Question 1: McFugal, Inc. has expected sales of 20 million. Fixed operating cost are 2.5 million, and the variable cost ratio is 65 percent. McFrugal has outstanding a 12 million, 8 percent bank loan. The firm also has outstanding 1 million share of common stock ($1 per value). McFrugal’s tax rate is 40 percent.
a) What is McFrugal’s degree of operating leverage at a sales level of 20 million?
b) What is McFrugal’s current degree of financial leverage?
c) Forecast McFrugal’s EPS if sales drop to $15 million
Question 2: East Publishing Company is doing an analysis of a proposed new finance textbook. Using the following data, answer (a) through (d).
Fixed Cost per Edition:
Development $18,000
Copyediting 5,000
Selling and promotion 7,000
Typesetting 40,000
Total $70,000
Variable Cost per Copy:
Printing and binding $4.20
Administrative cost 1.60
Salespeople’s commission .60
Author’s royalties 3.60
Bookstore discounts 6.00
Total $16.00
Projected Selling Price $30.00
The company’s marginal tax rate is 40 percent.
a) determine the company’s breakeven volume for this book:
i) In units
ii) In dollar sales.
b) Develop a breakeven chart for the textbook
c) Determine the number of copies East must sell in order to earn an (operating) profit of $21,000 on this book.
d) Suppose East feels that 30,000 is too high a price to charge for the new finance textbook. It has examined the competitive market and determined that $24,000 would be a better selling price. What would the breakeven volume be at this new selling price?
Question 3: Rodney Rodgers, a recent business school graduate, plans to open a wholesale dairy products firm. The business will be completely financed with equity. Rogers expects first year sales to total $5,500,000. He desires to earn a target pretax profit of $1,000,000 during his first year of operation. Variable cost are 40 percent of sales.
a) How large can Roger’s fixed operating cost be if he is to meet his profit target?
b) What is Rogers’ breakeven level of sales at the level of fixed operating cost determined in (a)
Question 4: Emco Products has a present capital structure consisting of only common stock (10 million shares). The company is planning a major expansion. At this time, the company is undecided between the following tow financing plans (assume a 40 percent marginal tax rate):
Plan 1 (Equity financing). Under this plan, an additional 5 million shares of common stock will be sold at $10 each.
Plan 2 (Debt financing). Under this plan, $50 million of 10 percent long-term debt will be sold.
One piece of information the company desires for its decision analysis is an EBIT-EPS analysis.
a) Calculate the EBIT-EPS indifference point
b) What happens to in indifference point if the interest rate on debt increases and the common stock sales price remains constant?
c) What happens to the indifference point if the interest rate on debt remains constant and the common stock sales price increases?
Question 5: Morton Industries is considering opening a new subsidiary in Boston, to be operated as a separate company. The company’s financial analysts expect the new facility’s average EBIT level to be $6 million per year. At this time, the company is considering the following tow financing plans (use a 40 percent marginal tax rate in your analysis):
Plan 1 (Equity financing). Under this plan, 2 million common shares will be sold at $10 each
Plan 2 (Debt equity financing). Under this plan, 10 million of 12 percent long-term debt and 1 million common shares at $10 each will be sold.
a) Calculate the EBIT-EPS indifference point
b) Calculate the expected EPS for both financing plans
c) What factors should the company consider in deciding which financing plan to adopt?
d) Which plan do you recommend the company adopt?
e) Suppose Morton adopts Plan 2 and the Boston facility initially operates at an annual EBIT level of $6 million. What is the time interest earned ration?
Question 6: Moon and Chittenden are considering a new Internet venture to sell used textbooks. The project requires $300,000 in financing. Two alternatives have been proposed:
Plan 1 (Common equity financing). Sell 30,000 shares of stock a net price of $10 per share.
Plan 2 (Debt equity financing). Sell a combination of 15,000 shares of stock at a net price of $10 per share and $150,000 of long-term debt at a pretax interest rate of 12 percent.
Assume the corporate tax rate is 40 percent.
a) Compute the indifference level of EBIT between these two alternatives.
b) If the firm’s EBIT next year has an expected value of $25,000, which plan would you recommend assuming maximizing EPS is a valid objective?