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Chapter 16: Operating and Financial Leverage
166
© Pearson Education Limited 2008
7. a.
Additional-financing Alternatives
Common Debt Preferred
EBIT (000s omitted) $6,000 $6,000.0 $6,000
b. (1)
Additional-financing Alternatives
Common Debt Preferred
EBIT (000s omitted) $3,000 $3,000.0 $3,000
Interest on existing debt 800 800.0 800
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition, Instructor’s Manual
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© Pearson Education Limited 2008
b. (2)
Additional-financing Alternatives
Common Debt Preferred
EBIT (000s omitted) $4,000 $4,000.0 $4,000
Interest on existing debt 800 800.0 800
b. (3)
Additional-financing Alternatives
Common Debt Preferred
EBIT (000s omitted) $8,000 $8,000.0 $8,000
Chapter 16: Operating and Financial Leverage
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© Pearson Education Limited 2008
c. (1)
Additional-financing Alternatives
Common Debt Preferred
EBIT (000s omitted) $6,000 $6,000 $6,000
Interest on existing debt 800 800 800
c. (2)
Additional-financing Alternatives
Common Debt Preferred
EBIT (000s omitted) $6,000 $6,000 $6,000
Interest on existing debt 800 800 800
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition, Instructor’s Manual
169
© Pearson Education Limited 2008
c. (3)
Additional-financing Alternatives
Common Debt Preferred
EBIT (000s omitted) $6,000 $6,000.0 $6,000
Interest on existing debt 800 800.0 800
8. (000s omitted)
Boehm-Gau: Interest Coverage = $5,000 / $1,600 = 3.13
Northern California: Interest Coverage = $100,000 / $45,000 = 2.22
$35,000
The question of with which company one feels more comfortable depends on the business
risk. Inasmuch as an electric utility has stable cash flows and Northern California is large, it
9. Matching, we get,
Company TD/TA LTD/Total Cap Industry
A 0.56 0.43 Chemical
Chapter 16: Operating and Financial Leverage
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© Pearson Education Limited 2008
The supermarket is likely to have the highest portion of total debt in the form of accounts
payable and a short-term liability, because purchases make up a large portion of total costs.
Therefore, we would expect it to have the greatest disparity between the two debt ratios.
SOLUTIONS TO SELF-CORRECTION PROBLEMS
1. a.
b.
c.
d.
e.
2. a. (Percent change in sales) × DOL = Percent change in EBIT
b.
DOL10,000 units =
BE
10,000 =2
10,000 – Q
12,000 - 5,000
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition, Instructor’s Manual
171
© Pearson Education Limited 2008
3. a. (000s omitted)
Debt
Preferred
Stock
Common
Stock
Operating profit (EBIT) $ 1,500 $ 1,500 $ 1,500
Interest on existing debt 360 360 360
b.
Approximate indifference points:
Debt dominates preferred by the same margin throughout. There is no indifference point
between these two alternative financing methods.
Mathematically, the indifference point between debt (1) and common (3), with 000s
omitted, is
Debt (1) Common Stock (3)
1,3 1,3
(EBIT $920) (1 0.40) 0 (EBIT $360) (1 – 0.40) 0
=
800 1,050
––– – –
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© Pearson Education Limited 2008
Note that for the debt alternative, the total before-tax interest is $920, and this is the
intercept on the horizontal axis. For the preferred stock alternative, we divide $480 by
(1 – 0.4) to get $800. When this is added to $360 in interest on existing debt, the
intercept becomes $1,160.
c. Debt (1):
d. For the present EBIT level, common is clearly preferable. EBIT would need to increase
4.
Q units
Q(P V)
Percentage change in
Q(P V) FC
operating profit (EBIT)
DQL Percentage change in Q / Q
output (or sales)
∆−
−−
==
∆
BE
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition, Instructor’s Manual
173
© Pearson Education Limited 2008
5. a. Total annual interest is determined as follows:
ratio
=
$1,110,000 [$250,000 / (1 .50)] =
+−
b. Required deviation of EBIT from its mean value before ratio in question becomes 1 : 1:
Interest coverage: $1,110,000 – $2,000,000 = –$890,000
Debt-service coverage: $390,000 0.260
$1,500,000
Table V in the Appendix at the end of the book can be used to determine the proportion
of the area under the normal curve, that is, Z-standard deviations left of the mean. This
c. There is a substantial probability of 40 percent that the company will fail to cover its
6. Aberez has a lower debt ratio than its industry norm. Vorlas has a higher ratio relative to its
industry. Both companies exceed modestly their industry norms with respect to interest
coverage. The lower debt/equity ratio and higher interest coverage for Vorlas’s industry
