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CHAPTER 6: Break-Even and Leverage Analysis

IM Problem Set & Solutions

CHAPTER 6: Break-Even and Leverage Analysis

Instructor’s Manual Problem Set

1. Repeat the Spuds and Suds Income Statement example from Chapter 6 in the text with the following assumptions: price per unit and fixed costs are expected to increase by an average annual rate of inflation of 2%. Also assume that variable costs as a percent of sales will remain constant at 65%. Finally, suppose that Spuds and Suds is a firm in the early stage of business, and that sales are projected to grow at a decreasing rate of 20%, 15%, 10% and 5% for 2011-2015 respectively.

a. Put together an income statement using the assumptions explained above.

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b. Calculate the operating break-even point in both units and dollars.

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c. How many units would Spuds and Suds need to sell in order to achieve earnings, before interest and taxes of $900,000?

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d. Calculate the degree of operating, financial, and combined leverage for each year.

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d. Create a Line chart that shows how the various leverage measures have changed over this five-year period.

2. Red Sunset Co. manufactures mobile phones and wants to add a brand new model to its current line of products. The firm has estimated that the new phone’s selling price will be $80 and that variable costs would represent 65% of the sale price. Fixed operating costs are estimated to be $15M and the firm’s marginal tax rate is expected to remain at 35%. The firm also has forecasted that interest expenses associated with the new chip will reach $5M. The firm has 5M of common shares outstanding and forecasts a total preferred dividend payment of $200,000 for the next year. If Red Sunset Co. expects to sell 1M units of the new phone, then:

a. Create an income statement with the previous information

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b. Calculate the operating break-even point in both units and dollars.

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c. How many units would Red Sunset Co. need to sell in order to achieve earnings, before interest and taxes of $2M?

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d. Calculate the degree of operating, financial, and combined leverage.

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e. Use the Goal Seek tool to determine the number of units that would allow Red Sunset Co. to break even in terms of its net income and the selling price to break even in terms of earnings before taxes. Also, determine with the same tool how much preferred dividends the firm would need to pay to keep a degree of financial leverage of 2.

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3. The Cold Experience, Inc., a leading manufacturer of frozen dessert products, is considering the addition of a new product: frozen yogurt. The firm estimates that each coup will sells for $2 and that the variable costs per coup will be 70% of the selling price. The firm expects to sell at least 10M coups the first year and that the marginal tax rate will be 40%. The firm wants to maintain its current degree of financial leverage of 1.5 and a maximum degree of combined leverage of 4.5. The firm expects to pay $300,000 in preferred dividends and has 1M shares of stock outstanding.

a. Create an income statement for the new frozen yogurt’s first year using the information provided above.

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b. Determine the operating break-even point in units and dollars as well as.

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c. How many coups would The Cold Experience, Inc. need to sell in order to achieve earnings, before interest and taxes, of $3M?

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4. The income statement from 2011 to 2007 of Kung Food Equipment, Inc., a restaurant equipment supplier, appears below.

a. Enter the data into your worksheet. Costs of revenues are variable costs. Also, research & development expenses are fixed costs. Finally, $500M of selling/general/administrative expenses constitute fixed costs while the rest are variable costs.

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b. Determine the degree of operating, financial, and combined leverage for each year.

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c. Create a Line chart that shows how the various leverage measures have changed over this five-year period.

5. Financial Data for four automotive parts manufacturers is given below:

XYZ, Inc. / Delphi
Automotive PLC. / Dragon
Auto parts Inc. / Pegasus
Industries
Inc.
Selling Price / $70 / $90 / $120 / $100
Unit Sales / 1,200,000 / 900,000 / 700,000 / 1,000,000
Times Interest Earned / 8 / 9 / 10 / 7
Variable Costs (% of Sales) / 57% / 55% / 53% / 60%
Fixed Costs / $9,000,000 / $12,000,000 / $10,000,000 / $11,000,000
Return on Common Equity / 11% / 10% / 9% / 8%
Common Equity / $120,000,000 / 110,000,000 / 150,000,000 / $140,000,000
Common Shares / 13,000,000 / 12,000,000 / 15,000,000 / 14,000,000

a. Using the financial data given in the above table, create income statements for each firm. Assume a common tax rate of 40% for each company.

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b. Determine the break-even points in both units and dollars, and the degrees of operating, financial, and combined leverage for each firm.

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c. How many units would each company need to sell in order to achieve earnings before interest and taxes of $15M?

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d. Create a Line chart that shows the various leverage measures for each company.

