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.

S-159 Copyright © 2005 by The McGraw-Hill Companies, Inc.

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.

Copyright © 2005 by The McGraw-Hill Companies, Inc. S-160

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
Fixed costs
a. BE 
Price - variable cost per unit

$80,000 $80,000
   16,000 units
$20  $15 $5

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

S-161 Copyright © 2005 by The McGraw-Hill Companies, Inc.

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

$15,000
a. BE 
$8.00  $7.50
 30,000 units

Profit  FC $25,000  $15,000

b. Q 
 P  VC $8.00  $7.50

$40,000
  80,000 units
$.50

Copyright © 2005 by The McGraw-Hill Companies, Inc. S-162

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.
Fixed costs
BE 
Price  variable cost per unit

$100,000 $100,000
   8,000 units
$28  $15.50 $12.50

b.
Fixed costs
BE 
Price  variable cost per unit

$75,000 $75,000
   6,818 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 © 2005 by The McGraw-Hill Companies, Inc.

5-4. 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 $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.

Solution:
Air Filter, Inc.

Variable Costs (per

Fixed Costs unit)
Rent $100,000
Factory labor $1.20
Executive salaries $89,000
Raw materials _______ .60
$189,000 $1.80

FC $189,000 $189,000
BE     45,000 units
P  VC $6.00  $1.80 $4.20

Copyright © 2005 by The McGraw-Hill Companies, Inc. S-164

5-5. 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 variable 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.

Solution:
Shawn Penn & Pencil Sets, Inc.
$80,000 $80,000
BE (before)    32,000 units
$5.00  $2.50 $2.50

$120,000 $120,000
BE (after)    40,000 units
$5.00  $2.00 $3.00

The break-even point will go up.

5-6. 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?

Solution:
Gibson & Sons

Cash related fixed costs = Total Fixed Costs – Depreciation

= $1,200,000 – 25% ($1,200,000)
= $1,200,000 – $300,000
= $900,000

$900,000
BE   375,000 units
$2.40

5-7. Draw two break-even graphs—one for a conservative firm using labor-intensive
production and another for a capital-intensive firm. Assuming these companies

S-165 Copyright © 2005 by The McGraw-Hill Companies, Inc.

 compete within the same industry and have identical sales, explain the impact of
changes in sales volume on both firms' profits.

Solution:

Labor-Intensive and capital-intensive break-even graphs

L a b o r-In te n s iv e C a p ita l-In te n s iv e

R e v e n u e a n d c o s ts R e v e n u e a n d c o s ts
T o ta l re v e n u e
T o ta l re v e n u e
fits B E fits
P ro T o ta l c o s ts P ro
T o ta l c o s ts
B E
V a ria b le c o s t
V a ria b le c o s t
F ix e d c o s ts

U n its p ro d u c e d a n d s o ld U n its p ro d u c e d a n d s o ld

The company having the high fixed costs will have lower variable costs
than its competitor since it has substituted capital for labor. With a lower
variable cost, the high fixed cost company will have a larger
contribution margin. Therefore, when sales rise, its profits will increase
faster than the low fixed cost firm and when the sales decline, the
reverse will be true.

Copyright © 2005 by The McGraw-Hill Companies, Inc. S-166

5-8. The Sosa Company produces baseball gloves. The company’s income statement
for 2004 is as follows:

Sosa Company
Income Statement
For the Year Ended December 31, 2004

Sales (20,000 gloves at $60 each)........................... $1,200,000

Less: Variable costs (20,000 gloves at 400,000
$20).........................................................................
Fixed costs.......................................................... 600,000
Earnings before interest and taxes (EBIT).............. 200,000
Interest expense....................................................... 80,000
Earnings before taxes (EBT)................................... 120,000
Income tax expense (30%)...................................... 36,000
Earnings after taxes (EAT)..................................... $ 84,000

Given this income statement, compute the following:

a. Degree of operating leverage.

b. Degree of financial leverage.
c. Degree of combined leverage.

Solution:
Sosa Company

Q = 20,000, P = $60, VC = $20, FC = $600,000, I = $80,000

Q  P  VC
a. DOL 
Q  P  VC   FC

20,000  $60  $20


20,000  $60  $20  $600,000

20,000  $40

20,000  $40  $600,000

S-167 Copyright © 2005 by The McGraw-Hill Companies, Inc.

5-8. Continued
$800,000 $800,000
   4.00 x
$800,000  $600,000 $200,000

EBIT $200,000
b. DFL  
EBIT  I $200,000  $80,000

$200,000
  1.67 x
$120,000

Q  P  VC 
c. DCL 
Q  P  VC   FC  I

20,000  $60  $20


20,000  $60  $20  $600,000  $80,000

$200,000 $40

$20,000 $40  $680,000

$800,000
  6.67 x
$120,000

Copyright © 2005 by The McGraw-Hill Companies, Inc. S-168

5-9. The Harmon Company manufactures skates. The company's income statement
for 2004 is as follows:

Harmon Company
Income Statement
For the Year Ended December 31, 2004

Sales (30,000 skates @ $25 each)........................... $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.

Solution:
Harmon Company

Q = 30,000, P = $25, VC = $7, FC = $270,000, I = $170,000

Q  P  VC
a. DOL 
Q  P  VC   FC

30,000  $25  $7 

30,000  $25  $7   $270,000

30,000  $18

30,000  $18  $270,000

S-169 Copyright © 2005 by The McGraw-Hill Companies, Inc.

