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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
a.
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
a.
$97,500
BE 7,500 units
$35 $22
= =
-
b.
Profit FC $262,500 $97,500
( VC) $35 $22
$360,000 27,692 units
$13
QP
+ +
= =
- -
= =
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
BE
Fixed
costs
Labor-Intensive Capital-Intensive
Units produced and sold
Revenue and costs
Total revenue
Total
costs
Variable
Cost
Profits
BE
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
a.
Fixed costs
BE Price Variable cost per unit
$255,000 $255,000 8,500 units
$66 $36 $30
=-
= = =
-
b.
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
a.
( 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
Q P
-
=- -
-
=- -
=-
= = =
-
5-10. (Continued)
b.
EBIT $200,000
DFL EBIT $200,000 $50,000
$200,000 1.33x
$150,000
I
= =
- -
= =
c.
( 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
-
=- - -
-
=- - -
= = =
- -
d.
$400,000 $400,000
BE 13,333 units
$60 $30 $30
= = =
-
