Chapt

er5

Di
scussi
onQuest
ions
5-
1. Di
scusst
hev
ari
oususesf
orbr
eak-
evenanal
ysi
s.

Suchanal
ysi
sall
owsthef
irmtodetermineatwhatl
evel
ofoper
ationsit
wil
lbr
eakevenandt
oexplor
etherelat
ionshi
pbetweenvol
ume,costs,
andprof
it
s.

5-
2. Whatf
actor
swouldcauseadif
ferenceintheuseoff
inanci
all
ever
age
f
orauti
li
tycompanyandanautomobilecompany?

Autil
ityisinastable,predi
ctableindust
ryandtheref
orecanaff
ordto
usemor ef i
nanciall
everaget hananautomobilecompany,whi
chis
generall
ysubjecttothei nf
luencesofthebusinesscycl
e.Anautomobil
e
manuf actur
ermaynotbeabl etoservi
cealar
geamountofdebtwhen
ther
eisadownt urnintheeconomy .

5-
3. Expl
ainhowthebr
eak-evenpoi
ntandoperat
inglev
erageareaf
fectedby
thechoi
ceofmanufactur
ingf
aci
li
ti
es(l
aborint
ensivever
suscapi
tal
i
ntensi
ve).

Alabor -i
ntensiv ecompanywi ll
hav elowf i
xedcostsanda
correspondi nglylowbr eak-evenpoint.Howev er,
theimpactofoperati
ng
l
ev erageont hef i
rmissmal l
andt herewillbeli
tt
lemagnifi
cati
onof
profitsasv olumei ncreases.Acapi tal-
int
ensivefi
rm,ontheotherhand,
willhaveahi gherbreak-evenpoi ntandenjoythepositi
veinf
luencesof
oper ati
nglev erageasv olumei ncreases.

5-
4. Whatroledoesdepr
eci
ati
onpl
ayinbreak-
evenanal
ysi
sbasedon
account
ingfl
ows?Basedoncashfl
ows?Whi chper
spect
ivei
slonger
ter
mi nnatur
e?

Forbr
eak-evenanal
ysisbasedonaccountingf
lows,depr
eciat
ionis
consi
deredpartoff
ixedcosts.Forcashf
lowpurposes,i
tisel
iminat
ed
fr
om fi
xedcosts.

Theaccounti
ngflowsper
spect
ivei
slonger
-ter
minnaturebecausewe
mustconsidert
heprobl
emsofequipmentrepl
acement.

Whatdoesr
iskt
aki
nghav
etodowi
tht
heuseofoper
ati
ngandf
inanci
al
5-
5. l
ever
age?

Bot
hoper
ati
ngandf
inanci
all
ever
agei
mpl
ythatt
hef
ir
m wi
l
lempl
oya

S-
140
heavycomponentoff
ixedcostr
esour
ces.Thi
sisi
nher
entl
yri
sky
becausetheobl
i
gati
ontomakepay ment
sremainsr
egardl
essoft
he
condit
ionoft
hecompanyortheeconomy.

S-
141
5-
6. Di
scusst
hel
i
mit
ati
onsoff
inanci
all
ever
age.

Debtcanonlybeusedupt oapoint.Beyondthat
,fi
nanci
all
everage
tendstoincr
easet heoveral
lcost
soff i
nanci
ngtothefir
m aswellas
encouragecredi
torstoplacerest
ri
cti
onsont hefi
rm.Theli
mitati
onsof
usingfi
nanci
al l
everagetendtobegreatesti
nindust
ri
esthatarehighl
y
cycli
cali
nnature.

5-
7. Howdoesthei
nter
estr
ateonnewdebti
nfl
uencet
heuseoff
inanci
al
l
ever
age?

Thehi
ghert
heint
erestr
ateonnewdebt
,thel
essat
tr
act
ivef
inanci
al
l
ever
ageist
othefir
m.

5-
8. Explainhowcombinedl
ever
agebr
ingst
oget
heroper
ati
ngi
ncomeand
earningspershar
e.

Operat
ingleverageprimari
lyaffect
stheoperat
ingincomeoft hefir
m.At
thi
spoint,
financial
lever
aget akesoveranddeter
mi nestheoveral
l
i
mpactonear ni
ngspershar e.Adeli
neati
onofthecombi nedeff
ectof
operat
ingandf i
nanciall
everageispresent
edinTabl e5-
6andFi gur
e5-5.

5-
9. Expl
ainwhyoper
ati
ngl
ever
agedecr
easesasacompanyi
ncr
eases
sal
esandshif
tsawayf
rom t
hebr
eak-ev
enpoi
nt.

Atprogressi
vel
yhigherl
ev el
sofoperati
onthanthebreak-evenpoi nt
,the
percent
agechangeinoper at
ingincomeasar esul
tofaper centage
changeinunitvol
umedi mini
shes.Thereasonispri
mar i
lymat hematical
—aswemov et
oincreasingl
yhigherl
evelsofoper
ati
ngi ncome, the
percent
agechangef r
om thehigherbaseisli
kel
ytobel ess.

5-
10. Wheny ouar
econsideri
ngtwodiff
erentfi
nancingplans,doesbeingat
thelev
elwher
eearningspershar
ear eequalbetweenthet woplans
alwaysmeanyouareindif
fer
entastowhichplanissel ect
ed?

Thepoi ntofequali
tyonl
ymeasuresindiff
erencebasedonear ni
ngsper
share.Sinceourulti
mategoali
smar ketvaluemaxi mizati
on,wemust
alsobeconcer nedwithhowtheseearningsarev al
ued.Twopl ansthat
havethesameear ni
ngspersharemaycal lfordi
fferentpri
ce-
earni
ngs
rati
os,parti
cul
arlywhenther
eisadiffer
entialri
skcomponenti nvol
ved
becauseofdebt .

S-
142
Pr
obl
ems
5-
1. ShockElectr
onicssel
lspor
tabl
eheat
ersf
or$25peruni
tandthev
ari
abl
e
costtoproducethem i
s$17.Mr.Ampsest
imat
esthatt
hefi
xedcost
s
are$96,
000.

a.Computethebr
eak-
evenpoi
ntinuni
ts.
b.Fi
ll
inthet
ablebel
ow( i
ndol
l
ars)t
oil
lustr
atet
hatt
hebr
eak-
even
poi
nthasbeenachi
eved.

Sales __
___
_____
_____
–Fixedcost
s __
___
_____
_____
–totalv
ari
ablecost
s _
_____
_____
___
_
Netprofi
t(l
oss) _ _
___
_____
_____

Sol
uti
on:
ShockEl
ect
roni
cs

b. Sales $300,
000(12,000uni
ts*$25)
–Fi
xedcosts 96,
000
–Totalv
ari
ablecosts 204,
000(12,
000unit
s
*$17)
Netprof
it(
loss) $ 0

S-
143
5-
2. TheHar t
nettCorpor
ati
onmanufact
uresbasebal
lbatswi
thSammy
Sosa'sautogr
aphstampedon.Eachbatsel
lsfor$13andhasavari
abl
e
costof$8.Thereis$20,
000i
nfixedcost
sinvolv
edinthepr
oduct
ion
process.

a.Computethebr
eak-evenpoi
ntinuni
ts.
b.Fi
ndthesales(
inunit
s)neededtoearnapr
ofi
tof$15,
000.

Sol
uti
on:
Har
tnet
tCor
por
ati
on

a.