5-9. Continued
$540,000 $540,000
   2x
$540,000  $270,000 $270,000

EBIT $270,000
b. DFL  
EBIT  I $270,000  $170,000

$270,000
  2.7 x
$100,000

Q  P  VC 
c. DCL 
Q  P  VC   FC  I

30,000  $25  $7 

30,000  $25  $7   $270,000  $170,000

30,000  $18 $540,000

   5.4 x
30,000  $18  $440,000 $100,000

$270,000
d. BE   15,000 units
$25  $7

Copyright © 2005 by The McGraw-Hill Companies, Inc. S-170

5-10. University Catering sells 50-pound bags of popcorn to university dormitories 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 25,000 bags.
c. What is the degree of operating leverage at 20,000 bags and 25,000 bags?
Why does the degree of operating leverage change as the quantity sold
increases?
d. If University Catering has an annual interest payment 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?

Solution:
University Catering

$80,000 $80,000
a. BE    16,000 bags
$10   $.10  50  $5

b. 12,000 bags 25,000 bags

Sales @ $10 per bag $120,000 $250,000
Less: Variables Costs ($5) (60,000) (125,000)
Fixed Costs (80,000) (80,000)
Profit or Loss ($ 20,000) $ 45,000

Q  P  VC
c. DOL 
Q  P  VC  FC
20,000  $10  $5
DOL at 20,000 
20,000  $10 - $5  $80,000

$100,000
  5.00 x
$20,000

S-171 Copyright © 2005 by The McGraw-Hill Companies, Inc.

5-10. Continued
25,000  $10  $5
DOL at 25,000 
25,000  $10 - $5  $80,000

$125,000
  2.78x
$45,000

Leverage goes down because we are further away from the break-even
point, thus the firm is operating on a larger profit base and leverage is
reduced.

EBIT
d. DFL 
EBIT  I

First determine the profit or loss (EBIT) at 20,000 bags. As indicated

in part b, the profit (EBIT) at 25,000 bags is $45,000:

20,000 bags
Sales @ $10 per bag $200,000
Less: Variable Costs ($5) 100,000
Fixed Costs 80,000
Profit or Loss $ 20,000

$20,000
DFL at 20,000 
$20,000  $10,000

 2.0 x

Copyright © 2005 by The McGraw-Hill Companies, Inc. S-172

5-10. Continued
$45,000
DFL at 25,000 
$45,000  $10,000

 1.29x

Q  P  VC
e. DCL 
Q  P  VC   FC  I

20,000  $10  $5

DCL at 20,000 
20,000  $10 - $5  $80,000  $10,000

$100,000
  10.0 x
$10,000

25,000  $10  $5

DCL at 25,000 
25,000  $10  $5  $80,000  $10,000

$125,000
  3.57 x
$35,000

5-11. 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

S-173 Copyright © 2005 by The McGraw-Hill Companies, Inc.

5-11. Continued

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?

Solution:
Leno Drug Stores and Hall Pharmaceuticals
a.
Leno Hall
EBIT $ 20,000 $ 20,000
Less: Interest 10,000 20,000
EBT 10,000 0
Less: Taxes @ 30% 3,000 0
EAT 7,000 0
Shares 20,000 10,000
EPS $.35 0
EBIT $ 30,000 $ 30,000
Less: Interest 10,000 20,000
EBT 20,000 10,000
Less: Taxes @ 30% 6,000 3,000
EAT 14,000 7,000
Shares 20,000 10,000
EPS $.70 $.70
EBIT $120,000 $120,000
Less: Interest 10000 20,000
EBT 110,000 100,000
Less: Taxes @ 30% 33,000 30,000
EAT 77,000 70,000
Shares 20,000 10,000
EPS $3.85 $7.00

Copyright © 2005 by The McGraw-Hill Companies, Inc. S-174

5-11. Continued

b. Before-tax return on assets = 6.67%, 10% and 40% at the respective

levels of EBIT. When the before-tax return on assets (EBIT/Total
Assets) is less than the cost of debt (10%), Leno does better with
less debt than Hall. When before-tax return on assets is equal to the
cost of debt, both firms have equal EPS. This would be where the
method of financing has a neutral effect on EPS. As return on assets
becomes greater than the interest rate, financial leverage becomes
more favorable for Hall.

c. 12% x $300,000 = $36,000 break-even level for EBIT.

5-12. In Problem 11, compute the stock price for Hall Pharmaceuticals if it sells at 13
times earnings per share and EBIT is $80,000.

Solution:

Hall Pharmaceuticals (Continued)

EBIT $80,000
Less: Interest 20,000
EBT $60,000
Less: Taxes @ 30% 18,000
EAT $42,000
Shares 10,000
EPS $ 4.20
P/E 13x
Stock Price $ 54.60

S-175 Copyright © 2005 by The McGraw-Hill Companies, Inc.

5-13. Pulp Paper Company and Holt Paper Company are able to generate earnings
before interest and taxes of $150,000.

The separate capital structures for Pulp and Holt are shown below:

Pulp Holt
Debt @ 10%.....................$ 800,000 Debt @ 10%.................. $ 400,000
Common stock, $5 par..... 700,000 Common stock, $5 par. . 1,100,000
Total...............................$1,500,000 Total............................ $1,500,000
Common shares................ 140,000 Common shares............. 220,000

a. Compute earnings per share for both firms. Assume a 40 percent tax rate.
b. In part a, you should have gotten the same answer for both companies'
earnings per share. Assume a P/E ratio of 20 for each company, what would
its stock price be?
c. Now as part of your analysis, assume the P/E ratio would be 15 for the
riskier company in terms of heavy debt utilization in the capital structure and
26 for the less risky company. What would the stock prices for the two firms
be under these assumptions? (Note: Although interest rates also would likely
be different based on risk, we hold them constant for ease of analysis).
d. Based on the evidence in part c, should management only be concerned
about the impact of financing plans on earnings per share or should
stockholders' wealth maximization (stock price) be considered as well?

