Chapter 5 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 will break even and to explore the relationship between volume, costs, and profits 5-2. What factors would cause a d ifference 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 subject to the influences of the business cycle. An automobile manufacturer may not be able to service a large amount of debt when there is a downturn in the economy 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 correspond ingly low break-even point. However, the impact of operating leverage on the firm is small and there will be little magnification of profits as volume increases. a capital-intensive firm, on the other hand, will have a higher break-even point and enjoy the positive influences of operating leverage as volume increases 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 considered part of fixed costs. For cash flow purposes, it is eliminated from fixed costs The accounting flows perspective is longer-term in nature because we must consider the problems of equipment replacement What does risk taking have to do with the use of operating and financial Both operating and financial leverage imply that the firm will employ a heavy component of fixed cost resources. This is inherently risky because the obligation to make payments remains regardless of the cond ition of the S-159 Copyright o by The McGraw-Hill Companies. In
Copyright © 2005 by The McGraw-Hill Companies, Inc. S-159 Chapter 5 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 will break even and to explore the relationship between volume, costs, and profits. 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 subject to the influences of the business cycle. An automobile manufacturer may not be able to service a large amount of debt when there is a downturn in the economy. 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 firm is small and there will be little magnification of profits as volume increases. A capital-intensive firm, on the other hand, will have a higher break-even point and enjoy the positive influences of operating leverage as volume increases. 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 considered part of fixed costs. For cash flow purposes, it is eliminated from fixed costs. The accounting flows perspective is longer-term in nature because we must consider the problems of equipment replacement. 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 heavy component of fixed cost resources. This is inherently risky because the obligation to make payments remains regardless of the condition of the company or the economy
6 Discuss the limitations of financial leverage Debt can only be used up to a point. Beyond that, financial leverage tends to increase the overall costs of financing to the firm as well as encourage cred itors to place restrictions on the firm. The limitations of using financial leverage tend to be greatest in industries that are highly cyclical in nature 5-7 How does the interest rate on new debt influence the use of financial leverage? The higher the interest rate on new debt, the less attractive financial leverage is to the firm Explain how combined leverage brings together operating income and earnings per share point, financial leverage takes over and determines the overall impact on his Operating leverage primarily affects the operating income of the firm. At earnings per share. a delineation of the combined effect of operating and financial leverage is presented in Table 5-6 and Figure 5-5 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, t In sult of a percentage cha unit volume diminishes. The reason is primarily mathematical -as we move to increasingly higher levels of operating income, the percentage change from the higher base is likely to be less 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 concerned with how these earnings are valued. Two plans that have the same earnings per share may call for different price-earnings ratios, particularly when there is a differential risk component involved because of debt Copyright o2005 by The McGranr-Hill Companies, Inc