S-
144
5-
3. Therapeut
icSyst
emssel
l
sit
spr
oduct
sfor$8peruni
t.I
thast
he
fol
l
owi ngcost
s:

Rent $120,
000
Factor
ylabor $1.
50peruni
t
Execut
ivesalar
ies $112,
000
Rawmat eri
al $.70peruni
t

Separatetheexpensesbetweenfixedandvar
iabl
ecostperuni
t.Using
thi
sinformati
onandt hesalespr
iceperuni
tof$6,computethebreak-
evenpoint.

Sol
uti
on:
Ther
apeut
icSy
stems

Var
iabl
eCosts
Fi
xedCost s (
peruni
t)
Rent $120,000
Factor
ylabor $1.
50
Execut
ivesalar
ies $112,000
Rawmat eri
als __
__ _
__ .
70
$232,000 $2.
20

S-
145
5-
4. Drawt wobreak-evengr
aphs—oneforaconservati
vefir
m usingl
abor-
i
ntensiveproducti
onandanotherf
oracapit
al-
intensi
vefir
m.Assumi ng
thesecompani escompetewit
hint
hesamei ndustryandhaveident
ical
sales,expl
ainthei
mpactofchangesinsal
esv ol
umeonbot hfi
rms'
profi
ts.

Sol
uti
on:

Labor-
Int
ensi
veandcapi
tal
-i
ntensi
vebr
eak-
even
graphs

Thecompanyhav i
ngt hehighf i
xedcost swi llhave
l
owerv ar
iablecoststhani t
scompet itorsincei thas
substi
tut
edcapi t
al f
orlabor.Withalowerv ariable
cost,
thehighfixedcostcompanywi llhav eal arger
contr
ibut
ionmar gin.Therefore,
whensal esr ise,it
s
prof
it
swi l
lincr
easef asterthanthelowf ixedcostf ir
m
andwhent hesalesdecl i
ne, t
hereversewi llbet r
ue.

S-
146
5-
5. JayLinol
eum Companyhasf i
xedcostsof$70,000.It
sproductcurrentl
y
sell
sfor$4perunitandhasv ariabl
ecost
sperunitof$2.60.Mr .Thomas,
theheadofmanufacturing,proposest
obuynewequi pmentthatwill
cost
$300,000anddri
veupf i
xedcost sto$105,
000.Althoughthepricewill
remainat$4perunit,t
hei ncr
easedautomati
onwi l
lreducevari
ablecosts
perunitt
o$2.25.

Asaresul
tofThomas'ssuggest
ion,
wil
lthebr
eak-
evenpoi
ntgoupor
down?Computethenecessar
ynumbers.

Sol
uti
on:
JayLi
nol
eum Company

Thebr
eak-
evenpoi
ntwi
l
lgoup.

5-
6. CallowayCabCompanydet erminesitsbreak-evenst r
ict
lyonthebasi sof
cashexpendi turesrelat
edtof i
xedcost s.It
st otalfi
xedcostsare
$400,000, but20per centofthisvalueisrepresentedbydepr eciat
ion.It
s
cont r
ibut
ionmar gi
n(priceminusv ari
ablecost )foreachunitis$3.60.
Howmanyuni tsdoest hefi
r m needtoselltor eachthecashbr eak-even
point?

Sol
uti
on:
Cal
l
owayCabCompany

Cashrel
atedfi
xedcost
s=TotalFi
xedCost
s–
Depr
eciat
ion
=$400,
000–20%($400,
000)
=$400,
000–$80,
000
=$320,
000

S-
147
5-
7. TheSt
erl
i
ngTi
reCompanyi
ncomest
atementf
or2001i
sasf
oll
ows:

St
erli
ngTi
reCompany
IncomeStat
ement
Fort
heYearEndedDecember31,
2001

Sales(20,
000ti
resat$60each) $1,
200,
000
Less:Vari
abl
ecosts(20,
000ti
resat 600,
000
$30)
Fixedcost
s 400,
000

Earningsbefor
eint
erestandt
axes 200,
000
(EBIT)
I
nterestexpense 50,
000

Ear
ningsbefor
etaxes(EBT) 150,
000
I
ncomet axexpense(
30%) 45,
000
Ear
ningsaft
ertaxes(
EAT) $ 105,
000

Gi
vent
hisi
ncomest
atement
,comput
ethef
oll
owi
ng:

a.Degreeofoperati
ngleverage.
b.Degreeoffi
nanciall
everage.
c.Degreeofcombinedleverage.
d.Break-
evenpointinuni
ts.

Sol
uti
on:
St
erl
i
ngTi
reCompany

Q=20,000,
P=$60,
VC=$30,
FC=$400,
000,
I=
$50,
000

S-
148
S-
149
5-
8. TheHardi
ngCompanymanufact
uresskat
es.Thecompany
'si
ncome
st
atementfor2001i
sasf
oll
ows:

Har di
ngCompany
IncomeStat
ement
Fort
heYearEndedDecember31,
2001

Sales(10,
000skat
es@ $50each) $500,
000
Less:Vari
abl
ecosts(
10,
000skatesat$20) 200,
000
Fixedcost
s 150,
000

Earni
ngsbef or
eint
erestandt
axes(
EBI
T) 150,
000
I
nterestexpense 60,
000

Ear
ningsbefor
etaxes(EBT) 90,
000
I
ncomet axexpense(
40%) 36,
000
Ear
ningsaft
ertaxes(
EAT) $54,
000

Gi
vent
hisi
ncomest
atement
,comput
ethef
oll
owi
ng:

a.Degreeofoperati
ngleverage.
b.Degreeoffi
nanciall
everage.
c.Degreeofcombinedleverage.
d.Break-
evenpointinuni
ts( numberofskat
es)
.

S-
150
Sol
uti
on:
Har
dingCompany

Q=10,000,
P=$50,
VC=$20,
FC=$150,
000,
I=
$60,
000

S-
151
5-
9. Moe&Chr i
s'Del
ici
ousBurgers,
Inc.
,sel
l
sfoodtoUni
ver
sit
yCafeter
ias
f
or$15abox.Thef i
xedcostsofthi
soperat
ionar
e$80,
000,whi
lethe
var
iabl
ecostperboxis$10.

a.Whatist hebr eak-ev enpoi ntinboxes?

b.Calcul
atet hepr ofi
torl osson15, 000boxesandon30, 000boxes.
c.Whatist hedegr eeofoper atinglever
ageat20,000boxesandat
30,000boxes?Whydoest hedegr eeofoperat
inglever
agechangeas
thequant i
tysoldi ncr eases?
d.I
fthef i
rm hasanannual i
nterestexpenseof$10,000,calcul
atet
he
degreeoff inanciallev erageatbot h20,000and30,000boxes.
e.Whatist hedegr eeofcombi nedleverageatbothsal
esl evel
s?

Sol
uti
on:
Moe&Chr
is'
Del
i
ciousBur
ger
s,I
nc.

b.
15,
000boxes 30,
000boxes
Sales@ $15perbox $225,
000 $450,000
Less:Vari
abl
esCosts (
$150,
000) ( $300,
000)
($10)
FixedCosts (
$80,
000) (
$80,
000)
Profi
torLoss (
$ 5,
000) $70,
000

S-
152
Lever
agegoesdownbecausewear efurtheraway
fr
om thebreak-
evenpoint
,thusthef
ir
mi soper at
ing
onalargerprof
itbaseandlever
agei
sr educed.