Copyright © 2005 by The McGraw-Hill Companies, Inc. S-176

Solution:

Pulp Paper Company and Holt Paper Company

a.
Pulp Holt
EBIT $150,000 $150,000
Less: Interest 80,000 40,000
EBT 70,000 110,000
Less: Taxes @ 40% 28,000 44,000
EAT 42,000 66,000
Shares 140,000 220,000
EPS $.30 $.30

b. Stock price = P/E x EPS

20 x $.30 = $6.00

c. Pulp Holt
15 x $.30 = $4.50 26 x $.30 = $7.80

d. Clearly, the ultimate objective should be to maximize the stock

price. While management would be indifferent between the two
plans based on earnings per share, Holt Paper, with the less risky
plan, has a higher stock price.

S-177 Copyright © 2005 by The McGraw-Hill Companies, Inc.

5-14. Firms in Japan often employ both high operating and financial leverage because
of the use of modern technology and close borrower-lender relationships.
Assume the Susaki Company has a sales volume of 100,000 units at a price of
$25 per unit; variable costs are $5 per unit and fixed costs are $1,500,000.
Interest expense is $250,000. What is the degree of combined leverage for this
Japanese firm?

Solution:
Susaki Company
Q  P  VC 
DCL 
Q  P  VC   FC  I

100,000  $25  $5


100,000  $25  $5  $1,500,000  $250,000

100,000  $20

100,000  $20  $1,750,000

$2,000,000 $2,000,000
   8x
$2,000,000  $1,750,000 250,000

Copyright © 2005 by The McGraw-Hill Companies, Inc. S-178

5-15. Glynn Enterprises and Monroe, Inc., both produce fluid control products. Their
financial information is as follows:

Capital Structure

Glynn Monroe
Debt @ 10%................................................... $1,500,000 0
Common stock, $10 per share........................ 500,000 $2,000,000
$2,000,000 $2,000,000
Common shares.............................................. 50,000 200,000

Operating Plan

Sales (200,000 units at $5 each).................... $1,000,000 $1,000,000

Less: Variable costs..................................... 600,000 200,000
($3 per unit) ($1 per unit)
Fixed costs................................................. 0 400,000
Earnings before interest and taxes (EBIT)..... $ 400,000 $ 400,000

a. If you combine Glynn’s capital structure with Monroe’s operating plan, what
is the degree of combined leverage?
b. If you combine Monroe’s capital structure with Glynn’s operating plan, what
is the degree of combined leverage?
c. Explain why you got the results you did in part b.
d. In part b, if sales double, by what percent will EPS increase?

S-179 Copyright © 2005 by The McGraw-Hill Companies, Inc.

5.15. Continued

Solution:
Glynn Enterprises and Monroe, Inc.
Q  P  VC 
a. DCL 
Q  P  VC   FC  I

200,000  $5  $1

200,000  $5  $1  $400,000  $150,000

200,000 $4 

$200,000 $4   $550,000
$800,000
  3.20x
$250,000

Q  P  VC
b. DCL 
Q  P  VC   FC  I

200,000  $5  $3

200,000  $5  $3  0  0

200,000  $2 

200,000  $2 

$400,000
  1x
$400,000

Copyright © 2005 by The McGraw-Hill Companies, Inc. S-180

5-15. Continued

c. The combined leverage is fairly high in part a because you are

combining firms that both use operating and financial leverage.
However, the leverage factor is only one in part b because
Monroe has no financial leverage and Glynn has no operating
leverage.

d. EPS will increase by 100 percent. However, there is no leverage

involved. EPS merely grows at the same rate as sales.

5-16. DeSoto Tools, Inc., is planning to expand production. The expansion will cost
$300,000, which can be financed either by bonds at an interest rate of 14 percent
or by selling 10,000 shares of common stock at $30 per share. The current
income statement before expansion is as follows:

DeSoto Tools, Inc.

Income Statement
199X

Sales............................................................... $1,500,000
Less: Variable costs..................................... $ 450,000
Fixed costs................................................. 550,000 1,000,000
Earnings before interest and taxes................. 500,000
Less: Interest expense.................................. 100,000
Earnings before taxes..................................... 400,000
Less: Taxes @ 34%..................................... 136,000
Earnings after taxes........................................ $ 264,000
Shares............................................................. 100,000
Earnings per share.......................................... $2.64

After the expansion, sales are expected to increase by $1,000,000. Variable costs
will remain 30 percent of sales, and fixed costs will increase to $800,000. The
tax rate is 34 percent.

a. Calculate the degree of operating leverage, the degree of financial leverage,

and the degree of combined leverage before expansion. (For the degree of
operating leverage, use the formula developed in footnote 2; for the degree
of combined leverage, use the formula developed in footnote 3. These
instructions apply throughout this problem.)

S-181 Copyright © 2005 by The McGraw-Hill Companies, Inc.

5-16. Continued

b. Construct the income statement for the two alternative financing plans.
c. Calculate the degree of operating leverage, the degree of financial leverage,
and the degree of combined leverage, after expansion.
d. Explain which financing plan you favor and the risks involved with each
plan.

Solution:
DeSoto Tools, Inc.
S  TVC
a. DOL 
S  TVC  FC

$1,500,000  $450,000
  2.1x
$1,500,000  $450,000  $550,000

EBIT
DFL 
EBIT  I

$500,000

$500,000  $100,000

$500,000
  1.25x
$400,000

Copyright © 2005 by The McGraw-Hill Companies, Inc. S-182

5-16. Continued
S  TVC
DCL 
S  TVC  FC  I

$1,500,000  $450,000

$1,500,000  $450,000  $550,000  $100,000

$1,050,000
  2.63x
$400,000

b. Income Statement After Expansion

Debt Equity
Sales $2,500,000 $2,500,000
Less: Variable Costs (30%) 750,000 750,000
Fixed Costs 800,000 800,000
EBIT 950,000 950,000
Less: Interest 142,0001 100,000
EBT 808,000 850,000
Less: Taxes @ 34% 274,720 289,000
EAT (Net Income) 533,280 561,000
Common Shares 100,000 110,0002
EPS $5.33 $5.10

1
New interest expense level if expansion is financed with debt.
$100,000 + 14% ($300,000) = $142,000
2
Number of common shares outstanding if expansion is
financed with equity.
100,000 + 10,000 = 110,000

S-183 Copyright © 2005 by The McGraw-Hill Companies, Inc.

