Corporate Finance Foundations Global Edition 15th Edition Block Solutions Manual 1

Chapter 05: Operating and Financial Leverage
Solution Manual for Corporate Finance Foundations

Global Edition 15th Edition by Block Hirt Danielsen ISBN
007716119X 9780077161194
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Chapter 5
Operating and Financial Leverage
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 (earn zero profit) 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.
5-1
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.
5-2
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.
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.
5-3
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.
5-4
Problems
1. Break-even analysis (LO2) Shock Electronics sells portable heaters for $71 per unit, and
the variable cost to produce them is $40. Mr. Amps estimates that the fixed costs are
$124,000.
a. Compute the break-even point in units.
b. Fill in the following table (in dollars) to illustrate that the break-even point has been
achieved.
Sales…………………. ____________
– Fixed costs…………. ____________
– Total variable costs… ____________
Net profit (loss)………. ____________
5-1. Solution:
Shock Electronics
Fixed costs
a. BE 
Pr ice-variable cost per unit
$124,000 $124,000
   4,000 units
$71  $40 $31
b. Sales $284,000 (4,000 units × $71)

– Fixed costs 124,000
– Total variable costs 160,000 (4,000 units × $40)
Net profit (loss) $ 0
2. Break-even analysis (LO2) The Hartnett Corporation manufactures baseball bats with
Pudge Rodriguez’s autograph stamped on them. Each bat sells for $35 and has a variable
cost of $22. There are $97,500 in fixed costs involved in the production process.
a. Compute the break-even point in units.
b. Find the sales (in units) needed to earn a profit of $262,500.
5-5
5-2. Solution:
Hartnett Corporation
$97,500
a. BE   7,500 units
$35  $22
Profit  FC $262,500  $97,500

b. Q 
(P  VC) $35  $22
$360,000
  27,692 units
$13
3. Break-even analysis (LO2) Therapeutic Systems sells its products for $30 per unit. It has
the following costs:
Rent ............................................ $230,000
Factory labor .............................. $12.50 per unit
Executives under contract .......... $514,600
Raw material .............................. $2.90 per unit
Separate the expenses between fixed and variable costs per unit. Using this information and
the sales price per unit of $30, compute the break-even point.
5-3. Solution:
Therapeutic Systems
Variable Costs
Fixed Costs (per unit)
Rent $230,000
Factory labor $12.50
Executive under
contract $514,600
5-6
Raw materials 2.90

$744,600 $15.40
FC $744,600 $744,600
BE     51,000 units
P  VC $30  $15.40 $14.60
4. Break-even analysis (LO2) Draw two break-even graphs—one for a conservative firm
using labor-intensive production and another for a capital-intensive firm. Assuming these
companies compete within the same industry and have identical sales, explain the impact of
changes in sales volume on both firms’ profits.
5-4. Solution:
Labor-Intensive and Capital-Intensive Break-Even Graphs
Labor-Intensive Capital-Intensive
Total revenue Total revenue
Revenue and costs Revenue and costs
Total Total
costs costs
Profits Profits
BE
Variable
BE Variable Cost
Cost
Fixed
costs
Fixed
costs
Units produced and sold Units produced and sold
The company having the higher 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.
5-7
5. Break-even analysis (LO2) Eaton Tool Company has fixed costs of $255,000, sells its
units for $66, and has variable costs of $36 per unit.
a. Compute the break-even point.
b. Ms. Eaton comes up with a new plan to cut fixed costs to $200,000. However, more
labor will now be required, which will increase variable costs per unit to $39. The
sales price will remain at $66. What is the new break-even point?
c. Under the new plan, what is likely to happen to profitability at very high volume
levels (compared to the old plan)?
5-5. Solution:
Eaton Tool Company

Fixed costs
a. BE 
Pr ice  Variable cost per unit
$255,000 $255,000
   8,500 units
$66  $36 $30
Fixed costs
b. BE 
Pr ice  Variable cost per unit
$200,000 $200,000
   7,407 units
$66  $39 $27
The break-even level decreases.