Fi
rstdeter
minetheprof
itorl
oss(
EBIT)at20,
000
boxes.Asindi
catedi
npartb,t
heprof
it(
EBIT)at
30,
000boxesis$70,000:

20,
000boxes
Sales@ $15perbox $300,
000
Less:Vari
abl
eCosts (200,
000)
($10)
Fi
xedCosts (80,
000)
Profi
torLoss $20,
000

S-
153
S-
154
5-
10. CainAutoSuppli
esandAbleAut
oPartsarecompeti
torsi
nthe
aft
ermarketf
orautosuppl
i
es.Thesepar
atecapi
tal
struct
uresf
orCai
n
andAblearepresent
edbel
ow.

Cai
n Abl
e
Debt@ 10% $50,000 Debt@ 10% $100,000
Commonst ock,
$10par 100,
000 Commonst ock,
$10par 50,000
Tot
al $150,000 Tot
al $150,000
Commonshar es 10,
000 Commonshar es 5,000

a.Comput eear ningspershar

eifearni
ngsbef or
einterestandtaxesare
$10,000,$15,000, and$50,
000(assumea30per centtaxrate).
b.Explai
nther elati
onshipbet
weenear ni
ngspershar eandt helevel
of
EBIT.
c.I
fthecostofdebtwentupt o12percentandallotherfactors
remainedequal ,
whatwouldbethebr eak-
evenlevelforEBIT?

S-
155
Sol
uti
on:
Cai
nAut
oSuppl
i
esandAbl
eAut
oPar
ts
a.
Cain Able
EBIT $10,000 $10,
000
Less:I
nterest 5,000 10,
000
EBT 5,000 0
Less:Taxes@ 30% 1,500 0
EAT 3,500 0
Shares 10,000 5,
000
EPS $.35 0
EBIT $15,000 $15,
000
Less:I
nterest 5,000 10,
000
EBT 10,000 5,
000
Less:Taxes@ 30% 3,000 1,
500
EAT 7,000 3,
500
Shares 10,000 5,
000
EPS $.70 $.70
EBIT $50,000 $50,
000
Less:I
nterest 5,000 10,
000
EBT 45,000 40,
000
Less:Taxes@ 30% 13,500 12,
000
EAT 31,500 28,
000
Shares 10,000 5,
000
EPS $3.15 $5.60

S-
156
 b.Before-taxret
urnonasset s=6. 67%,10%and33%
atther espect
ivelevelsofEBIT.Whent hebef ore-
taxreturnonasset s(EBIT/TotalAssets)isless
thanthecostofdebt( 10%),Caindoesbet terwi th
l
essdebtt hanAble.Whenbef ore-t
axr eturnon
assetsi sequaltothecostofdebt ,bothf i
rmshav e
equal EPS.Thiswoul dbewher ethemet hodof
fi
nanci nghasaneut raleff
ectonEPS.Asr et
ur non
assetsbecomesgr eaterthantheinterestrate,
fi
nanci all
everagebecomesmor efav orabl
ef or
Able.

c.12%*$150,
000=$18,
000br
eak-
evenl
evel
.

5-
11. InProbl
em 10,computet
hestockpri
ceforCai
nifi
tsel
l
sat18t
imes
earni
ngspershareandEBITi
s$40,000.

Sol
uti
on:

Cai
nSuppl
i
esandAbl
eAut
oPar
ts(
Cont
inued)

Cai
n
EBIT $40,
000
Less:I
nterest 5,
000
EBT $35,
000
Less:Taxes@ 30% 10,
500
EAT $24,
500
Shares 10,
000
EPS $ 2.45
P/E 18x
StockPri
ce $44.10

S-
157
5-
12. Sterl
i
ngOpt i
calandRoyal
Opti
cal
bothmakeglassf
ramesandeachi
s
abletogenerat
eearni
ngsbef
orei
nter
estandt
axesof$120,
000.

Thesepar
atecapi
tal
str
uct
uresf
orSt
erl
i
ngandRoy
alar
eshownbel
ow:

Sterl
ing Royal
Debt@ 12% $ 600,000 Debt@ 12% $ 200,
000
Commonst ock,$5par 400, 000 Commonst ock,$5par
800,
000
Tot
al $1,
000,000 Total $1,
000,
000
Commonshar es 80,000 Commonshar es 160,
000

a.Comput eear ni
ngspershar eforbot hfirms.Assumea25per centtax
rat
e.
b.I npar ta,youshoul dhav egot tenthesameanswerf orbot h
compani es' ear
ningspershar e.AssumeaP/ Er at
ioof20f oreach
company ,whatwoul dit
sst ockpr i
cebe?
c.Nowaspar tofy ouranalysis,assumet heP/ Erati
owoul dbe16f or
ther i
skiercompanyi ntermsofheav ydebtut i
l
izati
onint hecapital
structureand25f orthelessr iskycompany .Whatwoul dt hestock
pri
cesf orthet wof ir
msbeundert heseassumpt i
ons?(Not e:Alt
hough
i
nterestr atesal sowoul dlikelybedi f
ferentbasedonr i
sk, wehol d
them const antforeaseofanal y
sis).
d.Basedont heev idenceinpar tc, shoul
dmanagementonl ybe
concer nedaboutt hei mpactoff i
nancingpl ansonear ni
ngspershar e
orshoul dst ockhol ders'
weal thmaxi mization(stockpr i
ce)be
consider edaswel l?

Sol
uti
on:
St
erl
i
ngOpt
ical
andRoy
alOpt
ical
a.
Sterl
i
ng Royal
EBIT $120,
000 $120,
000
Less:I
nterest 72,
000 24,
000
EBT 48,
000 96,
000
Less:Taxes@ 25% 12,
000 24,
000
EAT 36,
000 72,
000
Shares 80,
000 160,
000
EPS $.
45 $.
45

b.St
ockpr
ice=P/E*EPS
20*$.
45=$9.
00

S-
158
 c. Ster
li
ng Royal
16*$.
45=$7.20 25*$.
45=$11.
25

d.Clear
ly,t
heul t
imat eobjectiv
eshouldbeto
maximizet hestockprice.Whi l
emanagement
wouldbei ndif
ferentbetweent hetwoplansbased
onearningspershar e,Roy alOpti
cal
,wi
ththeless
ri
skyplan,hasahi gherst ockpri
ce.

5-
13. Fir
msi nJapanof tenemploybothhighoperati
ngandf i
nanci
all
everage
becauseoft heuseofmoder ntechnologyandcloseborr
ower-l
ender
rel
ationshi
ps.Assumet heMitakaCompanyhasasal esvol
umeof
125,000unitsatapr i
ceof$25peruni t
;vari
ablecost
sare$5perunitand
fi
xedcost sare$1,800,
000.I
nterestexpenseis$400,
000.Whatisthe
degreeofcombi nedlever
ageforthisJapanesefir
m?

