry is operating at or near an optimal capital structure.
4. Emco Products has a present capital structure consisting only of common stock (10 million shares). The company is planning a major expansion. At this time, the company is undecided between the following two financial plans (assume a 40 percent marginal tax rate):
Plan 1 (Equity financing). Under this plan, an additional 5 million shares of common stock will be sold at $10 each.
Plan 2 (Debt financing). Under this plan, $50 million of 10 percent long term debt will be sold.
One piece of information the company desires for its decision analysis is an EBIT-EPS analysis.
a. Calculate the EBIT-EPS indifference point.
Interest under Debt Alternative = $50 (million) × 10% = $5 (million)
EPS (debt financing) = EPS (equity financing)
6EBIT = 9EBIT - 45
3 EBIT = 45
EBIT = $15
B.Graphically determine the EBIT-EPS indifference point
Hint: Use EBIT = $10 million and $25 million.
Please see the attached excel sheet for calculations
c. What happens to the indifference point if the interest rate on debt increases and the common stock sales price remains constant?
Indifference point moves to right, i.e., higher EBIT
d. What happens to the indifference point if the interest rate on debt remains constant and the common stock sales prices increases?
Indifference point moves to right, i.e., higher EBIT.
5. Morton Industries is considering opening a new subsidiary in Boston, to be operated as a separate company. The company’s financial analysts expect the new facility’s average EBIT level to be $6 million per year. At this time, the company is considering the following two financing plans (use a 40 percent marginal tax rate in your analysis):
Plan 1 (Equity Financing). Under this plan, $2 million common shares will be sold at $10 each.
Plan 2 (Debt equity financing). Under this plan, $10 million of 12 percent long-term debt and 1 million common shares at $10 each will be sold.
a. Calculate the EBIT-EPS indifference point.
EPS (Plan 1) = EPS (Plan 2)
[(EBIT - 0)(1 - .4)]/2 = [(EBIT - 1.2)(1 - .4)]/1
EBIT* = $2.4 million
b. Calculate the expected EPS for both financing plans.
Plan 1 Plan 2
EBIT $6.0 $6.0
I 0 1.2
EBT $6.0 $4.8
T @ 40% 2.4 1.92
EAT $3.6 $2.88
Shares Outstanding 2.0 1.0
EPS $1.80 $2.88
c. What factors should the company consider in deciding which financing plan to adopt?
The factors the company should consider include the following:
1. The plan's effect on the company's stock price (difficult to determine in practice).
2. The capital structure of the parent company.
3. The probability distribution of expected EBIT.
d. Which plan do you recommend the company adopt?
Adopt plan 2 if the company can be reasonably sure that EBIT will not drop too much in a recession. Otherwise, plan 1 appears better.
e. Suppose Morton adopts Plan 2, and the Boston facility initially operates at an annual EBIT level of $6 million. What is the times interest earned ratio?
T.I.E. = (EBIT/I) = (6.0/1.2) = 5 times
Note: This calculation assumes no short-term debt, either permanent or seasonal.
6. Moon and Chittenden are considering a new Internet venture to sell used textbooks. The project requires $300,000 in financing. Two alternatives have been proposed.
Plan 1 (Common equity financing). Sell 30, 000 shares of stock at a net price of $10 per share.
Plan 2 (Debt equity financing). Sell a combination of 15,000 shares of stock at a net price of $10 per share and $150,000 of long-term debt at a pretax interest rate of 12 percent.
Assume the corporate tax rate is 40 percent.
a. Compute the indifference level of EBIT between these two alternatives
Plan A
Debt= $0
Equity= $300,000
# of shares= 30,000
Interest rate= 12.00%
Interest expense= $0.00
Plan B
Debt= $150,000
Equity= $150,000
# of shares= 15,000
Interest rate= 12.00%
Interest expense= $18,000 =12.% x $150,000.
EPS = (EBIT - Interest)x (1-Tax rate) / # of shares
EPS
Plan A : (EBIT-0) (1-0.4)/30000
Plan B : (EBIT-18000) (1-0.4)/15000
For point of indifference EPS under two plans should be eaual
or
(EBIT-0) (1-0.4)/30000 = (EBIT-18000) (1-0.4)/15000
Solving for EBIT:
EBIT= $36,000
Answer: EBIT= $36,000
b. If the firm’s EBIT next year has an expected value of $25,000, which plan would you recommend assuming maximizing EPS is a valid objective?
Below the indifference point, the plan with lower debt is better
Hence opt for Plan A as it would give a higher EPS
Check:
EBIT= $25,000
Plan A
Debt $0
Earnings before interest and taxes (EBIT) ...... 25,000
Less Interest expense @ 12.00% 0 =12.% x $.
Earnings before taxes (EBT) ...... 25,000
Less Taxes @ 40% 10,000 =40.% x $25,000.
Net Income= 15,000
Number of shares= 30,000
EPS= $0.500 =$15,000. / 30,000.
Plan B
Debt $150,000
Earnings before interest and taxes (EBIT) ...... 25,000
Less Interest expense @ 12.00% 18,000 =12.% x $150,000.
Earnings before taxes (EBT) ...... 7,000
Less Taxes @ 40% 2,800 =40.% x $7,000.
Net Income= 4,200
Number of shares= 15,000
EPS= $0.280 =$4,200. / 15,000.