5-16. Continued

c.
S  TVC
DOL 
S  TVC  FC

$2,500,000  $750,000
DOL  Debt/Equity  
$2,500,000  $750,000  $800,000

$1,750,000
  1.84x
$950,000
EBIT
DFL 
EBIT  I

$950,000 $950,000
DFL  Debt     1.18x
$950,000  $142,000 $808,000

$950,000 $950,000
DFL  Equity     1.12x
$950,000  $100,000 $850,000

$2,500,000  $750,000
DCL  Debt  
$2,500,000  $750,000  $800,000  $142,000

$1,750,000
  2.17 x
$808,000

Copyright © 2005 by The McGraw-Hill Companies, Inc. S-184

5-16. Continued
$2,500,000  $750,000
DCL  Equity  
$2,500,000  $750,000  $800,000  $100,000

$1,750,000
  2.06x
$850,000

d. The debt financing plan provides a greater earnings per share at the
new sales level, but provides more risk because of the increased use
of debt. However, the interest coverage ratio in both cases is
certainly satisfactory and interest expense is well protected. The
crucial point is expectations for future sales. If sales are expected to
decline, the debt plan will not provide higher EPS at sales of less
than about $2 million so cyclical swings in sales, earnings, and
profit margins need to be considered in choosing the financing plan.

5-17. Using Standard & Poor’s data or annual reports, compare the financial and
operating leverage of Exxon, Eastman Kodak, and Delta Airlines for the most
current year. Explain the relationship between operating and financial leverage
for each company and the resultant combined leverage. What accounts for the
differences in leverage of these companies?

Solution:

The results for this problem change every year. This is primarily a
library assignment to facilitate class discussion.

S-185 Copyright © 2005 by The McGraw-Hill Companies, Inc.

5-18. Dickinson Company has $12 million in assets. Currently half of these assets
are financed with long-term debt at 10 percent and half with common stock
having a par value of $8. Ms. Smith, vice-president of finance, wishes to
analyze two refinancing plans, one with more debt (D) and one with more
equity (E). The company earns a return on assets before interest and taxes of
10 percent. The tax rate is 45 percent.

Under Plan D, a $3 million long-term bond would be sold at an interest rate of

12 percent and 375,000 shares of stock would be purchased in the market at $8
per share and retired.

Under Plan E, 375,000 shares of stock would be sold at $8 per share and the
$3,000,000 in proceeds would be used to reduce long-term debt.

a. How would each of these plans affect earnings per share? Consider the
current plan and the two new plans.
b. Which plan would be most favorable if return on assets fell to 5 percent?
Increased to 15 percent? Consider the current plan and the two new plans.
c. If the market price for common stock rose to $12 before the restructuring,
which plan would then be most attractive? Continue to assume that $3
million in debt will be used to retire stock in Plan D and $3 million of new
equity will be sold to retire debt in Plan E. Also assume for calculations in
part c that return on assets is 10 percent.

Copyright © 2005 by The McGraw-Hill Companies, Inc. S-186

Solution:
Dickinson Company
Income Statements

a. Return on assets = 10% EBIT = $1,200,000

Current Plan D Plan E

EBIT $1,200,000 $1,200,000 $1,200,000
Less: Interest 600,0001 960,0002 300,0003
EBT 600,000 240,000 900,000
Less: Taxes (45%) 270,000 108,000 405,000
EAT 330,000 132,000 495,000
Common shares 750,0004 375,000 1,125,000
EPS $.44 $.35 $.44

1
$6,000,000 debt @ 10%
2
$600,000 interest + ($3,000,000 debt @ 12%)
3
($6,000,000 – $3,000,000 debt retired) x 10%
4
($6,000,000 common equity)/($8 par value) = 750,000 shares

Plan E and the original plan provide the same earnings per share
because the cost of debt at 10 percent is equal to the operating return on
assets of 10 percent. With Plan D, the cost of increased debt rises to 12
percent, and the firm incurs negative leverage reducing EPS and also
increasing the financial risk to Dickinson.

S-187 Copyright © 2005 by The McGraw-Hill Companies, Inc.

5-18. Continued

b. Return on assets = 5% EBIT = $600,000

Current Plan D Plan E

EBIT $600,000 $600,000 $ 600,000
Less: Interest 600,000 960,000 300,000
EBT 0 (360,000) 300,000
Less: Taxes @ 45% --- (162,000) 135,000
EAT 0 $(198,000) $ 165,000
Common shares 750,000 375,000 1,125,000
EPS 0 $(.53) $.15

Return on assets = 15% EBIT = $1,800,000

Current Plan D Plan E

EBIT $1,800,000 $1,800,000 $1,800,000
Less: Interest 600,000 960,000 300,000
EBT 1,200,000 840,000 1,500,000
Less: Taxes @ 45% 540,000 378,000 675,000
EAT $ 660,000 $ 462,000 $ 825,000
Common shares 750,000 375,000 1,125,000
EPS $.88 $1.23 $.73

If the return on assets decreases to 5%, Plan E provides the best EPS,
and at 15% return, Plan D provides the best EPS. Plan D is still risky,
having an interest coverage ratio of less than 2.0.

Copyright © 2005 by The McGraw-Hill Companies, Inc. S-188

5-18. Continued

c. Return on Assets = 10% EBIT = $1,200,000

Current Plan D Plan E

EBIT $1,200,000 $1,200,000 $1,200,000
EAT 330,000 132,000 495,000
1
Common shares 750,000 500,000 1,000,0002
EPS $.44 $.26 $.50

1
750,000 – ($3,000,000/$12 per share)
= 750,000 – 250,000 = 500,000 shares
2
750,000 + ($3,000,000/$12 per share)
= 750,000 + 250,000 = 1,000,000 shares

As the price of the common stock increases, Plan E becomes more

attractive because fewer shares can be retired under Plan D and, by
the same logic, fewer shares need to be sold under Plan E.