Sol
uti
on:
Mi
takaCompany

S-
159
5-
14. Si
ncl
airManuf
acturi
ngandBoswel
lBrothersI
nc.arebothi
nvol
vedi
nthe
pr
oducti
onofbri
ckfort
hehomebuil
dingindust
ry.Thei
rfi
nanci
al
i
nfor
mationi
sasf ol
l
ows:

Capi
tal
Str
uct
ure

Sinclai
r Boswel
l
Debt@ 12% $ 600,000 0
Commonst ock,
$10pershar
e 400,000 $1,
000,
000
Tot
al $1,
000,000 $1,
000,
000
Commonshar es 40,
000 100,
000

Oper
ati
ngPl
an

Sales(
50,
000uni
tsat$20each) $1,
000,
000 $1,
000,
000
Less:
Vari
abl
ecost
s 800,
000 500,
000
(
$16perunit
) (
$10perunit
)
Fi
xedcost
s 0 300,
000

Ear
ningsbef
orei
nter
estandt
axes(
EBI
T) $ 200,
000 $ 200,
000

a.I
fy oucombi neSi ncl
air
'scapi
tal
struct
urewithBoswell'
soperat
ing
plan,whatisthedegr eeofcombinedleverage?(Roundtotwoplaces
totherightoft hedecimalpoi
nt.
)
b.I
fy oucombi neBoswel l'
scapi
talst
ructur
ewi t
hSinclai
r'
soperat
ing
plan,whatisthedegr eeofcombinedleverage?
c.Explai
nwhyy ougott heresul
tsyoudidinpartb.
d.I
npar tb,ifsalesdouble,bywhatpercentwill
EPSi ncr
ease?

S-
160
Sol
uti
on:
Si
ncl
airManuf
act
uri
ngandBoswel
lBr
other
s

c. Thelev
eragef actorisonl
y1xbecauseBoswel
l
hasnofinanciallev
erageandSi
nclai
rhasno
oper
ati
ngl everage.

S-
161
 d. EPSwil
lincreaseby100percent
.However
,ther
e
i
snoleverageinvol
ved.EPSmerelygr
owsatthe
samerateassales.

5-
15. TheNor manAut omati
cMai lerMachineCompanyi spl anningt
oexpand
producti
onbecauseofthei ncreasedvolumeofmai louts.Theincreased
mailoutcapaci
tywil
lcost$2, 000,
000.Theexpansi oncanbef i
nanced
ei
therbybondsatani nter
estr ateof12per centorbysel li
ng40,000
sharesofcommonst ockat$50pershar e.Thecurrentincome
stat
ement( bef
oreexpansion)i sasfol
l
ows:

Nor
manAutomat i
cMai
ler
IncomeStat
ement
200X

Sales $3,
000,
000
Less: Vari
ablecost s(40%) $1,
200,
000
Fixedcost s 800,
000
Earningsbef orei
nterestandtaxes 1,
000,
000
Less: I
nterestexpense 400,
000
Earningsbef oretaxes 600,
000
Less: Taxes(@ 35%) 210,
000
Earningsaf t
ertaxes 390,
000
Shares 100,
000
Earningspershar e $3.
90

Assumethataft
erexpansion,salesareexpect
edtoincreaseby
$1,
500,
000.Vari
abl
ecost swillremainat40percentofsales,
andf
ixed
cost
swil
lincr
easeby$550, 000.Thetaxrateis35percent.

a.Calcul at
et hedegr eeofoperati
nglever
age,thedegr eeoffinancial
l
ev erage, andt hedegreeofcombinedleveragebefor eexpansion.(For
thedegr eeofoper ati
nglever
age,usetheformuladev el
opedin
footnot e2; forthedegreeofcombinedleverage,uset heformula
dev elopedi nfootnote3.Theseinstr
ucti
onsappl ythroughoutthis
probl em. )
b.Const r
uctthei ncomest at
ementforthetwof i
nancial pl
ans.
c.Calcul at
et hedegr eeofoperati
nglever
age,thedegr eeoffinancial
l
ev erage, andt hedegreeofcombinedleverage,aft
erexpansi on,for
thet wof inancingplans.
d.Expl ainwhi chfinanci
ngplanyoufavorandt heri
sksi nvolv
ed.

S-
162
Sol
uti
on:
Nor
mal
Aut
omat
icMai
l
erMachi
ne

S-
163
b.I
ncomeSt
atementAf
terExpansi
on

Debt Equi
ty
Sales $4,500,
000 $4,
500,
000
Less:Var i
able 1,800,
000 1,
800,
000
Costs( 40%)
FixedCosts 1,
350,
000 1,
350,
000
EBIT 1,
350,
000 1,
350,
000
Less:Inter
est 0001
640, 400,
000
EBT 710,
000 950,
000
Less:Taxes@ 248,
500 332,
500
35%
EAT( NetIncome) 461,
500 617,
500
CommonShar es 100,
000 0002
140,
EPS $4.62 $4.41

(1)Newi nter
estexpenseleveli
fexpansi
onisfi
nanced
wit
hdebt .
$400,000+12%( $2,000,
000)=$400,000+
$240,
000=
$640,000
(2)Numberofcommonshar esoutst
andingi
f
expansionis
fi
nancedwi t
hequity.
100,
000+40, 000=140, 000

S-
164
d.Thedebtf i
nancingpl anprov i
desagr eaterearnings
pershar elevel,butprovi
desmor er iskbecauseof
theincreaseduseofdebtandhi gherDFLandDCL.
Thecr ucialpointisexpect ati
onsf orfuturesales.If
salesar eexpect edtodeclineoradv ancev ery
slowly,thedebtpl anwi l
lnotper form wellin
compar isontot heequitypl an.Conv ersely
, wi
th
i
ncr easi
ngsal es, t
hedebtpl anbecomesmor e
attr
active.Basedonpr ojectedov erallsal
esof
$4,500,000,thedebtpl anshoul dpr obablybe
favored.

S-
165
5-
16. Dicki
nsonCompanyhas$12mi l
li
oninassets.Currentlyhalfofthese
assetsar
ef inancedwit
hlong-term debtat10percentandhal fwith
commonst ockhavingaparv al
ueof$8.Ms.Smi th,vice-
presidentof
fi
nance,wishest oanal
yzetwor efi
nancingpl
ans,onewi t
hmor edebt(D)
andonewi thmor eequit
y(E).Thecompanyear nsar etur
nonasset s
befor
einterestandtaxesof10per cent.Thetaxrateis45per cent
.

UnderPlanD,a$3mi l
li
onlong-
term bondwouldbesol
datanint
erestr
ate
of12percentand375,000shar
esofst ockwoul
dbepurchasedi
nthe
marketat$8pershareandreti
red.

UnderPl
anE,375,
000sharesofst
ockwoul
dbesoldat$8pershar
eand
the$3,
000,
000inpr
oceedswouldbeusedt
oreducel
ong-
ter
m debt.

a.Howwoul deachoft heseplansaf fectearni

ngspershar e?Consi der
thecur r
entplanandt hetwonewpl ans.
b.Whi chplanwoul dbemostf avorableifreturnonassetsf ellt
o5
percent?Increasedt o15per cent?Consi derthecurr
entpl anandt he
twonewpl ans.
c.Ifthemar ketpriceforcommonst ockroset o$12beforet he
restruct
uring,whichpl anwouldthenbemostat t
racti
ve?Cont inueto
assumet hat$3mi l
lionindebtwi l
l beusedt oreti
restocki nPlanDand
$3mi l
li
onofnewequi t
ywil
lbesol dt oreti
redebtinPlanE.Al so
assumef orcalcul
ationsinpartct hatreturnonassetsis10per cent
.

