Chapter 05: Operating and Financial Leverage
Chapter 05: Operating and Financial Leverage
2. Sell $2.5 million of common stock at $20 per share.
3. Sell $1.25 million of debt at 12 percent and $1.25 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 $2,350,000 per year. Delsing is not sure how much this expansion will add to
sales, but he estimates that sales will rise by $1.25 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 $5.5
million before expansion and $6.5 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 $6.5 million for this question.
d. Compute EPS under all three methods of financing the expansion at $6.5 million in
sales (first year) and $10.5 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 $1,850,000 .50 Sales
.50 Sales $1,850,000
Sales $3,700,000
=+
=
=+
=
=
At break-even after expansion:
Chapter 05: Operating and Financial Leverage
(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
$900,000
$900,000
$900,000
Total I
625,000
300,000
450,000
EBT
$275,000
$600,000
$450,000
Taxes (40%)
110,000
240,000
180,000
EAT
$165,000
$360,000
$270,000
Shares (old)
250,000
250,000
250,000
Shares (new)
0
125,000
50,000
Total shares
250,000
375,000
300,000
EPS (EAT/Total
shares)
$0.66
$0.96
$0.90
EPS @ sales of $10,500,000
(100%
Debt) (1)
(100%
Equity) (2)
(50% Debt
and 50%
Equity) (3)
Sales
$10,500,000
$10,500,000
$10,500,000
– TVC
5,250,000
5,250,000
5,250,000
– FC
2,350,000
2,350,000
2,350,000
EBIT
$ 2,900,000
$ 2,900,000
$ 2,900,000
Total I
625,000
300,000
450,000
EBT
$ 2,275,000
$ 2,600,000
$2,450,000
Taxes (40%)
910,000
1,040,000
980,000
EAT
$1,365,000
$1,560,000
$1,470,000
Total shares
250,000
375,000
300,000
EPS
(EAT/Total
shares)
$5.46
$4.16
$4.90
Chapter 05: Operating and Financial Leverage
e. In the first year, when sales and profits are relatively low,
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, 20X1
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—20X1
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
*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 lend funds to Ryan Boot.
Ryan Boot Company is trying to plan the funds needed for 20X2. 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.
Chapter 05: Operating and Financial Leverage
e. What would be the required new funds if the company brings its ratios into line with
the industry average during 20X2? Specifically examine receivables turnover,
inventory turnover, and the profit margin. Use the new values to recompute the
factors in RNF (assume liabilities stay the same).
f. Do not calculate, only comment on these questions. How would required new funds
change if the company
(1) Were at full capacity?
(2) Raised the dividend payout ratio?
(3) Suffered a decreased growth in sales?
(4) Faced an accelerated inflation rate?
CP 5-1. Solution:
Ryan Boot Company
a. Ratio analysis
Ryan
Industry
Profit margin
$292,500/$7,000,000
4.18%
5.75%
Return on assets
$292,500/$8,130,000
3.60%
6.90%
Return on equity
$292,500/$2,880,000
10.16%
9.20%
Receivable turnover
$7,000,000/$3,000,000
2.33x
4.35x
Inventory turnover
$7,000,000/$1,000,000
7.00x
6.50x
Fixed asset turnover
$7,000,000/$4,000,000
1.75x
1.85x
Total asset turnover
$7,000,000/$8,130,000
.86x
1.20x
Current ratio
$4,130,000/$2,750,000
1.50x
1.45x
Quick ratio
$3,130,000/$2,750,000
1.14x
l.l0x
Debt to total assets
$5,250,000/$8,130,000
64.58
25.05
Interest coverage
$700,000/$250,000
2.80x
5.35x
Fixed charge coverage
See calculation below*
1.64x
4.62x
$700,000+200,000(Lease)
* 1.64x
$250,000 200,000 65,000 / (1 .35) =
+ + −
Lease expense of $200,000 and sinking fund of $65,000
Chapter 05: Operating and Financial Leverage
a. The company has a lower profit margin than the industry and
with inventory turnover and it is only slightly below the
industry in fixed asset turnover.
b. Break-even in sales
Sales Fixed costs Variable costs=+
(variable costs are expressed as a percentage of sales)
BE
Sales $2,100,000 .60 Sales
.40 S $2,100,000
S $2,100,000 / .40
S $5,250,000
=+
=
=
=
Chapter 05: Operating and Financial Leverage
Cash break-even
Sales (Fixed costs Noncash expenses*) +Variable costs=−
BE
BE
Sales ($2,100,000 $500,000) + .60 Sales
Sales $1,600,000 .60 Sales
.40 $1,600,000
$1,600,000 / .40
$4,000,000
S
S
S
=−
=+
=
=
=
*Depreciation
TVC
DOL TVC FC
$7,000,000 $4,200,000
$7,000,000 $4,200,000 $2,100,000
$2,800,000 4x
$700,000
S
S
−
=−−
−
=−−
==
EBIT $700,000
DFL EBIT $700,000 $250,000
$700,000 1.56x
$450,000
I
==
−−
==
TVC
DCL TVC FC
$7,000,000 $4,200,000
$7,000,000 $4,200,000 $2,100,000 $250,000
$2,800,000 6.22x
$450,000
S
SI
−
=− − −
−
=− − −
==
Chapter 05: Operating and Financial Leverage
c. Ryan is operating at a sales volume that is $1,750,000 above
the traditional break-even point and $3,000,000 above the
cash break-even point. This can be viewed as somewhat
positive.
One possible use of the funds might be to pay off part of the
current notes payable of $400,000. This might be acceptable
Chapter 05: Operating and Financial Leverage
d.
( ) ( ) ( )
2
AL
Required new funds= S S PS 1 D
SS
− − −
( ) ( )
( )
Change in Sales = 20% $7,000,000= $1,400,000
$4,130,000 $2,350,000
RNF $1,400,000 $1,400,000
$7,000,000 $7,000,000
4.18% $8,400,000 (1 .4)
=−
−−
( ) ( ) ( )
RNF = .590 $1,400,000 .336 $1,400,000 $351,120 .6
$826,000 $470,400 $210,672
$144,928
−−
= − −
=
e. Required funds if selected industry ratios were applied
Receivables = Sales/Receivable turnover
2
SS
Chapter 05: Operating and Financial Leverage
( ) ( )
( )( )
$2,739,195 $2,350,000
RNF= $1,400,000 $1,400,000
$7,000,000 $7,000,000
5.75% $8,400,000 1 .4
−
−−
( ) ( ) ( )
RNF .391 $1,400,000 .336 $1,400,000 $483,000 .6
$547,400 $470,400 $289,800
$212,800
= − −
= − −
=−
Required new funds (RNF) is negative, indicating there will
actually be an excess of funds equal to $212,180. This is due to
the much more rapid turnover of accounts receivable and the
higher profit margin.
f. (1) If Ryan Boots was at full capacity, more funds would be
needed to expand plant and equipment.
(4) As inflation increased, so would the cost of new assets,
especially inventory and plant and equipment. Even if