c. With less operating leverage and a smaller contribution
margin, profitability is likely to be less than it would have
been at very high volume levels.
6. Break-even analysis (LO2) Shawn Pen & Pencil Sets Inc. has fixed costs of $99,000. Its
product currently sells for $5 per unit and has variable costs of $3.00 per unit. Mr. Bic, the head
of manufacturing, proposes to buy new equipment that will cost $310,000 and drive up fixed
5-8
costs to $147,500. Although the price will remain at $5 per unit, the increased automation will
reduce costs per unit to $2.50.
As a result of Bic’s suggestion, will the break-even point go up or down? Compute the
necessary numbers.
5-6. Solution:
Shawn Pen & Pencil Sets Inc.
$99,000 $99,000
BE (before)    49,500 units
$5.00  $3.00 $2.00
$147,500 $147,500
BE (after)    59,000 units
$5.00  $2.50 $2.50
The break-even point will go up.
7. Cash break-even analysis (LO2) Calloway Cab Company determines its break-even
strictly on the basis of cash expenditures related to fixed costs. Its total fixed costs are
$450,000, but 5 percent of this value is represented by depreciation. Its contribution
margin (price minus variable cost) for each unit is $4.10. How many units does the firm
need to sell to reach the cash break-even point?
5-7. Solution:
Calloway Cab Company
Cash-related fixed costs = Total fixed costs – Depreciation

= $450,000 – 5% ($450,000)
= $450,000 – $22,500
= $427,500
$427,500
Cash BE   104,268
$4.10
5-9
8. Cash break-even analysis (LO2) Air Purifier Inc. computes its break-even point strictly
on the basis of cash expenditures related to fixed costs. Its total fixed costs are $2,650,000,
but 10 percent of this value is represented by depreciation. Its contribution margin (price
minus variable cost) for each unit is $80. How many units does the firm need to sell to
reach the cash break-even point?
5-8. Solution:
Air Purifier Inc.
= $2,650,000 – 10% (2,650,000)

= $2,650,000 – $265,000
= $2,385,000
2,385,000
BE   29,813 units
$80
9. Cash break-even analysis (LO2) Boise Timber Co. computes its break-even point strictly
on the basis of cash expenditures related to fixed costs. Its total fixed costs are $6,500,000,
but 10 percent of this value is represented by depreciation. Its contribution margin (price
minus variable cost) for each unit is $9. How many units does the firm need to sell to reach
the cash break-even point?
5-9. Solution:
Boise Timber Co.
= $6,500,000 – 10% ($6,500,000)
= $6,500,000 – $650,000
= $5,850,000
$5,850,000
BE   650, 000 units
$9
5-10
10. Degree of leverage (LO2 and 5) The Sterling Tire Company’s income statement for 2013
is as follows:
STERLING TIRE COMPANY

Income Statement
For the Year Ended December 31, 2013
Sales (30,000 tires at $80 each) ................................... $2,400,000
Less: Variable costs (30,000 tires at $40) ................ 1,200,000
Fixed costs .............................................................. 500,000
Earnings before interest and taxes (EBIT) .................. 700,000
Interest expense ........................................................... 55,000
Earnings before taxes (EBT) ....................................... 645,000
Income tax expense (20%) .......................................... 129,000
Earnings after taxes (EAT) .......................................... $ 516,000
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.
5-10. Solution:
Sterling Tire Company
Q = 30,000, P = $80, VC = $40, FC = $500,000, I = $55,000
Q(P  VC)
a. DOL 
Q(P  VC)  FC
30,000($80  $40)

30,000($80  $40)  $500,000
30,000($40)

30,000($40)  $500,000
$1,200,000 $1,200,000
   1.71x
$1,200,000  $500,000 $700,000
5-11
5-10. (Continued)
EBIT $700,000
b. DFL  
EBIT  I $700,000  $55,000
$700,000
  1.09x
$645,000
c.
Q (P  VC)
DCL 
Q(P  VC)  FC  I
30,000($80  $40)

30,000($80  $40)  $500,000  $55,000
$1,200,000 $1,200,000
   1.86x
$1,200,000  $500,000  $55,000 $645,000
$500,000 $500,000
d. BE    12,500 units
$80  $40 $40
11. Degree of leverage (LO2 and 5) The Harding Company manufactures skates. The
company’s income statement for 2013 is as follows:
5-12
HARDING COMPANY
Income Statement
For the Year Ended December 31, 2013
Sales (10,500 skates @ $60 each) ................................. $630,000
Less: Variable costs (10,500 skates at $25)................... 262,500
Fixed costs ................................................................. 200,000
Earnings before interest and taxes (EBIT) .................... 167,500
Interest expense ............................................................. 62,500
Earnings before taxes (EBT) ......................................... 105,000
Income tax expense (30%) ............................................ 31,500
Earnings after taxes (EAT) ............................................ $ 73,500
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 (number of skates).
5-11. Solution:
Harding Company
Q = 10,500, P = $60, VC = $25, FC = $200,000, I = $62,500
Q(P  VC)
a. DOL 
Q(P  VC)  FC
10,500($60  $25)

