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Genuine Motor Products Case 4
Combined Leverage
Purpose: The case illustrates the potential impact on a company when it goes from dependence on labor
intensive variable costs to fixed cost automation. The effects are further highlighted when the new
equipment is heavily financed by debt. The upside is emphasized through increased earnings per share,
while the downside is related to a higher break-even level (an expanded definition of cash flow
break-even is introduced and very carefully explained). Not only are earnings per share and break-even
covered, but so are all the various measures of degree of leverage. In addition to numerous calculations,
the student is called upon to make judgmental decisions as an aggressive industrial engineer comes into
conflict with a conservative chief financial officer.
Relation to Text: The case should follow Chapter 5.
Complexity: The case is moderately complex. It should require 1 – 1½ hours.
Solutions
1. Figure 4
Sales (1,000,000 units @ $30 per unit)......................................................................................$30,000,000
Fixed costs* .............................................................................................................................5,800,000
Total variable costs (1,000,000 units @ $18.80 per unit) ......................................................18,800,000
*Fixed costs include $2,800,000 in depreciation.
2. The first reason earnings per share has increased from $.91 to $1.15 relates to automation. That is
even though fixed costs have gone up, total variable costs have gone down by even more. Thus,
A second reason is that the $14 million increase in fixed assets was heavily financed by debt rather
( )
3. DOL ( )
Q P VC
Q P VC FC
-
=- -
Before (Figure 2) After (Figure 4)
Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent
of McGraw-Hill Education.
67.1
000,000,3$
000,00,5$
000,000,2)5($000,000,1
)5($000,000,1
000,000,2$)25$30($000,000,1
)25$30($000,000,1
07.2
000,400,5
000,200,11$
000,800,5$)20.11($000,000,1
)20.11($000,000,1
000,800,5$)80.18$30($000,000,1
)80.18$30($000,000,1
I-EBIT
EBIT
DFL
Before (Figure 2) After (Figure 4)
08.1
000,785,2$
000,000,3$
000,215$000,000,3$
000,000,3$
31.1
000,110,4
000,400,5$
000,290,1$000,4 00,5$
000,400,5$
( )
DCL ( )
Q P VC
Q P VC FC I
-
=- - -
Before (Figure 2) After (Figure 4)
80.1
000,785,2$
000,000,5$
000,215,2$)5($000,000,1
)5($000,000,1
000,215$000,000,2$)25$30($000,000,1
)25$30($000,000,1
73.2
000,110,4
000,200,11$
000,090,7$)20.11($000,000,1
)20.11($000,000,1
000,290,1$000,800,5$)80.18$30($000,000,1
)80.18$30($000,000,1
4. Operating BE FC
P VC
=-
Before (Figure 2) After (Figure 4)
000,000,2$
25$30$
000,000,2$
000,800,5$
80.18$30$
000,800,5$
(Fixed costs Depreciation) Interest
5. Revised BE Price ( ) ( ) Variable cost per unitP VC
- +
=-
Before (Figure 2) After (Figure 4)
units 000,243
5$
000,215,1$
5$
000,215$000,000,1
25$30$
000,215$)000,000,1$000,000,2($
units 036,383
20.11$
000,290,4$
20.11$
000,290,1$000,000,3$
80.18$30$
000,290,1)000,800,2$000,800,5($
6. Using the revised break-even analysis from question 5, the company would be in trouble. It requires
383,036 units to cover all cash outflows, and at 300,000 units, this is not possible. While 300,000
units represents only 30 percent of current sales volume of 1,000,000 units, the auto parts industry is
highly cyclical.
7. Earnings per share at 1,500,000 units
Sales (1,500,000 units @ $30 per unit)........................................................................$45,000,0
00
Fixed costs .................................................................................................................5,800,000
Total variable costs (1,500,000 units @ $18.80 per unit) ........................................ 28,200,0
00
Operating income..........................................................................................................11,000,00
0
Interest (10.75% x $12,000,000) ..............................................................................
1,290,000
Earnings before taxes....................................................................................................9,710,000
Taxes (35%) ...............................................................................................................
3,398,500
Earnings after taxes....................................................................................................... $
6,311,500
Shares.............................................................................................................................2,320,000
Earnings per share......................................................................................................... $2.72
8. There is no correct answer as to who is right. The changes that Mike Anton suggests will definitely
increase profitability. At 1,000,000 units, earnings per share are $.91 under the old plan and $1.15
Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent
of McGraw-Hill Education.
On the other hand, the new plan exposes the firm to more risk of not covering its cash obligations. As
computed in question 6, the revised break-even point is 383,036 units under the new plan and a
The key variable in determining the success or failure of the new plan is volume. As long as volume
stays the same or goes up, the new plan is definitely going to be a success (even if volume declines
somewhat, it may still be desirable). However, if volume falls sharply in a recession, the new plan
Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent
of McGraw-Hill Education.