S-
166
Sol
uti
on:
Dicki
nsonCompany
IncomeStat
ements

a.Ret
urnonasset
s=10% EBI
T=$1,
200,
000

Curr
ent Pl
anD Pl
anE
EBI
T $1,
200,00 $1,
200,
000 $1,
200,
000
0
Less:
Int
erest 0002
960, 0003
300,
0001
600,
EBT 600,
000 240,
000 900,
000
Less:
Taxes 108,
000 405,
000
(45%) 270,
000
EAT 132,
000 495,
000
330,
000
Commonshar
es 750,0004 375,
000 1,
125,
000
EPS $.44 $.
35 $.
44

(
1)$6,000,000debt@ 10%
(
2)$600,000i nt
erest+( $3,000,
000debt@ 12%)
(
3)($6,000,000–$3, 000,000debtret
ir
ed)*10%
(
4)($6,000,000commonequi ty
)/(
$8parval
ue)=
750,000shar es

PlanEandt heor i
ginalpl
anpr ovi
dethesame
earni
ngspershar ebecauset hecostofdebtat10
percentisequaltotheoper at
ingret
urnonassets
of10per cent.Wit
hPl anD,thecostofincr
eased
debtrisesto12per cent,
andt hefi
rmincur
s
negati
v elev
eragereducingEPSandal so
i
ncreasingthefinancialr
isktoDicki
nson.

S-
167
b. Ret
urnonasset
s=5% EBI
T=$600,
000

Cur
rent PlanD Pl
anE
EBI
T $600,
000 $600,
000 $600, 00
0
Less:
Int
erest 600,
000 960,
000 300, 000
EBT 0 (360,
000) 300,000
Less:
Taxes -
-- (162,
000)
(45%) 135,000
EAT 0 $(198,
000) $165,00
0
Commonshar
es 750,
000 375,
000 1,
125,000
EPS 0 $(.
53) $.15

Ret
urnonasset
s=15% EBI
T=$1,
800,
000

Curr
ent Pl
anD Pl
anE
EBI
T $1,
800,00 $1,
800,
000 $1,
800,
000
0
Less:
Int
erest 960,
000 300,
000
600,
000
EBT 1,
200,
000 840,
000 1,
500,
000
Less:
Taxes 378,
000 675,
000
(45%) 540,
000
EAT $ 660,
00 $ 462,
000 $825,
000
0
Commonshar
es 750,
000 375,
000 1,
125,
000
EPS $.
88 $1.
23 $.
73

I
fther eturnonassetsdecreasesto5%, Pl
anEpr ov
ides
thebestEPS, andat15%r eturn,
PlanDpr ovi
desthebest
EPS.Pl anDissti
llr
isky,
hav i
ngani nt
erestcover
agerat
io
oflesst han2.
0.

S-
168
 c. Ret
urnonAsset
s=10%EBI
T=$1,
200,
000

Curr
ent PlanD PlanE
EBI
T $1,
200,00 $1,
200,000 $1,200,00
0 0
EAT 132,000
330,
000 495,
000
1
Commonshar
es 750,
000 500,000 1,
000,0002
EPS $.
44 $.26 $.50

(
1) 750,
000–( $3,
000,000/
$12pershar
e)
=750,000–250,000=500,000
(
2) 750,
000+($3,000,000/
$12pershar
e)
=750,000+250,000=1,000,
000

Asthepri
ceofthecommonst ocki
ncreases,Pl
anE
becomesmoreat t
ract
ivebecausefewersharescanbe
ret
ir
edunderPlanDand, bythesamelogic,f
ewershar
es
needtobesoldunderPlanE.

5-
17. TheLopez -Porti
ll
oCompanyhas$10mi l
li
oninassets,80percent
fi
nancedbydebtand20per centfinancedbycommonst ock.Theinter
est
rat
eont hedebti s15percentandt heparval
ueofthest ockis$10per
share.PresidentLopezPort
il
loisconsider
ingtwofinancingplansforan
expansionto$15mi l
li
oninassets.

UnderPlanA,t
hedebttototal
assetsrat
iowil
lbemaintai
ned,butnew
debtwil
lcostawhopping18percent
!UnderPlanB,onl
ynewcommon
stockat$10pershar
ewi l
lbei
ssued.Thetaxrat
eis40percent.

a.IfEBITis15percentont otalassets, computeearni

ngspershar e
(EPS)bef or
etheexpansi onandundert hetwoalt
ernati
ves.
b.Whati sthedegreeoffinanciall
ever ageundereachofthethreeplans?
c.Ifstockcouldbesoldat$20pershar eduet oi
ncreasedexpectati
ons
forthef i
rm'
ssalesandear nings,whati mpactwouldthishaveon
earningspershareforthet woexpansi onalter
nat
ives?Comput e
earningspershareforeach.
d.Explainwhycorporatefinancialof
ficersareconcernedabouttheir
stockv al
ues!

S-
169
S-
170
Sol
uti
on:
Lopez-
Por
ti
ll
oCompany

a. Ret
urnonAsset
s=12%

Current Pl
anA Pl
anB
EBIT $1,500,00 $2, 250,00 $2,250,000
0 0
Less:I
nterest 1,200,000(a 1,
920,000(c 1,
200,
000(e)
) )
EBT 300,000 330,
000 1,
050,000
Less:Taxes@
40% 420,000
120,000 132,
000
EAT $180, 00 $198, 00 $630,000
0 0
Common 200,000(b) 300,000(d) 700, 000(
f)
shares
EPS $.90 $.66 $.90

(
a)( 80%*$10, 000,000)*15%=$8, 000,000*15%=
$1,200,
000
(
b)( 20%*$10, 000,000)/$10=$2,000,
000/ $10=
200,000shar es
(
c)$1, 200,
000( current
)+( 80%*$5,000,000)*18%
=$1,200,000+$720, 000=$1, 920,
000
(
d)200, 000shar es(curr
ent)+(20%*$5, 000,000)
/$10
=200,000+100, 000=300,000shares
(
e)unchanged
(
f) 200,000shar es(curr
ent)+$5,000,
000/ $10=
200,000+500, 000=700, 000shares

S-
171
b.

c.
PlanA Pl
anB
EAT $198,000 $630,
000
Common 250,0001 0002
450,
Shar
es
EPS $.
79 $1.
40
1
200,
000shares(cur
rent
)+( 20%*$5,000,000)
/$20
=200,000+50,000=250,000shares
2
200,
000shares(cur
rent
)+$5, 000,
000/$20
=200,000+250,000=450,000shares

PlanBwoul dconti
nuetoprovi
dethehigherear
nings
pershares.Thedif
fer
encebetweenpl
ansAandBi s
evengreaterthant
hatindi
cat
edinpart(a)
.
d. Notonl ydoesthepr i
ceoft hecommonst ock
createwealt
htot heshareholder
, whichi st
hemaj or
objecti
veofthefinanci
almanager , butitgr
eatly
i
nf l
uencestheabili
tytofi
ancépr ojectsatahi ghor
l
owcostofcapi tal.Costofcapitalwi l
lbediscussed
i
nChapt er10,andonewi llseethei mpactthatt he
costofcapital
hasoncapi talbudget ingdecisions.

S-
172
5-
18. Mr.Goldisinthewidgetbusiness.Hecur r
entl
ysel
ls1mi l
lionwidgetsa
yearat$5each.Hisvari
ablecostt oproducethewidget
sis$3peruni t,
andhehas$1, 500,
000infixedcosts.Hissales-
to-
assetsrati
oisfive
ti
mes,and40per centofhisassetsarefinancedwit
h8per centdebt,wi
th
thebalancefi
nancedbycommonst ockat$10pershare.Thet axrat
eis
40percent.