5-19. Johnson Grass and Garden Centers has $20 million in assets, 75 percent financed
by debt and 25 percent financed by common stock. The interest rate on the debt is
12 percent and the par value of the stock is $10 per share. President Johnson is
considering two financing plans for an expansion to $30 million in assets.

Under Plan A, the debt-to-total assets ratio will be maintained, but new debt will
cost 15 percent! New stock will be sold at $10 per share. Under Plan B, only new
common stock at $10 per share will be issued. The tax rate is 40 percent.

a. If EBIT is 12 percent on total assets, compute earnings per share (EPS) before
the expansion and under the two alternatives.
b. What is the degree of financial leverage under each of the three plans?
c. If stock could be sold at $20 per share due to increased expectations for the
firm's sales and earnings, what impact would this have on earnings per share
for the two expansion alternatives? Compute earnings per share for each.
d. Explain why corporate financial officers are concerned about their stock
values!

S-189 Copyright © 2005 by The McGraw-Hill Companies, Inc.

5-19. Continued

Solution:
Johnson Grass and Garden Centers

a. Return on Assets = 12%

Current Plan A Plan B

EBIT $2,400,000 $3,600,000 $3,600,000
Less: Interest 1,800,0001 2,925,0003 1,200,0005
EBT 600,000 675,000 1,800,000
Less: Taxes @
40% 240,000 270,000 720,000
EAT $ 360,000 $ 405,000 $1,080,000
Common shares 500,0002 750,0004 1,500,0006
EPS $.72 $.54 $.72

1
(75% x $20,000,000) x 12% = $15,000,000 x 12% = $1,800,000
2
(25% x $20,000,000)/$10 = $5,000,000/$10 =
500,000 shares
3
$1,800,000 (current) + (75% x $10,000,000) x 15%
= $1,800,000 + $1,125,000 = $2,925,000
4
500,000 shares (current) + (25% x $10,000,000)/$10
= 500,000 + 250,000 = 750,000 shares
5
unchanged
6
500,000 shares (current) + $10,000,000/$10 =
500,000 + 1,000,000 = 1,500,000 shares

Copyright © 2005 by The McGraw-Hill Companies, Inc. S-190

5-19. Continued

b.
EBIT
DFL 
EBIT  I

$2,400,000
DFL (Current)   4.00 x
$2,400,000  $1,800,000

$3,600,000
DFL (Plan A)   5.33x
$3,600,000  $2,925,000

$3,600,000
DFL (Plan B)   2x
$3,600,000  $1,800,000
c.
Plan A Plan B
EAT $405,000 $1,080,000
Common Shares 625,0001 1,000,0002
EPS $.65 $1.08

1
500,000 shares (current) + (25% x $10,000,000)/$20
= 500,000 + 125,000 = 625,000 shares
2
500,000 shares (current) + $10,000,000/$20
= 500,000 + 500,000 = 1,000,000 shares

Plan B would continue to provide the higher earnings per share than
Plan A. The difference between plans A and B is even greater than
that indicated in part (a).

S-191 Copyright © 2005 by The McGraw-Hill Companies, Inc.

5-19. Continued

d. Not only does the price of the common stock create wealth to the
shareholder, which is the major objective of the financial manager,
but it greatly influences the ability to raise capital to finance projects
at a high or low cost. Cost of capital will be discussed in Chapter 10,
and one will see the impact that the cost of capital has on capital
budgeting decisions.
5-20. Mr. Katz is in the widget business. He currently sells 2 million widgets a year at
$4 each. His variable cost to produce the widgets is $3 per unit, and he has
$1,500,000 in fixed costs. His sales-to-assets ratio is four times, and 40 percent of
his assets are financed with 9 percent debt, with the balance financed by common
stock at $10 per share. The tax rate is 30 percent.

His brother-in-law, Mr. Doberman, says Mr. Katz is doing it all wrong. By
reducing his price to $3.75 a widget, he could increase his volume of units sold
by 40 percent. Fixed costs would remain constant, and variable costs would
remain $3 per unit. His sales-to-assets ratio would be 5 times.

Furthermore, he could increase his debt-to-assets ratio to 50 percent, with the

balance in common stock. It is assumed that the interest rate would go up by 1
percent and the price of stock would remain constant.

a. Compute earnings per share under the Katz plan.

b. Compute earnings per share under the Doberman plan.
c. Mr. Katz’s wife does not think that fixed costs would remain constant under
the Doberman plan but that they would go up by 20 percent. If this is the case,
should Mr. Katz shift to the Doberman plan, based on earnings per share?

Copyright © 2005 by The McGraw-Hill Companies, Inc. S-192

5-20. Continued

Solution:
Katz-Doberman

a. Katz Plan

Sales ($2,000,000 units x $4)..................... $8,000,000

–Fixed costs................................................ –1,500,000
–Variable costs (2,000,000 units x $3)....... –6,000,000
Operating income (EBIT)........................... $ 500,000
–Interest1..................................................... 72,000
EBT............................................................ $ 428,000
–Taxes @ 30%........................................... 128,400
EAT............................................................ $ 299,600
Shares2........................................................ 120,000
Earnings Per Share..................................... $2.50

Sales $8,000,000
Assets    $2,000,000
Asset Turnover 4

1
Debt = 40% of Assets
40% x $2,000,000 = $800,000
Interest = 9% x $800,000 = $72,000
2
Stock = 60% of $2,000,000 = $1,200,000
Shares = $1,200,000/$10 = 120,000

S-193 Copyright © 2005 by The McGraw-Hill Companies, Inc.