Copyright © 2005 by The McGraw-Hill Companies, Inc. S-160 5-6. Discuss the limitations of financial leverage. Debt can only be used up to a point. Beyond that, financial leverage tends to increase the overall costs of financing to the firm as well as encourage creditors to place restrictions on the firm. The limitations of using financial leverage tend to be greatest in industries that are highly cyclical in nature. 5-7. How does the interest rate on new debt influence the use of financial leverage? The higher the interest rate on new debt, the less attractive financial leverage is to the firm. 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 this point, financial leverage takes over and determines the overall impact on earnings per share. A delineation of the combined effect of operating and financial leverage is presented in Table 5-6 and Figure 5-5. 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 percentage change in operating income as a result of a percentage change in unit volume diminishes. The reason is primarily mathematical — as we move to increasingly higher levels of operating income, the percentage change from the higher base is likely to be less. 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 concerned with how these earnings are valued. Two plans that have the same earnings per share may call for different price-earnings ratios, particularly when there is a differential risk component involved because of debt
Problems Gateway Appliance toasters sell for $20 per unit, and the variable cost to produce them is $15. Gateway estimates that the fixed costs are $80,000 a. Compute the break-even point in units b. Fill in the table below (in dollars) to illustrate that the break-even point has been achieved Sales - Fixed costs -total variable costs Net profit(loss) Solution: Gateway Appliance Fixed costs a. BE= Price-variable cost per unit 80000S80.000 16.000 units $20-S15$5 b. Sales $320000(16000 units x$20) fixed costs 80,000 - Total variable costs _240,000 (16,000 units $15) Net profit (loss) 0 S-161 Copyright o by The McGraw-Hill Companies. In
Copyright © 2005 by The McGraw-Hill Companies, Inc. S-161 Problems 5-1. Gateway Appliance toasters sell for $20 per unit, and the variable cost to produce them is $15. Gateway estimates that the fixed costs are $80,000. a. Compute the break-even point in units. b. Fill in the table below (in dollars) to illustrate that the break-even point has been achieved. Sales _______________ –Fixed costs _______________ –total variable costs _______________ Net profit (loss) _______________ Solution: Gateway Appliance 16,000 units $5 $80,000 $20 $15 $80,000 Price - variable cost per unit Fixed costs a. BE = = − = = b. Sales $320,000 (16,000 units x $20) –Fixed costs 80,000 –Total variable costs 240,000 (16,000 units x $15) Net profit (loss) $ 0
Hazardous Toys Company produces boomerangs that sell for $8 each and have a variable cost of $7.50. Fixed costs are $15 a. Compute the break-even point in units b. Find the sales(in units)needed to earn a profit of $25,000 Solution: The Hazardous Toys Company $l5,000 . BE s800c7=30000nits Profit+FC$25,000+$15000 b. Q P-VC $800-$750 $40,000 80.000 units $50 Copyright o2005 by The McGranr-Hill Companies, Inc. S-162
Copyright © 2005 by The McGraw-Hill Companies, Inc. S-162 5-2. Hazardous Toys Company produces boomerangs that sell for $8 each and have a variable cost of $7.50. Fixed costs are $15,000. a. Compute the break-even point in units. b. Find the sales (in units) needed to earn a profit of $25,000. Solution: The Hazardous Toys Company a. 30,000 units $8.00 $7.50 $15,000 BE = − = ( ) 80,000 units $.50 $40,000 $8.00 $7.50 $25,000 $15,000 P VC Profit FC b. Q = = − + = − + =
Ensco Lighting Company has fixed costs of $100,000, sells its units for $28 and has variable costs of $15.50 per unit a. Compute the breakeven point b. Ms. Watts comes up with a new plan to cut fixed costs to $75,000 However, more labor will now be required, which will increase variable costs per unit to $17. The sales price will remain at $28. What is the new breakeven point? c. Under the new plan, what is likely to happen to profitability at very high volume levels(compared to the old pla Solution: Ensco Lighting Company Fixed costs BE= Price-variable cost per unit s3 00.000$100.000 1550$12.508.000 units Fixed costs BE Price- variable cost per unit $75,000$75,000 6. units $28-$17$11 The breakeven level decreases c. With less operating leverage and a smaller contribution margin profitability is likely to be less at very high volume levels S-163 Copyright o by The McGraw-Hill Companies. In