10,500($60  $25)  $200,000
10,500($35)

10,500($35)  $200,000
$367,500 $367,500
   2.19x
$367,500  $200,000 $167,500
5-13
5-11. (Continued)
EBIT $167,500
b. DFL  
EBIT  I $167,500  $62,500
$167,500
  1.60x
$105,000
Q( P  VC)
c. DCL 
Q( P  VC)  FC  I
10,500($60  $25)

10,500($60  $25)  $200,000  $62,500
$10,500($35) $367,500
   3.50x
$10,500($35)  $262,500 $105,000
$200,000 $200, 000

d. BE    5, 714 skates
$60  $25 $35
12. Break-even point and degree of leverage (LO2 and 5) Healthy Foods Inc. sells 60-pound
bags of grapes to the military for $15 a bag. The fixed costs of this operation are $90,000,
while the variable costs of grapes are $.15 per pound.
a. What is the break-even point in bags?
b. Calculate the profit or loss on 14,000 bags and on 35,000 bags.
c. What is the degree of operating leverage at 21,000 bags and at 35,000 bags?
Why does the degree of operating leverage change as the quantity sold increases?
d. If Healthy Foods has an annual interest expense of $17,000, calculate the degree of
financial leverage at both 21,000 and 35,000 bags.
e. What is the degree of combined leverage at both sales levels?
5-12. Solution:
Healthy Foods Inc.
$90,000 $90,000
a. BE    15,000 bags
$15  ($.15  60) $6
5-14
b. 14,000
35,000 bags
bags
Sales @ $15 per bag $210,000 $525,000
Less: Variables costs ($6) (84,000) (210,000)
Fixed costs (90,000) (90,000)
Profit or loss ($ 6,000) $120,000
Q( P  VC)
c. DOL 
Q( P  VC)  FC
21,000($15  $9)
DOL at 21,000 
21,000 ($15  $9)  $90,000
$126,000
  3.50x
$36,000
35,000 ($15  $9)
DOL at 35,000 
35,000($15  $9)  $90,000
$210,000
  1.75x
$120,000
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.
5-12. (Continued)
EBIT
d. DFL 
EBIT  I
First determine the profit or loss (EBIT) at 21,000 bags. As
indicated in part b, the profit (EBIT) at 35,000 bags
is $120,000:
21,000 bags
Sales @ $15 per bag $315,000
Less: Variable costs ($6) 126,000
Fixed costs 90,000
5-15
Profit or loss $36,000

$36,000
DFL at 21,000 
$36,000  $17,000
 1.89x
$120,000
DFL at 35,000 
$120,000  $17,000
 1.17x
Q( P  VC)
e. DCL 
Q( P  VC)  FC  I
21,000 ($15  $9)
DCL at 21,000 
21,000($15  $9)  $90,000  $17,000
$126,000
  6.63x
$19,000
35,000 ($15  $9)

DCL at 25,000 
35,000($15  $9)  $90,000  $17,000
$210,000
  2.04x
$103,000
13. Break-even point and degree of leverage (LO2 and 5) United Snack Company sells
50-pound bags of peanuts to university dormitories for $20 a bag. The fixed costs of this
operation are $176,250, while the variable costs of peanuts are $.15 per pound.
a. What is the break-even point in bags?
b. Calculate the profit or loss on 7,000 bags and on 20,000 bags.
c. What is the degree of operating leverage at 19,000 bags and at 24,000 bags? Why
does the degree of operating leverage change as the quantity sold increases?
d. If United Snack Company has an annual interest expense of $15,000, calculate the
degree of financial leverage at both 19,000 and 24,000 bags.
e. What is the degree of combined leverage at both sales levels?
5-16
5-13. Solution:
United Snack Company
$176,250 $176, 250
a. BE    14,100 bags
$20  ($.15  50) $12.50
b.
7,000 bags 20,000 bags