5-20. Continued

b. Doberman Plan

Sales ($2,800,000 units at $3.75)............... $10,500,000

–Fixed costs................................................ 1,500,000
–Variable costs (2,800,000 units x $3)....... 8,400,000
Operating income (EBIT).......................... $ 600,000
–Interest3..................................................... 105,000
EBT............................................................ $ 495,000
–Taxes @ 30%........................................... 148,500
EAT............................................................ $ 346,500
Shares4........................................................ 105,000
Earnings Per Share..................................... $3.30

Sales $10,500,000
Assets    $2,100,000
Asset Turnover 5

3
Debt = 50% of Assets
50% x $2,100,000 = $1,050,000
Interest = 10% x $1,050,000 = $105,000
4
Stock = 50% of $2,100,000 = $1,050,000
Shares = $1,050,000/$10 = 105,000

Copyright © 2005 by The McGraw-Hill Companies, Inc. S-194

5-20. Continued

c. Doberman Plan (based on Mrs. Katz’s Assumption)

Sales........................................................... $10,500,000
–Fixed costs ($1,500,000 x 1.20)............... 1,800,000
–Variable costs........................................... 8,400,000
Operating income (EBIT)........................... $ 300,000
–Interest...................................................... 105,000
EBT............................................................ $ 195,000
–Taxes @ 30%........................................... 58,500
EAT............................................................ $ 136,500
Shares......................................................... 105,000
Earnings Per Share..................................... $1.30

No! Mr. Katz should not shift to the Doberman plan if Mrs. Katz’s
assumption is correct.

S-195 Copyright © 2005 by The McGraw-Hill Companies, Inc.

5-21. Highland Cable Company is considering an expansion of its facilities. Its current
income statement is as follows:

Sales........................................................................ $4,000,000
Less: Variable expense (50% of sales)................. 2,000,000
Fixed expense...................................................... 1,500,000
Earnings before interest and taxes (EBIT).............. 500,000
Interest (10% cost).................................................. 140,000
Earnings before taxes (EBT)................................... 360,000
Tax (30%)............................................................... 108,000
Earnings after taxes (EAT)..................................... $ 252,000
Shares of common stock 200,000
Earnings per share................................................... $1.26

Highland Cable Company is currently financed with 50 percent debt and 50

percent equity (common stock, par value of $10). To expand the facilities, Mr.
Highland estimates a need for $2 million in additional financing. His investment
banker has laid out three plans for him to consider:

1. Sell $2 million of debt at 13 percent.

2. Sell $2 million of common stock at $20 per share.
3. Sell $1 million of debt at 12 percent and $1 million of common stock at $25
per share.

Variable costs are expected to stay at 50 percent of sales, while fixed expenses
will increase to $1,900,000 per year. Mr. Highland is not sure how much this
expansion will add to sales, but he estimates that sales will rise by $1 million per
year for the next five years.

Mr. Highland is interested in a thorough analysis of his expansion plans and

methods of financing. He would like you to analyze the following:

a. The break-even point for operating expenses before and after expansion (in
sales dollars).
b. The degree of operating leverage before and after expansion. Assume sales of
$4 million before expansion and $5 million after expansion. Use the formula
in footnote 2.
c. The degree of financial leverage before expansion at sales of $4 million and
for all three methods of financing after expansion. Assume sales of $5 million
for the second part of this question.
d. Compute EPS under all three methods of financing the expansion at $5
million in sales (first year) and $9 million in sales (last year).
e. What can we learn from the answer to part d about the advisability of the
three methods of financing the expansion?

Copyright © 2005 by The McGraw-Hill Companies, Inc. S-196

5-21. Continued

Solution:
Highland Cable Company

a. At break-even before expansion:

PQ = FC + VC
where PQ equals sales volume at break-even point

Sales = Fixed costs + Variable costs

(Variable costs = 50% of sales)

Sales = $1,500,000 + .50 sales

.50 sales = $1,500,000
Sales = $3,000,000

At break-even after expansion:

Sales = $1,900,000 + .50 sales

.50 sales = $1,900,000
Sales = $3,800,000

b. Degree of operating leverage, before expansion, at sales of

$4,000,000
Q  P  VC  S  TVC
DOL  
Q  P  VC   FC S  TVC  FC

$4,000,000  $2,000,000

$4,000,000  $2,000,000  $1,500,000

$2,000,000
  4x
500,000

S-197 Copyright © 2005 by The McGraw-Hill Companies, Inc.

5-21. Continued

Degree of operating leverage after expansion at sales of $5,000,000

$5,000,000  $2,500,000
DOL 
$5,000,000  $2,500,000  $1,900,000

$2,500,000
  4.17 x
$600,000

This could also be computed for subsequent years.

c. DFL before expansion:

EBIT
DFL 
EBIT  1

Compute EBIT Sales $4,000,000

–TVC 2,000,000
–FC 1,500,000
EBIT $ 500,000
I = $ 140,000

$500,000 $500,000
   1.39x
$500,000  $140,000 $360,000

Copyright © 2005 by The McGraw-Hill Companies, Inc. S-198

5-21. Continued

DFL after expansion:

EBIT
DFL 
EBIT  I

Compute EBIT and I for all three plans:

(50% Debt
(100% Debt) (100% Equity) and Equity
(1) (2) (`3)
Sales $5,000,000 $5,000,000 $5,000,000
–TVC 2,500,000 2,500,000 2,500,000
–FC 1,900,000 1,900,000 1,900,000
EBIT $ 600,000 $ 600,000 $ 600,000
I – Old Debt 140,000 140,000 140,000
I – New Debt 260,000 0 120,000
Total Interest $ 400,000 $ 140,000 $ 260,000

EBIT
DFL 
EBIT  I

(1) (2) (3)

$600,000 $600,000 $600,000

 $600,000  $400,000  $600,000  $140,000  $600,000  $260,000 

DFL = 3x 1.30x 1.76x

S-199 Copyright © 2005 by The McGraw-Hill Companies, Inc.

