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Chapter 05: Operating and Financial Leverage
5-41
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 1.15)
1,725,000
−Variable costs (1,400,000 units $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
27. Expansion, break-even analysis, and leverage (LO2, 3 & 4) Delsing Canning Company
is considering an expansion of its facilities. Its current income statement is as follows:
Sales ...............................................................
$5,000,000
Less: Variable expense (50% of sales) ..........
2,500,000
Fixed expense ............................................
1,800,000
Earnings before interest and taxes (EBIT) .......
700,000
Interest (10% cost) ..........................................
200,000
Earnings before taxes (EBT)............................
500,000
Tax (30%) .......................................................
150,000
Earnings after taxes (EAT) ..............................
$ 350,000
Shares of common stock—200,000 .................
Earnings per share ...........................................
$1.75
The company is currently financed with 50 percent 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 additional financing. His investment banker has laid out three plans for him
to consider:
1. Sell $2 million of debt at 13 percent.
Chapter 05: Operating and Financial Leverage
5-42
2. Sell $2 million of common stock at $20 per share.
3. Sell $1 million of debt at 12 percent and $1 million of common stock at $25 per
share.
Variable costs are expected to stay at 50 percent of sales, while fixed expenses will
increase to $2,300,000 per year. Delsing is not sure how much this expansion will add to
sales, but he estimates that sales will rise by $1 million per year for the next five years.
Delsing is interested in a thorough analysis 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 leverage before and after expansion. Assume sales of $5
million before expansion and $6 million after expansion. Use the formula in footnote
2 of the chapter.
c. The degree of financial leverage before expansion and for all three methods of
financing after expansion. Assume sales of $6 million for this question.
d. Compute EPS under all three methods of financing the expansion at $6 million in
sales (first year) and $10 million in sales (last year).
e. What can we learn from the answer to part d about the advisability of the three
methods of financing the expansion?
5-27. Solution:
Delsing Canning Company
a. At break-even before expansion:
PQ FC VC
where PQ equals sales volume at break-even point
=+
Sales Fixed costs Variable costs
(Variable costs 50% of sales)
Sales $1,800,000 .50 Sales
.50 Sales $1,800,000
Sales $3,600,000
=+
=
=+
=
=
At break-even after expansion:
Chapter 05: Operating and Financial Leverage
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
( )
( )
Q P VC S TVC
DOL= Q P VC FC S TVC FC
$5,000,000 $2,500,000
$5,000,000 $2,500,000 $1,800,000
$2,500,000 3.57x
$700,000
−−
=
− − − −
−
=−−
==
5-27. (Continued)
Degree of operating leverage after expansion at sales of
$6,000,000
$6,000,000 $3,000,000
DOL= $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:
EBIT
DFL = EBIT 1−
Chapter 05: Operating and Financial Leverage
$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)
(1)
(100%
Equity) (2)
(50% Debt
and 50%
Equity) (3)
Sales
$6,000,000
$6,000,000
$6,000,000
–TVC (.50)
3,000,000
3,000,000
3,000,000
–FC
2,300,000
2,300,000
2,300,000
EBIT
$ 700,000
$ 700,000
$ 700,000
I – Old Debt
200,000
200,000
200,000
I – New Debt
260,000
0
120,000
Total Interest
$ 460,000
$ 200,000
$ 320,000
5-27. (Continued)
EBIT
DFL = EBIT I−
(1) (2) (3)
( ) ( ) ( )
$700,000 $700,000 $700,000
$700,000 $460,000 $700,000 $200,000 $700,000 $320,000−−−
DFL = 2.92x 1.40x 1.84x
Chapter 05: Operating and Financial Leverage
5-45
(refer back to part c to get the values for EBIT and Total I)
(100%
Debt) (1)
(100%
Equity) (2)
(50% Debt
and 50%
Equity) (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 (EAT/Total
shares)
$.84
$1.17
$1.11
(100%
Debt) (1)
(100%
Equity) (2)
(50% Debt
and 50%
Equity) (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
2,300,000
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
$1,568,000
$1,750,000
$1,666,000
Total Shares
200,000
300,000
240,000
EPS
(EAT/Total
Shares)
$7.84
$5.83
$6.94
Chapter 05: Operating and Financial Leverage
5-46
COMPREHENSIVE PROBLEM
Comprehensive Problem 1.
Ryan Boot Company (review of Chapters 2 through 5) (multiple LO’s from Chapters 2
through 5)
RYAN BOOT COMPANY
Balance Sheet
December 31, 2010
Assets
Liabilities and Stockholders' Equity
Cash .........................................
$ 50,000
Accounts payable ..................
$2,200,000
Marketable securities ...............
80,000
Accrued expenses ..................
150,000
Accounts receivable .................
3,000,000
Notes payable (current) .........
400,000
Inventory..................................
1,000,000
Bonds (10%) .........................
2,500,000
Gross plant and equipment
Less.......................................
6,000,00
Common stock (1.7 million
shares, par value $1) ...........
1,700,000
Accumulated depreciation ..
2,000,000
Retained earnings ..................
1,180,000
Total assets ..............................
$8,130,000
Total liabilities and
stockholders' equity ............
$8,130,000
Income Statement—2010
Sates (credit) ........................................................................
$7,000,000
Fixed costs* .........................................................................
2,100,000
Variable costs (0.60) ............................................................
4,200,000
Earnings before interest and taxes ........................................
700,000
Less: Interest .....................................................................
250,000
Earnings before taxes ...........................................................
450,000
Less: Taxes @ 35% ...........................................................
157,500
Earnings after taxes ..............................................................
$ 292,500
Dividends (40% payout) ....................................................
117,000
Increased retained earnings ..................................................
$ 175,500
Chapter 05: Operating and Financial Leverage
5-47
*Fixed costs include (a) lease expense of $200,000 and (b) depreciation of
$500,000.
Note: Ryan Boots also has $65,000 per year in sinking fund obligations
associated with its bond issue. The sinking fund represents an annual repayment
of the principal amount of the bond. It is not tax-deductible.
Comprehensive Problem 1 (Continued)
Ratios
Ryan Boot
(to be filled in)
Industry
Profit margin ..................................
_____________
5.75%
Return on assets .............................
_____________
6.90%
Return on equity .............................
_____________
9.20%
Receivables turnover ......................
_____________
4.35X
Inventory turnover..........................
_____________
6.50X
Fixed-asset turnover .......................
_____________
1.85X
Total-asset turnover ........................
_____________
1.20X
Current ratio ...................................
_____________
1.45X
Quick ratio .....................................
_____________
1.10X
Debt to total assets .........................
_____________
25 05%
Interest coverage ............................
_____________
5.35X
Fixed charge coverage ....................
_____________
4.62X
a. Analyze Ryan Boot Company, using ratio 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
performance.
b. In your analysis, calculate the overall break-even point in sales dollars and the cash
break-even point. Also compute the degree of operating leverage, degree of financial
leverage, and degree of combined leverage. (Use footnote 2 for DOL and footnote 3
in the chapter for DCL.)
c. Use the information in parts a and b to discuss the risk associated with this company.
Given the risk, 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 percent, which can be absorbed without increasing
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 part
of the liability calculation.
