A. Calculate the Return on Invested Capital (ROIC) for Each Firm

Denise Sullivan

Problems

13-1

BREAK-EVEN ANALYSIS - A company’s fixed operating costs are $430,000, its variable costs are $2.95 per unit, and the product’s sales price is $4.50. What is the company’s break-even point; that is, at what unit sales volume will its income equal its costs?

13-5

FINANCIAL LEVERAGE EFFECTS - Firms HL and LL are identical except for their financial leverage ratios and the interest rates they pay on debt. Each has $20 million in invested capital, has $4 million of EBIT, and is in the 40% federal-plus-state tax bracket. Firm HL, however, has a debt-to-capital ratio of 50% and pays 12% interest on its debt, whereas LL has a 30% debt-to-capital ratio and pays only 10% interest on its debt. Neither firm uses preferred stock in its capital structure.

a. Calculate the return on invested capital (ROIC) for each firm.

b. Calculate the return on equity (ROE) for each firm.

c. Observing that HL has a higher ROE, LL’s treasurer is thinking of raising the debt-to-

capital ratio from 30% to 60% even though that would increase LL’s interest rate on all debt to 15%. Calculate the new ROE for LL.

13-6

BREAK-EVEN ANALYSIS - The Warren Watch Company sells watches for $26, fixed costs are $155,000, and variable costs are $13 per watch.

a. What is the firm’s gain or loss at sales of 9,000 watches? At 15,000 watches?

b. What is the break-even point? Illustrate by means of a chart.

c. What would happen to the break-even point if the selling price was raised to $33? What is the significance of this analysis?

d. What would happen to the break-even point if the selling price was raised to $33 but variable costs rose to $24 a unit?

14-1

RESIDUAL DIVIDEND MODEL - Altamonte Telecommunications has a target capital structure that consists of 45% debt and 55% equity. The company anticipates that its capital budget for the upcoming year will be $1,000,000. If Altamonte reports net income of $1,200,000 and it follows a residual dividend payout policy, what will be its dividend payout ratio?

14-3

STOCK REPURCHASES - Gamma Industries has net income of $3,800,000, and it has 1,490,000 shares of common stock outstanding. The company’s stock currently trades at $67 a share. Gamma is considering a plan in which it will use available cash to repurchase 10% of its shares in the open market at the current $67 stock price. The repurchase is expected to have no effect on net income or the company’s P/E ratio. What will be its stock price following the stock repurchase?

14-5

EXTERNAL EQUITY FINANCING - Coastal Carolina Heating and Cooling Inc. has a 6-month backlog of orders for its patented solar heating system. To meet this demand, management plans to expand production capacity by 45% with a $20 million investment in plant and machinery. The firm wants to maintain a 35% debt level in its capital structure. It also wants to maintain its past dividend policy of distributing 55% of last year’s net income. In 2016, net income was $5 million. How much external equity must Coastal Carolina seek at the beginning of 2017 to expand capacity as desired? Assume that the firm uses only debt and common equity in its capital structure.