Hisbrother
-i
n- l
aw,Mr.Silv
er man,sayshei sdoingi tal
lwrong.Byr educi
ng
hispri
ceto$4. 50awidget ,hecouldincreasehisv olumeofuni t
ssol dby
40percent.Fixedcostswoul dremai nconstant,andv ari
ablecost swould
remain$3peruni t
.Hissal es-t
o-assetsrati
owoul dbe6. 3t i
mes.
Furt
hermore,hecouldi ncreasehisdebt -
to-
assetsr ati
oto50per cent,wit
h
thebalanceincommonst ock.Itisassumedt hattheinterestratewoul d
goupby1per centandt hepr i
ceofst ockwouldr emainconst ant.

a.Comput eear
ningspershar eundertheGol dplan.
b.Comput eear
ningspershar eundertheSilvermanplan.
c.Mr.Gold'swi
fe,thechieff
inancial
of f
icer
,doesnott hi
nkthatfi
xed
cost
swoul dremainconstantundert heSil
v er
manpl anbutthatt
hey
wouldgoupby15per cent.Ift
hisisthecase, shoul
dMr .Gol
dshiftt
o
theSi
lvermanplan,basedonear ningspershar e?

Sol
uti
on:
Gol
d-Si
l
ver
man

a.Gol
dPl
an

Sales( $1,
000, 000unit
s*$5) $5,
000,
000
–Fixedcost s –1,
500,
000
–Var iabl
ecost s –3,
000,
000
Oper ati
ngi ncome( EBI
T) $ 500,
000
1
–Interest 32,
000
EBT $ 468,
000
–Tax es@ 40% 187,
200
EAT $ 280,
800
Shares2 60,
000
EarningsPerShar e $4.
68

S-
173
1
Debt=40%ofAsset s=40%*$1, 000,
000=$400,
000
I
nterest=8%*$400,000=$32,000
2
Stock=60%of$1,000,000=$600,000
Shares=$600,
000/$10=$60,000

b.Si
l
ver
manPl
an

Sales( $1,
400, 000unit
sat$4.50) $6,
300,
000
–Fixedcost s 1,
500,
000
–Var iabl
ecost s(1,
400,000unit
s*$3) 4,
200,
000
Oper ati
ngi ncome( EBI
T) $600,000
3
–Interest 45,
000
EBT $555,000
–Tax es@ 40% 222,
000
EAT $333,000
Shares4 50,
000
EarningsPerShar e $6.
66

3
Debt=50%ofAsset s=50%*$1, 000,
000=$500,
000
I
nterest=9%*$500,000=$45,000
4
Stock=50%of$1,000,000=$500,000
Shares=$500,
000/$10=$50,000

S-
174
 c.Si
l
ver
manPl
an(
basedonMr
s.Gol
d'
sAssumpt
ion)

Sales( $1,
400,000unit
sat$4. 50) $6,
300,
000
–Fixedcost s($1,
500,000*1.15) 1,
725,
000
–Var iabl
ecosts(1,
400, 000unit
s*$3) 4,
200,
000
Oper ati
ngincome( EBIT) $375,000
–Interest 45,
000
EBT $330,000
–Tax es@ 40% 132,
000
EAT $198,000
Shares 50,
000
EarningsPerShar e $3.
96

No!Goldshoul
dnotshif
ttot
heSi
l
ver
manPl
ani
fMr
s.
Gol
d'sassumpti
oniscorr
ect
.

5-
19. Del
singCanni
ngCompanyi
sconsi
der
inganexpansi
onofi
tsf
aci
l
iti
es.I
ts
cur
renti
ncomestat
ementi
sasfol
l
ows:

Sales $5,
000,
000
Less:Vari
ableexpense(
50%ofsal
es) 2,
500,
000
Fixedexpense 1,
800,
000

Earni
ngsbef
oreint
erestandt
axes(
EBI
T) 700,
000
I
nterest(
10%cost) 200,
000

Ear
ningsbefor
etaxes(EBT) 500,
000
Tax(30%) 150,
000
Ear
ningsaft
ertaxes(
EAT) 350,
000

Sharesofcommonst
ock—200,
000
Earni
ngspershar
e $1.
75

S-
175
Thecompanyiscur rent
lyf
inancedwith50percentdebtand50per cent
equi
ty(commonst ock,parval
ueof$10).Inordertoexpandthefacil
it
ies,
Mr.Delsi
ngesti
mat esaneedf or$2mill
i
oninadditi
onalfi
nanci
ng.Hi s
i
nvestmentbankerhaslaidoutthreepl
ansforhimt oconsi
der:

1.Sel
l$2mill
ionofdebtat13percent.
2.Sel
l$2mill
ionofcommonst ockat$20pershar
e.
3.Sel
l$1mill
ionofdebtat12percentand$1mil
li
onofcommonst
ock
at$25pershar
e.

Vari
ablecost
sareexpectedtostayat50percentofsales,whi
lefi
xed
expenseswil
li
ncreaseto$2,300,
000peryear.Del
singisnotsurehow
mucht hi
sexpansi
onwi l
laddtosales,
butheestimatesthatsal
eswil
lri
se
by$1mi l
li
onperyearforthenextf
iveyear
s.

Del
singi
sint
erestedinathor
oughanal
ysi
sofhi
sexpansi
onpl
ansand
methodsoff
inancing.Hewouldl
i
keyoutoanal
yzet
hefol
lowi
ng:

a.Thebr eak-evenpoi ntf oroper ati

ngexpensesbef oreandaf ter
expansion( insalesdol l
ar s).
b.Thedegr eeofoper atingl ev eragebef oreandaf t
erexpansi on.Assume
salesof$5mi l
l
ionbef oreexpansi onand$6mi ll
ionafterexpansi on.
Uset hef or
mul ainf oot not e2.
c.Thedegr eeoff inanci al l
ev eragebef oreexpansionandf orallt
hree
met hodsoff inanci
ngaf terexpansi on.Assumesal esof$6mi l
li
onf or
thi
squest i
on.
d.Comput eEPSunderal lthr eemet hodsoff inancingtheexpansi onat
$6mi ll
ioninsal es(firsty ear )and$10mi l
li
oni nsales(lastyear).
e.Whatcanwel earnf rom t heanswert opartdaboutt headv isabil
ityof
thethreemet hodsoff inanci ngtheexpansi on?