Copyright © 2005 by The McGraw-Hill Companies, Inc. S-163 5-3. Ensco Lighting Company has fixed costs of $100,000, sells its units for $28 and has variable costs of $15.50 per unit. a. Compute the breakeven point. b. Ms. Watts comes up with a new plan to cut fixed costs to $75,000. However, more labor will now be required, which will increase variable costs per unit to $17. The sales price will remain at $28. What is the new breakeven point? c. Under the new plan, what is likely to happen to profitability at very high volume levels (compared to the old plan)? Solution: Ensco Lighting Company a. 8,000 units $12.50 $100,000 $28 $15.50 $100,000 Price variable cost per unit Fixed costs BE = = − = − = b. 6,818 units $11 $75,000 $28 $17 $75,000 Price variable cost per unit Fixed costs BE = = − = − = The breakeven level decreases. c. With less operating leverage and a smaller contribution margin, profitability is likely to be less at very high volume levels
Air filter ducts for $6 per unit. It has the folle Rent $100,000 Factory labor $1. 20 per unit Executive salaries $89000 Raw material s, 60 per unit Separate the expenses between fixed and variable cost per unit. Using this information and the sales price per unit of $6, compute the break-even point olution Air Filter. In Variable Costs(pel Fixed costs unit Rent $100.000 Factory lab $.20 Executive salaries $89000 Raw materials 60 $l89000 FC $189,000$189,000 BE 一=45000 units P-VC$6.00-$1.80$4.20 Copyright o2005 by The McGranr-Hill Companies, Inc. S-164
Copyright © 2005 by The McGraw-Hill Companies, Inc. S-164 5-4. Air Filter, Inc. sells its products for $6 per unit. It has the following costs: Rent $100,000 Factory labor $1.20 per unit Executive salaries $89,000 Raw material $ .60 per unit Separate the expenses between fixed and variable cost per unit. Using this information and the sales price per unit of $6, compute the break-even point. Solution: Air Filter, Inc. Fixed Costs Variable Costs (per unit) Rent $100,000 Factory labor $1.20 Executive salaries $89,000 Raw materials _______ .60 $189,000 $1.80 45,000 units $4.20 $189,000 $6.00 $1.80 $189,000 P VC FC BE = = − = − =
Shawn Penn 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 variable 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 number Solution: Shawn penn Pencil sets. Inc $80,000$80.000 BE(before) 32000 units $500-$250$2.50 $120000$120.000 BE(after)= 40.000 units $5.00-$2.00$3.00 The break-even point will go up 5-6. Gibson Sons, an appliance manufacturer, computes its break-even point strictly on the basis of cash expend itures related to fixed costs. Its total fixed costs are $1,200,000, but 25 percent of this value is represented by depreciation Its contribution margin (price minus variable cost) for each unit is $2.40. How many units does the firm need to sell to reach the cash break-even point? Solution: Gibson sons Cash related fixed costs= Total Fixed Costs-Depreciation =$1,200,000-25%($1,200,000 $1,200,000-$300,000 $900,000 $900000 BE 375. units 240 S-165 Copyright o by The McGraw-Hill Companies. In
Copyright © 2005 by The McGraw-Hill Companies, Inc. S-165 5-5. Shawn Penn & 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 variable 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. Solution: Shawn Penn & Pencil Sets, Inc. 40,000 units $3.00 $120,000 $5.00 $2.00 $120,000 BE (after) 32,000 units $2.50 $80,000 $5.00 $2.50 $80,000 BE (before) = = − = = = − = The break-even point will go up. 5-6. Gibson & Sons, an appliance manufacturer, computes its break-even point strictly on the basis of cash expenditures related to fixed costs. Its total fixed costs are $1,200,000, but 25 percent of this value is represented by depreciation. Its contribution margin (price minus variable cost) for each unit is $2.40. How many units does the firm need to sell to reach the cash break-even point? Solution: Gibson & Sons Cash related fixed costs = Total Fixed Costs – Depreciation = $1,200,000 – 25% ($1,200,000) = $1,200,000 – $300,000 = $900,000 375,000 units $2.40 $900,000 BE = =