5-21. Continued

d. EPS @ sales of $5,000,000

(refer back to part c to get the values for EBIT and Total I)

(50% Debt
(100% Debt) (100% Equity) and Equity
(1) (2) (`3)
EBIT $600,000 $600,000 $600,000
Total Interest 400,000 140,000 260,000
EBT $200,000 $460,000 $340,000
Taxes (30%) 60,000 138,000 102,000
EAT $140,000 $322,000 $238,000
Shares (old) 200,000 200,000 200,000
Shares (new) 0 100,000 40,000
Total Shares 200,000 300,000 240,000
EPS (EAT/ Total
shares) $.70 $1.07 $.99

Copyright © 2005 by The McGraw-Hill Companies, Inc. S-200

5-21. Continued

EPS @ sales of $9,000,000

(50% Debt
(100% Debt) (100% Equity) and Equity
(1) (2) (`3)
Sales $9,000,000 $9,000,000 $9,000,000
–TVC 4,500,000 4,500,000 4,500,000
–FC 1,900,000 1,900,000 1,900,000
EBIT $2,600,000 $2,600,000 $2,600,000
Total Interest
400,000 140,000 260,000
EBT $2,200,000 $2,460,000 $2,340,000
Taxes (30%)
660,000 738,000 702,000
EAT $1,540,000 $1,722,000 $1,638,000
Total Shares
200,000 300,000 240,000
EPS (EAT/ Total
Shares)
$7.70 $5.74 $6.83

e. In the first year, when sales and profits are relatively low, plan 2
(100% equity) appears to be the best alternative. However, as sales
expand up to $9 million, financial leverage begins to produce results
as EBIT increases and Plan 1 (100% debt) is the highest yielding
alternative.

S-201 Copyright © 2005 by The McGraw-Hill Companies, Inc.

Comprehensive Problem
CP 5-1. Aspen Ski Company
Balance Sheet
December 31, 2004

Assets Liabilities and Stockholders' Equity

Cash............................... $ 40,000 Accounts payable............. $1,800,000
Marketable securities.... 60,000 Accrued expenses............. 100,000
Accounts receivable...... 1,000,000 Notes payable (current).... 600,000
Inventory....................... 3,000,000 Bonds (10%).................... 2,000,000
Gross plan and Common stock (1.5 million
equipment.................... 5,000,000 shares, par value $1)...... 1,500,000
Less: Accumulated Retained earnings............. 1,100,000
depreciation............. 2,000,000

Total liabilities and

Total assets.................... $7,100,00 stockholders' equity........ $7,100,000

Income Statement—2004

Sales (credit)........................................................... $6,000,000

Fixed costs*............................................................ 1,800,000
Variable costs (0.60)............................................... 3,600,000
Earnings before interest and taxes.......................... 600,000
Less: Interest......................................................... 200,000
Earnings before taxes.............................................. 400,000
Less: Taxes @ 40%.............................................. 160,000
Earnings after taxes................................................. $ 240,000
Dividends.............................................................. 43,200
Increased retained earnings..................................... $ 196,800

*Fixed costs include (a) lease expense of $190,000 and (b) depreciation of
$400,000.

Note: Aspen Ski also has $100,000 per year in sinking fund obligations
associated with its bond issue. The sinking fund represents an annual repayment
of the principal amount of the bond. It is not tax deductible.

Copyright © 2005 by The McGraw-Hill Companies, Inc. S-202

CP 5-1. Continued.

Ratios
Aspen Ski
(to be filled in) Industry
Profit margin.................................................. 6.1%
Return on assets............................................. 6.5%
Return on equity............................................. 8.9%
Receivables turnover...................................... 4.9x
Inventory turnover......................................... 4.4x
Fixed asset turnover....................................... 2.1x
Total asset turnover........................................ 1.06x
Current ratio................................................... 1.4x
Quick ratio..................................................... 1.1x
Debt to total assets......................................... 27%
Interest coverage............................................ 4.2x
Fixed charge coverage................................... 3.0x

a. Analyze Aspen Ski Company, using ratio analysis. Compute the ratios
above for Aspen and compare them to the industry data that is given.
Discuss the weak points, strong points, and what you think should be done
to improve the company's performance.
b. In your analysis, calculate the overall break-even point in the sales dollars
and the cash break-even point. Also compute the degree of operating
leverage, degree of financial leverage, and degree of combined leverage.
c. Use the information in parts a and b to discuss the risk associated with this
company. Given the risk, decide whether a bank should loan funds to Aspen
Ski.

Aspen Ski Company is trying to plan the funds needed for 2005. The
management anticipates an increase in sales of 20 percent, which can be
absorbed without increasing fixed assets.

d. What would be Aspen’s needs for external funds based on the current
balance sheet? Compute RNF (required new funds). Notes payable (current)
are not part of the liability calculation.

e. What would be the required new funds if the company brings its ratios into
line with the industry average during 2005? Specifically examine
receivables turnover, inventory turnover, and the profit margin. Use the new
values to recomputed the factors in RNF (assume liabilities stay the same).

S-203 Copyright © 2005 by The McGraw-Hill Companies, Inc.

