Chapter 05: Operating and Financial Leverage
5-21
5-16. Solution:
a. Cain Auto Supplies and Able Auto Parts
Cain
Able
EBIT
$10,000
$10,000
Less: Interest
5,000
10,000
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
10,000
EBT
10,000
5,000
Less: Taxes @ 30%
3,000
1,500
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
Chapter 05: Operating and Financial Leverage
5-22
5-16. (Continued)
b. Before-tax return on assets = 6.67%, 10% and 33% at the
respective levels of EBIT. When the before-tax return on
assets (EBIT/Total Assets) is less than the cost of debt
17. P/E Ratio (LO6) In Problem 16, compute the stock price 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
P/E
18x
Stock Price
$ 44.10
18. Leverage and stockholder wealth (LO4) Sterling Optical and Royal Optical both 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:
Chapter 05: Operating and Financial Leverage
5-23
Sterling
Royal
Debt @ 12%………………
$ 600,000
Debt @ 12%……………
$ 200,000
Common stock, $5 par……
400,000
Common stock, $5 par
800,000
Total………………………
$1,000,000
Total……………………
$1,000,000
Common shares…………..
80,000
Common shares…………
160,000
a. Compute earnings per share for both firms. Assume a 25 percent tax rate.
b. In part a, you should have gotten 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 P/E 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 firms 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 part c, should management only be concerned about the
impact of financing plans on earnings per share or should stockholders’ wealth
maximization (stock price) be considered as well?
5-18. Solution:
Sterling Optical and Royal Optical
a.
Sterling
Royal
EBIT
$120,000
$120,000
Less: Interest
72,000
24,000
EBT
48,000
96,000
Less: Taxes @ 25%
12,000
24,000
EAT
36,000
72,000
Shares
80,000
160,000
EPS
$.45
$.45
b. Stock price = P/E ×EPS
20 × $.45 = $9.00
Chapter 05: Operating and Financial Leverage
c. Sterling Royal
16 × $.45 = $7.20 25 × $.45 = $11.25
19. Japanese firm and combined leverage (LO5) Firms in Japan often employ both high
operating and financial leverage because of the use of modern technology and close
borrower-lender relationships. Assume the Mitaka Company has a sales volume of 125,000
units at a price of $25 per unit; variable costs are $5 per unit and fixed costs are
$1,800,000. Interest expense is $400,000. What is the degree of combined leverage for this
Japanese firm?
5-19. Solution:
Mitaka Company
Q(P VC)
DCL Q(P VC) FC I
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
−
=
− − −
−
=
− − −
=
−
Chapter 05: Operating and Financial Leverage
5-25
20. Combining operating and financial leverage (LO5) Sinclair Manufacturing and Boswell
Brothers Inc. are both involved in the production of brick for the homebuilding industry.
Their financial information is as follows:
Capital Structure
Sinclair
Boswell
Debt @ 12%………………………………………………..….
$ 600,000
0
Common stock, $10 per share…………………………..
400,000
$ 1,000,000
Total……………………………………………………..…….
$ 1,000,000
$ 1,000,000
Common shares……………………………………………….
40,000
100,000
Operating Plan
Sales (50,000 units at $20 each)…………………………
$ 1,000,000
$ 1,000,000
Less: Variable costs….…………………………………..
800,000
500,000
…………………………………………..…………………………..
($16 per unit)
($10 per unit)
Fixed costs.……
0
300,000
Earnings before interest and taxes (EBIT)……………
$ 200,000
$ 200,000
a. If you combine Sinclair’s capital structure with Boswell’s operating plan, what is the
degree of combined leverage? (Round to two places to the light of the decimal point.)
b. If you combine Boswell’s capital structure with Sinclair’s operating plan, what is the
degree of combined leverage?
c. Explain why you got the results 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
Chapter 05: Operating and Financial Leverage
a.
Q(P VC)
DCL Q(P VC) FC I
50,000 ($20 $10)
50,000 ($20 $10) $300,000 $72,000
500,000
500,000 $300,000 $72,000
$500,000
$128,000
3.91x
−
=
− − −
−
=
− − −
=
−−
=
=
b.
Q(P VC)
DCL Q(P VC) FC I
50,000($20 $16)
50,000($20 $16) 0 0
50,000($4)
50,000($4)
−
=
− − −
−
=
− − −
=
Chapter 05: Operating and Financial Leverage
5-27
5-20. (Continued)
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.
Chapter 05: Operating and Financial Leverage
5-21. Solution:
Norman Automatic Mailer Machine
a.
S TVC
DOL S TVC FC
−
=
−−
$3,000,000 $1,200,000
$3,000,000 $1,200,000 $800,000
$1,800,000 1.8x
$1,000,000
EBIT
DFL EBIT I
$1,000,000
$1,000,000 $400,000
$1,000,000 1.67x
$600,000
−
=
−−
==
=
−
=
−
==
S TVC
DCL S TVC FC I
$600,000
−
=
==
Chapter 05: Operating and Financial Leverage
5-29
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.
(2) Number of common shares outstanding if expansion is
financed with equity.
Chapter 05: Operating and Financial Leverage
5-21. (Continued)
c.
S TVC
DOL (Sameundereitherplan)
S TVC FC
−
=
−−
$4,500,000 $1,800,000
DOL (Debt/Equity) $4,500,000 $1,800,000 $1,350,000
$2,700,000 2x
$1,350,000
−
=
−−
==
EBIT
DFL EBIT I
$1,350,000 $1,350,000
DFL (Debt) 1.90x
$1,350,000-$640,000 $710,000
$1,350,000 $1,350,000
DFL (Equity) 1.42x
$1,350,000-$400,000 $950,000
$4,500,000 $1,800,000
DCL (Debt) $4,500,000 $1,800,000
=
−
= = =
= = =
−
=
−−
$1,350,000 $640,000
$2,700,000 3.80x
$710,000
−
==
$4,500,000 $1,800,000
DCL (Equity) $4,500,000 $1,800,000 $1,350,000 $400,000
$2,700,000 2.84x
−
=
− − −