5-1. Discuss the various uses for break-even analysis.
5-2. What factors would cause a difference in the use of financial leverage for a utility company and an automobile company?
5-3. Explain how the break-even point and operating leverage are affected by the choice of manufacturing facilities (labor intensive versus capital intensive).
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?
5-5.What does risk taking have to do with the use of operating and financial leverage?
5-6. Discuss the limitations of financial leverage.
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.
5-9. Explain why operating leverage decreases as a company increases sales and shifts away from the break-even point.
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?
Chapter 5
Problems
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 the break-even point has been achieved.
Sales ____________
- Fixed costs ____________
- Total variable costs ____________
Net profit (loss) ____________
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.
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 break-even 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 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)?
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 under contract
$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.
5. Eaton Tool Company has fixed costs of $200,000, sells its units for $56, and has variable costs of $31 per unit.
a. Compute the break-even point.
b. Ms. Eaton comes up with a new plan to cut fixed costs to $150,000. However, more labor will now be required, which will increase variable costs per unit to $34. The sales price will remain at $56. 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)?
6. 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 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.
7. Jay Linoleum Company has fixed costs of $70,000. Its product currently sells for $4 per unit and has variable costs per unit of $2.60. Mr. Thomas, the head of manufacturing, proposes to buy new equipment that will cost $300,000 and drive up fixed costs to $105,000. Although the price will remain at $4 per unit, the increased automation will reduce variable costs per unit to $2.25.
As a result of Thomas's suggestion, will the break-even point go up or down? Compute the necessary numbers.
8. 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?
9. Air Purifier, Inc., computes its break-even point strictly on the basis of cash expenditures related to fixed costs. Its total fixed costs are $2,400,000, but 15 percent of this value is represented by depreciation. Its contribution margin (price minus variable cost) for each unit is $30. How many units does the firm need to sell to reach the cash break-even point?
10. 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.
11. The Sterling Tire Company's income statement for 2008 is as follows:
STERLING TIRE COMPANY
Income Statement
For the Year Ended December 31, 2008
Sales (20,000 tires at $60 each) $1,200,000
Less: Variable costs (20,000 tires at $30) 600,000
Fixed costs 400,000
Earnings before interest and taxes (EBIT) 200,000
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.
12. The Harmon Company manufactures skates. The company's income statement for 2008 is as follows:
HARMON COMPANY
Income Statement
For the Year Ended December 31, 2008
Sales (30,000 skates @ $25) $750,000
Less: Variable costs (30,000 skates at $7) 210,000
Fixed costs 270,000
Earnings before interest and taxes (EBIT) 270,000
Interest expense 170,000
Earnings before taxes (EBT) 100,000
Income tax expense (35%) 35,000
Earnings after taxes (EAT) $ 65,000
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.
13. Healthy Foods, Inc. sells 50-pound bags of grapes to the military for $10 a bag. The fixed costs of this operation are $80,000, while the variable costs of the popcorn are $.10 per pound.
a. What is the break-even point in bags?
b. Calculate the profit or loss on 12,000 bags and on 25,000 bags.
c. What is the degree of operating leverage at 20,000 bags and at 25,000 bags? Why does the degree of operating leverage change as the quantity sold increases?
d. If Healthy Foods has an annual interest expense of $10,000, calculate the degree of financial leverage at both 20,000 and 25,000 bags.
e. What is the degree of combined leverage at both sales levels?
14. U.S. Steal has the following income statement data:
Units Sold Total Variable Costs Fixed
Costs Total Costs Total Revenue Operating Income (Loss)
40,000 $ 80,000 $50,000 $130,000 $160,000 $30,000
60,000 120,000 50,000 170,000 240,000 70,000
a. Compute DOL based on the formula below (see page 128 for an example):
b. Confirm that your answer to part a is correct by recomputing DOL using formula
5-3 on page___. There may be a slight difference due to rounding.
Q represents beginning units sold (all calculations should be done at this level). P can be found by dividing total revenue by units sold. VC can be found by dividing total variable costs by units sold.
15. Leno's Drug Stores and Hall's Pharmaceuticals are competitors in the discount drug chain store business. The separate capital structures for Leno and Hall are presented below.
Leno Hall
Debt @ 10% $100,000 Debt @ 10% $200,000
Common stock, $10 par 200,000 Common stock, $10 par 100,000
Total $300,000 Total $300,000
Shares 20,000 Common shares 10,000
a. Compute earnings per share if earnings before interest and taxes are $20,000, $30,000, and $120,000 (assume a 30 percent tax rate).
b. Explain the relationship between earnings per share and the level of EBIT.
c. If the cost of debt went up to 12 percent and all other factors remained equal, what would be the break-even level for EBIT?