CP 5-1. Continued

f. Do not calculate, only comment on these questions. How would required new
funds change if the company:

1. Were at full capacity?

2. Raised the dividend payout ratio?
3. Suffered a decreased growth in sales?
4. Faced an accelerated inflation rate?

CP Solution:
Aspen Ski Company

a. Ratio analysis
Aspen Industry
Profit margin $240,000/$6,000,000 4.00% 6.1%
Return on assets $240,000/$7,100,000 3.38% 6.5%
Return on equity $240,000/$2,600,000 9.23% 8.9%
Receivable turnover $6,000,000/$1,000,000 6x 4.9x
Inventory turnover $6,000,000/$3,000,000 2x 4.4x
Fixed asset turnover $6,000,000/$3,000,000 2x 2.1x
Total asset turnover $6,000,000/$7,100,000 .85x 1.06x
Current ratio $4,100,000/$2,500,000 1.64x 1.4x
Quick ratio $1,100,000/$2,500,000 .44x 1.1x
Debt to total assets $4,500,000/$7,100,000 63.4% 27.0%
Interest coverage $600,000/$200,000 3x 4.2x
Fixed charge
coverage See calculation below* 1.42x 3.0x

$600,000  $190,000  Lease 

 1.42 x
$200,000  $190,000  $100,000/ 1  .4 

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CP 5-1. Continued

The company has a lower profit margin than the industry and the
problem is further compounded by the slow turnover of assets (.85x
versus an industry norm of 1.06x). This leads to a much lower
return on assets. The company has a higher return on equity than
the industry, but this is accomplished through the firm's heavy debt
ratio rather than through superior profitability.

The slow turnover of assets can be directly traced to the unusually

high level of inventory. The firm's inventory turnover ratio is only
2x, versus an industry norm of 4.4x. Actually the firm does quite
well with receivable turnover and is only slightly below the industry
in fixed asset turnover.

The previously mentioned heavy debt position becomes more

apparent when we examine times interest earned and fixed charge
coverage. The latter is particularly low due to lease expenses and
sinking fund obligations.

b. Break-even in sales
Sales = Fixed Costs + Variable costs
(variable costs are expressed as a percentage of sales)

SalesBE = $1,800,000 + .60 Sales

.40 S = $1,800,000
S = $2,800,000/.40
S = $4,500,000

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CP 5-1. Continued

Cash break-even
Sales = (Fixed costs – Non cash expenses*) +
Variable costs
SalesBE = ($1,800,000 – $400,000) + .60 Sales
SalesBE = $1,400,000 + .60 Sales
.40 S = $1,400,000
S = $1,400,000/.40
S = $3,500,000

*Depreciation
S  TVC
DOL 
S  TVC  FC

$6,000,000  $3,600,000

$6,000,000  $3,600,000  $1,800,000

$2,400,000
  4x
$600,000

EBIT
DFL 
EBIT  I

$600,000

$600,000  $200,000

$600,000
  1.5x
$400,000

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CP 5-1. Continued
S  TVC
DCL 
S  TVC  FC  I

$6,000,000  $3,600,000

$6,000,000  $3,600,000  $1,800,000  $200,000

$2,400,000
  6x
$400,000

c. Aspen is operating at a sales volume that is $1,500,000 above the

traditional break-even point and $2,500,000 above the cash break-
even point. This can be viewed as somewhat positive.

However, the firm has a high degree of leverage, which indicates

any reduction in sales volume could have a very negative impact on
profitability. The DOL of 4x is associated with heavy fixed assets
and relatively high fixed costs. The DFL of 1.5x is attributed to
high debt reliance. Actually, if we were to include the lease
payments of $190,000 with the interest payments of $200,000, the
DFL would be almost 3x.

The banker would have to question the potential use of the funds
and the firm's ability to pay back the loan. Actually, the firm
already appears to have an abundant amount of assets, so hopefully
a large expansion would not take place here. There appears to be a
need to reduce inventory rather than increase the level.

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CP 5-1. Continued

One possible use of the funds might be to pay off part of the current
notes payable of $600,000. This might be acceptable if the firm can
demonstrate the ability to meet its future obligations. The banker
should request to see pro forma financial statements and projections
of future cash flow generation. The loan might only be acceptable if
the firm can bring its inventory position back in line and improve its
profitability.


d. Required new funds   S  L  S  PS2 1  D 
S S

$4,100,000
RNF   $6,000,000  20%   $1,900,000
$6,000,000 $6,000,000

 $6,000,000  20%   .04%  $7,200,000 1  .18

RNF = .683 ($1,200,000) – .317 ($1,200,000) – $288,000 (.82)

= $819,600 – $380,400 – $236,160
= $203,040

e. Required funds if selected industry ratios were applied to Aspen

Receivables = Sales/Receivable turnover

Receivables = $6,000,000/4.9
Receivables = $1,224,489
Inventory = Sales/inventory turnover
Inventory = $6,000,000/4.4
= $1,363,636

Profit Margin = 6.1%

Copyright © 2005 by The McGraw-Hill Companies, Inc. S-208

CP 5-1. Continued

Revised A (assets)
= $40,000 + $60,000 + $1,224,489 + $1,363,636
= $2,688,125

RNF   S  L  S  PS2 1  D 
S S

$2,688,125
RNF   $6,000,000  20%   $1,900,000
$6,000,000 $6,000,000

($6,000,000 x 20%) – .061 ($7,200,000) (1 – .18)

RNF = .448 ($1,200,000) – .317 ($1,200,000) – $439,200 (.82)

= $537,600 – $380,400 – $360,144
= $202,944

Required new funds (RNF) is negative, indicating there will actually

be an excess of funds equal to $202,944. This is due to the much
more rapid turnover of inventory and the higher profit margin.

f. (1) If Aspen Ski were at full capacity, more funds would be needed
to expand plant and equipment.

(2) More funds would be needed to offset the larger payout of

earnings to dividends.

(3) Fewer funds would be required as sales grow less rapidly.

Fewer new assets would be needed to support sales growth.

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CP 5-1. Continued

(4) As inflation increased so would the cost of new assets,

especially inventory and plant and equipment. Even if sales
prices could be increased, more assets would be required to
support the same physical level of sales. Increased profits alone
would not make up for the higher level of assets required and
more funds would be needed.

Copyright © 2005 by The McGraw-Hill Companies, Inc. S-210