Question:
Imagine that you were hired recently as a financial analyst for a relatively new, highly leveraged ski manufacturer located in the foothills of Colorado's Rocky Mountains. Your firm manufactures only one product, a state-of-the-art snow ski. The company has been operating up to this point without much quantitative knowledge of the business and financial risks it faces. Ski season just ended, however, so the president of the company has started to focus more on the financial aspects of managing the business. He has set up a meeting for next week with the CFO, Maria Sanchez, to discuss matters such as the business and financial risks faced by the company. Accordingly, Maria has asked you to prepare an analysis to assist her in her discussions with the president. As a first step in your work, you compiled the following information regarding the cost structure of the company:
Output level
80,000 units
Operating assets
$4,000,000
Operating asset turnover
8 times
Return on operating assets
32%
Degree of operating leverage
6 times
Interest expense
$600,000
Tax rate
35%
As the next step, you need to determine the break-even point in units of output for the company. One of your strong points has been that you always prepare supporting work papers, which show how you arrived at your conclusions. You know Maria would like to see these work papers to facilitate her review of your work. Therefore, you will have the information you require to prepare an analytical income statement for the company. You are sure that Maria would also like to see this statement. In addition, you know that you need it to be able to answer the following questions. You also know Maria expects you to prepare, in a format that is presentable to the president, answers to the following questions to serve as a basis for her discussions with the president.
a. What is the firm's break-even point in sales dollars?
b. If sales should increase by 30 percent (as the president expects), by what percentage would EBT (earnings before taxes) and net income increase?
c. Prepare another income statement, this time to verify the calculations from part b.