Test Bank

1. What should be the formula on cell B5? /
a. =B1/(B3-B4)/B3
b. =B1/B3-B4*B3
c. =(B1/B3)-B4*B3
d. =B1/(B3-B4)*B3
e. =B1/(B3+B4)*B3

Solution: d.

2. What should be the formula on cell B7? /
a. =B2+B6/B4-B5
b. =(B2+B6)/B4-B5
c. =B2+B6/(B4-B5)
d. =(B2-B6)/(B4+B5)
e. =(B2+B6)/(B4-B5)

Solution: e.

3. What should be the formula on cell B5? /
a. =(B1-B2)/B4
b. =(B2-B3)/B4
c. =(B1-B2)/B3
d. =(B1+B2)/B4
e. =(B1-B3)/B4

Solution: a.

4. What should be the formula on cell B8? /
a. =B1/(B2-B7/(1-B6))
b. =B2/(B3-B7/(1-B6))
c. =B2/B3-B7/(1-B6)
d. =B3/(B2-B7/(1-B6))
e. =B2/(B3-B7/(1+B6))

Solution: b.

5. What should be the formula on cell B6? /
a. =B5*(B1-B2)/B3
b. =B5*B1-B2/B4
c. =B5*(B1-B2)/B4
d. =B5*(B2-B3)/B4
e. =B5*(B1-B3)/B4

Solution: c.

6. What should be the formula on cell B5? /
a. =(1-B4*B3*B1-B2)/B3
b. =(1-B4)*(B4*B1-B2)/B4
c. =(1-B4)*(B3*B1+B2)/B3
d. =(1-B4)*(B3*B1-B2)/B3
e. =(1-B3)*(B3*B1-B2)/B4

Solution: d.

7. What should be the formula on cell B5? /
a. =B1*(B3*(B4-1)+B2*(1-B4))/B1
b. =B1*B2*B4-1+B3*1-B4/B4
c. =B1*(B2*(B4+1)+B3*(1+B4))/B4
d. =B1*B2*(B4-1)+B3*(1-B4)/B4
e. =B1*(B2*(B4-1)+B3*(1-B4))/B4

Solution: e.

8. What should be the outcome of cell B?
a. #DIV/0!
b. #N/A
c. #ERROR/0!
d. #IDIOT!!!
e. #NO IDEA/0!

Solution: b.

9. Which of the following should be the correct formula for cell B8? /
a. =(B1-B2)/B4
b. =B5*(B6-B7)/B4
c. =(B1-B2)/(B1-B2-B3)
d. =(B5*B6-B5*B7)/(B5*B6-B5*B7-B3)
e. All of the above

Solution: b.

10. All of the following are correct formulas for cell B10, EXCEPT? /
a. =(B1-B2)/B4
b. =B5*(B6-B7)/B4
c. =(B1-B6*B5)/(B1-B2-B3)
d. =(B5*B6-B5*B7)/(B5*B6-B5*B7-B3)
e. =B9/B8

Solution: c.

11. What should be the formula on cell B5? /
a. =B1/(B3-B4)
b. =(B1+B2)/(B3+B4)
c. =(B1-B2)/(B3+B4)
d. =(B1-B2)/(B3-B4)
e. =(B1+B2)/(B3-B4)

Solution: d.

12. What should be the formula on cell B4? /
a. =B1/(B2+B3)
b. =B3/B2
c. =B2/B3
d. =B2*B3
e. =B2+B3

Solution: b.

13. What should be the formula on cell B5? /
a. =(B3/C3-1)/(B2/C2+1)
b. =(C3/B3-1)/(C2/B2-1)
c. =(B3/C3-1)/(B2/C2-1)
d. =(B2/C2-1)/(B3/C3-1)
e. =(B3/C3+1)/(B2/C2+1)

Solution: c.

14. What should be the formula on cell B5? /
a. =(B4/C4-1)/(B3/C3-1)
b. =(C3/B3-1)/(C2/B2-1)
c. =(B3/C3-1)/(B2/C2-1)
d. =(C4/B4-1)/(C3/B3-1)
e. =(B4/C4+1)/(B3/C3+1)

Solution: a.

15. What should be the formula on cell B5? /
a. =(B4/C4-1)/(B3/C3-1)
b. =(B4/C4-1)/(B2/C2-1)
c. =(B3/C3-1)/(B2/C2-1)
d. =(C4/B4-1)/(C2/CB-1)
e. =(B4/C4+1)/(B2/C2+1)

Solution: b.