Draw two break-even graphs--one for a conservative firm using labor-intensive production and another for a capital-intensive firm. Assuming these companies compete within the same industry and have identical sales, explain the impact of changes in sales volume on both firms' profits Solution: Labor-Intensive and capital-intensive break-even graphs Labor-Intensive Capital-Intensive Revenue and costs Revenue and costs Total revenue Total revenue Total costs Total costs BE Variable cost Variable cost Fixed costs Units produced and sold Units produced and sold The company having the high fixed costs will have lower variable costs than its competitor since it has substituted capital for labor. With a lower variable cost, the high fixed cost company will have a larger contribution margin. Therefore, when sales rise, its profits will increase faster than the low fixed cost firm and when the sales decline the reverse will be true Copyright o2005 by The McGranr-Hill Companies, Inc. S-166
Copyright © 2005 by The McGraw-Hill Companies, Inc. S-166 5-7. Draw two break-even graphs—one for a conservative firm using labor-intensive production and another for a capital-intensive firm. Assuming these companies compete within the same industry and have identical sales, explain the impact of changes in sales volume on both firms' profits. Solution: Labor-Intensive and capital-intensive break-even graphs Revenue and costs Revenue and costs Total revenue Total revenue Profits Profits Total costs Total costs Variable cost Variable cost Fixed costs Units produced and sold Units produced and sold BE BE Labor-Intensive Capital-Intensive The company having the high fixed costs will have lower variable costs than its competitor since it has substituted capital for labor. With a lower variable cost, the high fixed cost company will have a larger contribution margin. Therefore, when sales rise, its profits will increase faster than the low fixed cost firm and when the sales decline, the reverse will be true
The Sosa Company produces baseball gloves. The companys income statement for 2004 is as follows Sosa o Income statement For the Year Ended December 31. 2004 Sales(20,000 gloves at $60 each) $1,200000 Less: Variable costs(20, 000 gloves at 400,000 Fixed costs 600.000 Earnings before interest and taxes (EBIt) 200,000 Interest expense Earnings before taxes(EBT) 120,000 ncome tax expense(30%) Earnings after taxes (EAT) 84.000 Given this income statement, compute the following a. Degree of operating leverage b. Degree of financial leverage c. Degree of combined leverage Solution: Sosa company Q=20,000,P=$60,VC=$20,FC=$600,000,1=$80,000 . DOL Q(P-vC) Q(P-VC)-FC 20000(60-$20) 20.000(60-$20)-$60000 20.00040) 20.000(40)-60000 S-167 Copyright o by The McGraw-Hill Companies. In
Copyright © 2005 by The McGraw-Hill Companies, Inc. S-167 5-8. The Sosa Company produces baseball gloves. The company’s income statement for 2004 is as follows: Sosa Company Income Statement For the Year Ended December 31, 2004 Sales (20,000 gloves at $60 each).......................... $1,200,000 Less: Variable costs (20,000 gloves at $20)......................................................................... 400,000 Fixed costs.......................................................... 600,000 Earnings before interest and taxes (EBIT)............. 200,000 Interest expense ...................................................... 80,000 Earnings before taxes (EBT).................................. 120,000 Income tax expense (30%) ..................................... 36,000 Earnings after taxes (EAT)..................................... $ 84,000 Given this income statement, compute the following: a. Degree of operating leverage. b. Degree of financial leverage. c. Degree of combined leverage. Solution: Sosa Company Q = 20,000, P = $60, VC = $20, FC = $600,000, I = $80,000 ( ) ( ) ( ) ( ) ( ) 20,000 ($40) $600,000 20,000 $40 20,000 $60 $20 $600,000 20 000 $60 $20 Q P VC FC Q P VC a. DOL − = − − − = − − − =
5-8. Continued $800.000 $800.000 =4.00x 800.000-$600.000$200,000 EBIT $200.000 b. DFL EBII-I$200.000-$80.000 $200.000 1.67X $120,000 Q(P-vC) Q(P-VC)-FC-I 20.00060-$20) 2000060-$20)-$6000008000 $200040) $200040)-S680000 800.000 6.67X $120.000 Copyright o2005 by The McGranr-Hill Companies, Inc. S-168
Copyright © 2005 by The McGraw-Hill Companies, Inc. S-168 5-8. Continued 4.00x $200,000 $800,000 $800,000 $600,000 $800,000 = = − = 1.67x $120,000 $200,000 $200,000 $80,000 $200,000 EBIT I EBIT b. DFL = = − = − = ( ) ( ) ( ) ( ) ( ) ( ) 6.67x $120,000 $800,000 $20,000 $40 $680,000 $200,000 $40 20,000 $60 $20 $600,000 $80,000 20,000 $60 $20 Q P VC FC I Q P VC c. DCL = = − = − − − − = − − − − =