S-
176
Sol
uti
on:
Dei
singCabl
eCompany

a.Atbr
eak-
evenbef
oreexpansi
on:

PQ=FC+VC
wher
ePQequal
ssal
esv
olumeatbr
eak-
even
poi
nt

Sal
es =Fi
xedcosts+Vari
abl
ecost
s
(
Vari
ablecost
s=50%ofsales)

Sal
es =$1,
800,
000+.
50sal
es
.
50sales =$1,
800,
000
Sal
es =$3,
600,
000

Atbr
eak-
evenaf
terexpansi
on:

Sal
es =$2,
300,
000+.
50sal
es
.
50sales =$2,
300,
000
Sal
es =$4,
600,
000

b.Degreeofoperati
nglev
erage,
bef
oreexpansi
on,
at
sal
esof$5,000,000

S-
177
Degreeofoperat
ingl
ever
ageaf
terexpansi
onatsal
es
of$6,000,
000

Thi
scoul
dal
sobecomput
edf
orsubsequenty
ear
s.

c.DFLbef
oreexpansi
on:

S-
178
 DFLAf
terExpansi
on:

Comput
eEBI
TandIf
oral
lthr
eepl
ans:

(50%Debt
and50%
(
100%Debt
) (
100%Equit
y) Equity
(
1) (
2) (
`3)
Sal
es $6,
000,
000 $6,
000,
000 $6,
000,
000
–TVC( .
50) 3,
000,
000 3,
000,
000 3,
000,
000
–FC 2,
300,
000 2,
300,
000 2,
300,
000
EBI
T $700,
000 $700,000 $700,000
I–OldDebt 200,
000 200,
000 200,
000
I–New 260,
000 0 120,
000
Debt
Total
I $460,
000 $200,
000 $320,
00

(
1) (
2) (
3)

DFL=2.
92x 1.
40x 1.
84x

S-
179
d.EPS@ salesof$6,
000,
000
(r
eferbackt
opartctogett
hev
aluesf
orEBI
Tand
Tot
alI)

(50%Debt
and50%
(
100%Debt)(
100%Equit
y) Equi ty
(
1) (
2) (`
3)
EBIT $700,
000 $700,
000 $700,000
TotalI 460,
000 200,
000 320,000
EBT $240,
000 $500,
000 $380,000
Taxes( 30%) 72,
000 150,
000 114,000
EAT $168,
000 $350,
000 $266,000
Shares( ol
d) 200, 000 200,
000 200,000
Shares 0 100,
000 40,000
(new)
Total 200,
000 300,
000 240,000
Shares
EPS( EAT/
Total $.
84 $1.
17 $1.11
shares)

S-
180
EPS@ sal
esof$10,
000,
000

(
50%Debt
and50%
(
100%Debt)(
100%Equity
) Equit
y
(
1) (
2) (`
3)
Sal
es $10,
000,
00 $10,000,
000 $10,
000,000
0
–TVC 5,
000,
000 5,
000,
000 5,
000,000
–FC 2,
300,
000 2,
300,
000 2,
300,000
EBIT $2,
700,
000 $2,
700,
000 $2,700,000
TotalI 460,
000 200,
000 320,000
EBT $2,
240,
000 $2,
500,
000 $2,380,000
Taxes
(30%) 672,
000 750,
000 714,
000
EAT $1,
568,
000 $1,
750,
000 $1,
666,
000
Total
Shares 200,
000 300,
000 240,
000
EPS( EAT/
Total
Shares) $7.
84 $5.
83 $6.
94

e.Int hefir
styear ,
whensal esandprofi
tsarerel
ati
vel
y
l
ow, plan2( 100%equi t
y)appearstobethebest
alternati
ve.Howev er,assalesexpandupto$10
mi l
lion,fi
nancialleveragebeginstoproduceresul
ts
asEBI TincreasesandPl an1(100%debt)isthe
highesty iel
dingal t
ernati
v e.

S-
181
Compr
ehensi
vePr
obl
em
CP5-
1. Ry
anBootCompany
Bal
anceSheet
December31,2001

Asset s Liabi
lit
iesandSt ockhol
ders'
Equi
ty
Cash $ 50,
000 Account spayable $2,
200,
000
Mar ketablesecurit
ies 80,
000 Accruedexpenses 150,
000
Account sreceivable 3,000,
000 Notespay abl
e( curr
ent) 400,000
I
nv entory 1,
000,
000 Bonds( 10%) 2,
500,
000
Grosspl anand Commonst ock( 1.
7mi l
li
on
equipment 6,
000,
000 shares,parvalue$1) 1, 700,
000
Less: Accumul at
ed Retai
nedear nings 1,
180,
000
depr eci
ati
on 2,
000,
000

Tot
alli
abi
li
ti
esand
Tot
alasset
s $8,
130,
00 st
ockhol
ders'
equi
ty $8,
130,
000

I
ncomeSt
atement
—2001

Sales( credit) $7,

000,
000
Fixedcost s* 2,
100,
000
Variablecost s(0.
60) 4,
200,
000
Earningsbef oreint
erestandtaxes 700,
000
Less: Interest 250,
000
Earningsbef oretaxes 450,
000
Less: Taxes@ 35% 157,
500
Earningsaf tert
axes $292,500
Dividends( 40%pay out
) 117,
000
I
ncr easedr etai
nedearnings $175,500

*Fi
xedcost
sincl
ude(
a)l
easeexpenseof$200,
000and(
b)depr
eci
ati
on
of$500,
000.

Note:RyanBootsal
sohas$65, 000peryearinsi
nkingfundobl
igat
ions
associat
edwit
hitsbondissue.Thesinki
ngfundrepresent
sanannual
repaymentoft
heprinci
palamountoft hebond.I
tisnottaxdeduct
ible.

S-
182
 Rat
ios
RyanBoot
(
tobefi
l
ledi
n) I
ndustr
y
Profitmar gin 5.
75%
Returnonasset s 6.
90%
Returnonequi ty 9.
20%
Recei vablest urnov er 4.35x
I
nv entoryt urnov er 6.50x
Fi
xed- assett urnov er 1.85x
Total-assett urnov er 1.20x
Currentr atio 1.45x
Quickr atio 1.10x
Debtt ot otalasset s 25.
05%
I
nterestcov erage 5.35x
Fi
xedchar gecov erage 4.62x

a.Anal yzeRy anBootCompany ,

usi ngratioanalysis.Comput ethe
rati
osabov ef orRy anandcompar ethem tot heindust rydatat hati
s
given.Di scusst heweakpoi nt
s, str
ongpoi nts,andwhaty outhink
shoul dbedonet oi mprovet hecompany '
sper for
mance.
b.Inyouranal ysis,calcul
atet heov erallbreak-
ev enpointi nthesal es
dollarsandt hecashbr eak-evenpoi nt.Alsocomput et hedegr eeof
oper atingleverage, degreeoff inanciallever
age, anddegr eeof
combi nedlev erage.(Usef ootnot e2f orDOLandf oot note3f orDCL.)
c.Uset heinformat ioninpar saandbt
t odiscusst heriskassoci ated
witht hiscompany .Giv
ent her i
sk, decidewhet herabankshoul dloan
fundst oRy anBoot .

RyanBootCompanyi stryi
ngtopl
anthefundsneededfor2002.The
managementanti
cipatesanincr
easeinsal
esof20percent,whi
chcan
bedwi
beabsor thoutincreasi
ngfi
xedasset
s.

d.Whatwoul dbeRyan'
sneedsforext
ernalfundsbasedont hecur
rent
balancesheet
?ComputeRNF( r
equir
ednewf unds)
.Notespayabl
e
(curr
ent)andbondsar
enotpartoft
hel i
abil
it
ycalcul
ati
on.

e.Whatwoul dbetherequirednewf undsifthecompanybr i

ngsit
s
rati
osint
ol i
newiththei
ndustryav er
agedur i
ng2002?Specifi
cal
ly
examinereceiv
ablestur
nov er
,invent
oryturnover
,andtheprofi
t
mar gi
n.Usethenewv al
uest orecomput edthefact
orsinRNF
(assumeliabi
li
ti
esstaythesame) .

f
. Donotcalcul
ate,
onl
ycommentont hesequest
ions.Howwoul
d
requi
rednewfundschangei
fthecompany:

S-
183
 1.Wer eatful
lcapacit
y?
2.Raisedthedivi
dendpayoutrat
io?
3.Suffer
edadecr easedgr
owthinsales?
4.Facedanaccel er
atedi
nfl
ati
onr at
e?

