978-1259277160 Chapter 5 Solution Manual Part 1

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Chapter 5

Operating and Financial Leverage

Discussion Questions

5-1. Discuss the various uses for break-even analysis.

Such analysis allows the firm to determine at what level of operations it

5-2. What factors would cause a difference in the use of financial leverage for a

utility company and an automobile company?

A utility is in a stable, predictable industry and therefore can afford to use

more financial leverage than an automobile company, which is generally

5-3. Explain how the break-even point and operating leverage are affected by

the choice of manufacturing facilities (labor intensive versus capital

intensive).

A labor-intensive company will have low fixed costs and a correspondingly

low break-even point. However, the impact of operating leverage on the

5-4. What role does depreciation play in break-even analysis based on

accounting flows? Based on cash flows? Which perspective is longer term

in nature?

For break-even analysis based on accounting flows, depreciation is

5-5. What does risk taking have to do with the use of operating and financial

leverage?

Both operating and financial leverage imply that the firm will employ a

5-6. Discuss the limitations of financial leverage.

Debt can only be used up to a point. Beyond that, financial leverage tends

5-7. How does the interest rate on new debt influence the use of financial

leverage?

5-8. Explain how combined leverage brings together operating income and

earnings per share.

Operating leverage primarily affects the operating income of the firm. At

5-9. Explain why operating leverage decreases as a company increases sales

and shifts away from the break-even point.

At progressively higher levels of operations than the break-even point, the

5-10. When you are considering two different financing plans, does being at the

level where earnings per share are equal between the two plans always

mean you are indifferent as to which plan is selected?

The point of equality only measures indifference based on earnings per share.

Since our ultimate goal is market value maximization, we must also be

Chapter 5

Problems

1. Break-even analysis (LO2) Shock Electronics sells portable heaters for $35 per unit, and

the variable cost to produce them is $22. Mr. Amps estimates that the fixed costs are

$97,500.

a. Compute the break-even point in units.

b. Fill in the following table (in dollars) to illustrate that the break-even point has been

achieved.

Sales…………………. ____________

– Fixed costs…………. ____________

– Total variable costs… ____________

Net profit (loss)………. ____________

5-1. Solution:

Shock Electronics

Fixed costs

BE Pr ice-variable cost per unit

$97,500 $97,500 7,500 units

$35 $22 $13

= = =

–

b. Sales $262,500 (7,500 units × $35)

2. Break-even analysis (LO2) The Hartnett Corporation manufactures baseball bats with

Pudge Rodriguez’s autograph stamped on them. Each bat sells for $35 and has a variable

cost of $22. There are $97,500 in fixed costs involved in the production process.

a. Compute the break-even point in units.

b. Find the sales (in units) needed to earn a profit of $262,500.

5-2. Solution:

Hartnett Corporation

$97,500

BE 7,500 units

$35 $22

= =

–

Profit FC $262,500 $97,500

( VC) $35 $22

$360,000 27,692 units

$13

+ +

= =

– –

= =

3. Break-even analysis (LO2) Therapeutic Systems sells its products for $13 per unit. It has

the following costs:

Rent…………………….…..………..…. $145,000

Factory labor…….…..………..…..… $4.00 per unit

Executives under contract........... $186,500

Raw material……..…..…..……….... $1.20 per unit

Separate the expenses between fixed and variable costs per unit. Using this information and

the sales price per unit of $13, compute the break-even point.

5-3. Solution:

Therapeutic Systems

Fixed Costs

Variable Costs

(per unit)

Units produced and sold

Revenue and costs

Total revenue

Total

costs

Variable

Cost

Profits

Fixed

costs

Labor-Intensive Capital-Intensive

Units produced and sold

Revenue and costs

Total revenue

Total

costs

Variable

Cost

Profits

Fixed

costs

The company having the higher fixed costs will have lower

variable costs than its competitor since it has substituted capital

5. Break-even analysis (LO2) Eaton Tool Company has fixed costs of $255,000, sells its

units for $66, and has variable costs of $36 per unit.

a. Compute the break-even point.

b. Ms. Eaton comes up with a new plan to cut fixed costs to $200,000. However, more

labor will now be required, which will increase variable costs per unit to $39. The

sales price will remain at $66. What is the new break-even point?

c. Under the new plan, what is likely to happen to profitability at very high volume

levels (compared to the old plan)?

5-5. Solution:

Eaton Tool Company

Fixed costs

BE Price Variable cost per unit

$255,000 $255,000 8,500 units

$66 $36 $30

=–

= = =

–

Fixed costs

BE Price Variable cost per unit

$200,000 $200,000 7,407 units

$66 $39 $27

=–

= = =

–

c. With less operating leverage and a smaller contribution

6. Break-even analysis (LO2) Shawn Pen & Pencil Sets Inc. has fixed costs of $80,000. Its

product currently sells for $5 per unit and has variable costs of $2.50 per unit. Mr. Bic, the head

of manufacturing, proposes to buy new equipment that will cost $400,000 and drive up fixed

costs to $120,000. Although the price will remain at $5 per unit, the increased automation will

reduce costs per unit to $2.00.

As a result of Bic’s suggestion, will the break-even point go up or down? Compute the

necessary numbers.

5-6. Solution:

Shawn Pen & Pencil Sets Inc.

$80,000 $80,000

BE (before) 32,000 units

$5.00 $2.50 $2.50

= = =

–

$120,000 $120,000

BE (after) 40,000 units

$5.00 $2.00 $3.00

= = =

–

7. Cash break-even analysis (LO2) Calloway Cab Company determines its break-even

strictly on the basis of cash expenditures related to fixed costs. Its total fixed costs are

$450,000, but 5 percent of this value is represented by depreciation. Its contribution

margin (price minus variable cost) for each unit is $4.10. How many units does the firm

need to sell to reach the cash break-even point?

5-7. Solution:

Calloway Cab Company

Cash-related fixed costs = Total fixed costs – Depreciation

$427,500

Cash BE 104,268

$4.10

= =

8. Cash break-even analysis (LO2) Air Purifier Inc. computes its break-even point strictly

on the basis of cash expenditures related to fixed costs. Its total fixed costs are $2,450,000,

but 15 percent of this value is represented by depreciation. Its contribution margin (price

minus variable cost) for each unit is $40. How many units does the firm need to sell to

reach the cash break-even point?

5-8. Solution:

Air Purifier Inc.

Cash-related fixed costs = Total fixed costs – Depreciation

Interest expense…………………………………………………… 50,000

Earnings before taxes (EBT)…………………………………. 150,000

Income tax expense (30%)……………………………………. 45,000

Earnings after taxes (EAT)………………………………..….. $ 105,000

Given this income statement, compute the following:

a. Degree of operating leverage.

b. Degree of financial leverage.

c. Degree of combined leverage.

d. Break-even point in units.

5-10. Solution:

Sterling Tire Company

( VC)

DOL ( VC) FC

20,000($60 $30)

20,000($60 $30) $400,000

20,000($30)

20,000($30) $40,000

$600,000 $600,000 3.00x

$600,000 $400,000 $200,000

Q P

–

=– –

–

=– –

=–

= = =

–

5-10. (Continued)

EBIT $200,000

DFL EBIT $200,000 $50,000

$200,000 1.33x

$150,000

= =

– –

= =

( VC)

DCL ( VC) FC

20,000($60 $30)

20,000($60 $30) $400,000 $50,000

$600,000 $600,000 4x

$600,000 $400,000 $50,000 $150,000

Q P

Q P I

–

=– – –

–

=– – –

= = =

– –

$400,000 $400,000

BE 13,333 units

$60 $30 $30

= = =

–