Chapter 5



Chapter 5

Operating and Financial Leverage

13. Break-even point and degree of leverage (LO2 & 5) United Snack Company sells

50-pound bags of peanuts to university dormitories for $10 a bag. The fixed costs of this operation are $80,000, while the variable costs of peanuts are $.10 per pound.

a. What is the break-even point in bags?

b. Calculate the profit or loss on 12,000 bags and on 25,000 bags.

c. What is the degree of operating leverage at 20,000 bags and at 25,000 bags? Why does the degree of operating leverage change as the quantity sold increases?

d. If United Snack Company has an annual interest expense of $10,000, calculate the degree of financial leverage at both 20,000 and 25,000 bags.

e. What is the degree of combined leverage at both sales levels?

5-13. Solution:

United Snack Company

a. [pic]

b.

| |12,000 bags |25,000 bags |

|Sales @ $10 per bag |$120,000 |$250,000 |

|Less: Variables Costs ($5) |(60,000) |(125,000) |

|Fixed Costs | (80,000) |(80,000) |

|Profit or Loss (EBIT) |($ 20,000) |$ 45,000 |

5-13. (Continued)

c. [pic]

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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.

5-13. (Continued)

d. [pic]

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 bags |

|Sales @ $10 per bag |$200,000 |

|Less: Variable Costs ($5) |100,000 |

| Fixed Costs |80,000 |

|Profit or Loss (EBIT) |$ 20,000 |

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e. [pic]

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21. Expansion and leverage (LO5) The Norman Automatic Mailer Machine Company is planning to expand production because of the increased volume of mailouts. The increased mailout capacity will cost $2,000,000. The expansion can be financed either by bonds at an interest rate of 12 percent or by selling 40,000 shares of common stock at $50 per share. The current income statement (before expansion) is as follows:

|NORMAN AUTOMATIC MAILER |

|Income Statement |

|201X |

|Sales. | |$3,000,000 |

| Less: Variable costs (40%). |$1,200,000 | |

| Fixed costs | 800,000 | |

|Earnings before interest and taxes | |1,000,000 |

| Less: Interest expense | | 400,000 |

|Earnings before taxes | |600,000 |

| Less: Taxes (@ 35%) | | 210,000 |

|Earnings after taxes | |$ 390,000 |

|Shares | |100,000 |

|Earnings per share | |$ 3.90 |

Assume that after expansion, sales are expected to increase by $1,500,000. Variable costs will remain at 40 percent of sales, and fixed costs will increase by $550,000. The tax rate is 35 percent.

a. Calculate the degree of operating leverage, the degree of financial leverage, and the degree 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 degree of operating leverage, the degree of financial leverage, and the degree of combined leverage, after expansion, for the two financing plans.

d. Explain which financing plan you favor and the risks involved.

5-21. Solution:

Norman Automatic Mailer Machine

a. [pic]

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5-21. (Continued)

b. Income Statement After Expansion

| |Debt |Equity |

|Sales |$4,500,000 |$4,500,000 |

|Less: Variable Costs (40%) |1,800,000 |1,800,000 |

|Fixed Costs |1,350,000 |1,350,000 |

|EBIT |1,350,000 |1,350,000 |

|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 |140,0002 |

|EPS |$ 4.62 |$ 4.41 |

(1) New interest expense level if expansion is financed with debt.

$400,000 + 12% ($2,000,000) = $400,000 + $240,000 = $640,000

(2) Number of common shares outstanding if expansion is financed with equity.

100,000 + 40,000 = 140,000

5-21. (Continued)

c. [pic][pic]

[pic]

[pic]

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 perform 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, the debt plan should probably be favored.

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