CPSol
uti
on:
Ry
anBootCompany

a.Rat ioanaly
sis Ryan I ndustry
Profitmargin $292,500/$7,
000,
000 4.
18% 5.
75%
Returnonasset s $292,500/$8,
130,
000 3.
60% 6.
90%
Returnonequi ty $292,500/$2,
880,
000 10.
16% 9.
20%
Recei v
able $7,000,
000/$3,
000,
00 2.33x 4.35x
tur
nov er 0
I
nv entorytur
nover $7,000,
000/$1,
000,
00 7.
00x 6.
50x
0
Fixedasset $7,000,
000/$4,
000,
00 1.
75x 1.
85x
turnov er 0
Tot alasset $7,000,
000/$8,
130,
00 .
86x 1.
20x
turnov er 0
Cur rentrat
io $4,130,
000/$2,
750,
00 1.
50x 1.
45x
0
Qui
ckr
ati
o $3,130,
000/$2,
750,
00 1.
14x 1.
10x
0
Debtt ototal $5,250,
000/$8,
130,
00 64.
58% 25.
05%
asset s 0
Interestcover
age $700,
000/$250,
000 2.
80x 5.
35x
Fixedchar ge
cov erage seecal
cul
ati
onbel
ow* 1.
64x 4.
62x

a.Thecompanyhasal
owerpr
ofi
tmar
gint
hant
he

S-
184
 i
ndust r
yandt hepr obl
em isfurthercompoundedby
theslowt urnov erofassets(.86xv ersusanindustr
y
norm of1.20x) .Thisleadstoamuchl owerretur
n
onasset s.Thecompanyhasahi gherr et
urnon
equit
yt hant heindustry,butthi
sisaccompl ished
thr
ought hef ir
m' sheavydebtr ati
or athert
han
thr
oughsuper iorprofi
tabil
it
y.

Theslowt ur
noverofassetscanbedi rectl
ytraced
totheunusual l
yhighlevelofaccount sreceivabl
e.
Thef i
rm'saccountsreceivableturnoverrati
oi sonl
y
2.33x,versusanindustrynorm of4. 35x.Actuall
y
thefir
m doesqui t
ewel lwithreceivabletur
nov er
anditsonl ysl
ight
lybelowt heindustryinfi
xed
assetturnover.

Thepr ev
iouslymenti
onedheav ydebtpositi
on
becomesmor eapparentwhenweexami neti
mes
i
nterestearnedandfixedchargecoverage.The
l
atterisparti
cul
arl
ylowduet oleaseexpensesand
si
nkingfundobligat
ions.

b.Break-eveni
nsal es
Sales =Fi xedCost s+Vari
ablecost
s
(vari
ablecostsareexpressedasapercent
ageof
sales)
SalesBE =$2,100,000+.60Sales
.40S =$2, 100,000
S =$2, 100,000/.
40
S =$5, 250,000

Cashbreak-even
Sal
es =( Fi
xedcosts–Noncashexpenses*
)+
Vari
ablecost
s
Sal
esBE =( $2,
100,000–$500,
000)+.
60Sales

S-
185
 Sal
esBE =$1,600,
000+.60Sal
es
.
40S =$1,600,
000
S =$1,600,
000/.
40
S =$4,000,
000
*Depreci
ati
on

c.Ryanisoperat
ingatasal
esvolumet hatis
$1,
750,000abovethet
radi
ti
onalbreak-evenpoint
and$3,000,
000abovethecashbreak-evenpoint.
Thiscanbev i
ewedassomewhatposi ti
ve.

S-
186
 Howev er
, t
hef irm hasahighdegreeofl everage,
whichindicatesanyr educti
oninsalesvolume
couldhaveav erynegativ
eimpactonpr of i
tabil
i
ty.
TheDOLof4xi sassociatedwit
hheav yf i
xed
assetsandr elativ
elyhi
ghf i
xedcosts.TheDFLof
1.56xisattri
but edtohighdebtrel
iance.Act ual
ly,
if
wewer etoi ncludetheleasepayment sof$200, 000
withtheinterestpay mentsof$250,000,theDFL
wouldbeal most3x.

Thebankerwoul dhavet oquestionthepotent

ial
useoft hefundsandthef i
rm'sabili
tyt
opayback
theloan.Actual
ly,t
hef i
rm al
readyappearstohav e
anabundantamountofasset s,sohopefull
yalarge
expansionwoul dnottakeplacehere.There
appearstobeaneedt oreduceaccountsreceivabl
e
rat
herthani ncr
easethelevel.

Onepossi bl
euseoft hef undsmi ghtbetopayof f
par tofthecurrentnot espay ableof$400,000.This
mi ghtbeaccept ableifthef ir
m candemonst rate
theabi l
i
t ytomeeti t
sf utureobligati
ons.Thebanker
shoul drequesttoseepr of or
maf inanci
al
statement sandpr ojecti
onsoff ut
urecashf l
ow
gener at
ion.Thel oanmi ghtonl ybeacceptableifthe
fi
rm canbr i
ngdowni tsinventoryposit
ionbackin
l
ineandi mprovei t
spr ofit
abili
ty.

d.

S-
187
RNF=.590($1,
400,
000)–.336(
$1,400,
000)–$351,
120
(.
6)
=$826,
000–$470,400–$210,672
=$144,
928

S-
188
e.Requir
edfundsi
fselectedindust
ryrat
ioswer
e
appl
ied
Receiv
abl
es=Sales/Receivablet
urnover
Receiv
abl
es=$7,000,000/4.35
Receiv
abl
es=$1,609,195

Rev
isedA(asset
s)
=$50,
000+$80,000+$1,
609,
195+$1,
000,
000
=$2,
739,
195

Pr
ofi
tMar
gin=5.
75%

(
$7,
000,
000*20%)–5.
75%(
$8,
400,
000)(
1–.
4)

RNF =.391($1,
400,
000)–.336($1,
400,
000)–$483,
000
(
.6)
=$547,
400–$470,400–$289,
800
=$212,
800

Requirednewf unds(RNF)isnegati
ve,indicati
ng
therewillactuall
ybeanexcessoff undsequal t
o
$212,180.Thi sisduetothemuchmor er apid
turnoverofinventoryandthehigherprofi
tmar gin.

f
.(1)IfRy
anBootswereatf
ull
capacit
y,moref
unds
wouldbeneededt
oexpandplantand
equi
pment.

(
2)Mor
efundswoul
dbeneededt
oof
fsett
he

S-
189
 l
argerpay
outofear
ningst
odi
vi
dends.

(
3)Fewerfundswouldberequir
edassal
esgr
ow
l
essrapidl
y.Fewernewassetswoul
dbe
neededtosupportsal
esgrowth.

(
4)Asinflationincreasedsowoul dthecostofnew
assets, especiall
yinventor
yandplantand
equipment .Evenifsalespri
cescouldbe
i
ncreased, mor eassetswouldber equir
edto
suppor tthesamephy si
call
evelofsales.
Incr
easedpr ofitsal
onewoul dnotmakeupf or
thehigherl evelofassetsrequir
edandmor e
fundswoul dbeneeded.

S-
190