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