Sales @ $20 per bag $140,000 $400,000
Less: Variables costs ($7.50) (52,500) (150,000)
Fixed costs
(176,250)
(176,250)
Profit or loss (EBIT) ($ 88,750) $ 73,750
5-13. (Continued)
Q( P  VC)
c. DOL 
Q( P  VC)  FC
19,000($20  $7.50)
DOL at 19,000 
19,000 ($20  $7.50)  $176,250
$237,500
  3.88x
$61,250
24,000 ($20  $7.50)

DOL at 24,000 
24, 000($20  $7.50)  $176, 250
$300, 000
  2.42x
$123, 750
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.
5-17
5-13. (Continued)
EBIT
d. DFL 
EBIT  I
First determine the profit or loss (EBIT) at 19,000 bags and
at 24,000 bag:
19,000 bags 24,000 bags
Sales @ $20 per bag $380,000 $480,000
Less: Variable costs ($7.50) 142,500 180,000
Fixed costs 176,250 176,250
Profit or loss (EBIT) $ 61,250 $ 123,750
$61,250
DFL at 19,000 
$61, 250  $15, 000
 1.32x
$123,750
DFL at 24,000 
$123, 750  $15, 000
 1.14x
Q( P  VC)
e. DCL 
Q( P  VC)  FC  I
19,000 ($20  $7.50)
DCL at 19,000 
19,000($20  $7.50)  $176, 250  $15, 000
$237,500
  5.14x
$46, 250
24,000 ($20  $7.50)
DCL at 24,000 
24, 000($20  $7.50)  $176, 250  $15, 000
$300, 000
  2.76x
$108, 750
5-18
14. Nonlinear breakeven analysis (LO2) International Data Systems information on revenue
and costs is only relevant up to a sales volume of 120,000 units. After 120,000 units, the
market becomes saturated and the price per unit falls from $8.00 to $5.80. Also, there are
cost overruns at a production volume of over 120,000 units, and variable cost per unit goes
up from $4.00 to $4.50. Fixed costs remain the same at $70,000.
a. Compute operating income at 120,000 units.
b. Compute operating income at 220,000 units.
5-14. Solution:
International Data Systems
a. Sales (120,000  $8) ......................................... $960,000
Total variable costs (120,000  $4) .................. 480,000
Fixed costs ........................................................ 70,000
Operating income ............................................. $410,000
b. Sales (220,000  $1,276,000

$5.80)
..........................................................................
Total variable costs (220,000  990,000

$4.50)
..........................................................................
Fixed 70,000
costs
..........................................................................
5-19
Operating $216,000
income
..........................................................................
5-20
15. Use of different formulas for operating leverage (LO3) U.S. Steal has the following
income statement data:
Total Operating
Units Variable Fixed Total Total Income
Sold Costs Costs Costs Revenue (Loss)
60,000 $ 120,000 $50,000 $170,000 $360,000 $190,000
80,000 160,000 50,000 210,000 480,000 270,000
a. Compute DOL based on the following formula:

Percent change in operating income
DOL 
Percent change in units sold
b. Confirm that your answer to part a is correct by recomputing DOL using Formula 5–
3. There may be a slight difference due to rounding.
Q( P  VC)
DOL 
Q( P  VC)  FC
Q represents beginning units sold (all calculations should be done at this level).
P can be found by dividing total revenue by units sold.
VC can be found by dividing total variable costs by units sold.
5-15. Solution:
U.S. Steal
Percent change in operating income
a. DOL 
Percent change in units sold
$80, 000
190, 000 42%
   1.27
20, 000 33%
60, 000
Q( P  VC)
DOL 
b. Q( P  VC)  FC
5-21
5-22
Q  60,000
Total revenue $360,000

P   $6
Units sold 60,000
Total variable costs $120,000

VC    $2
Units sold 60,000
FC  $50,000
60,000 ($6  $2) $240,000

DOL  
60,000($6  $2)  $50,000 $240,000  $50,000
$240,000
  1.26
$190,000
16. Earnings per share and financial leverage (LO4) Lenow’s Drug Stores and Hall’s
Pharmaceuticals are competitors in the discount drug chain store business. The separate
capital structures for Lenow and Hall are presented next.
Lenow Hall
Debt @ Debt @
10% $100,000 10% $200,000
............................................. ..............................................
Common stock, $10 Common stock, $10
par 200,000 par 100,000
............................................. ..............................................
Total Total
$300,000 $300,000
............................................. ..............................................
Shares Common
............................................. 20,000 shares 10,000
..............................................
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.
5-23
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?
5-24
5-16. Solution:
a. Lenow Drug Stores and Hall Pharmaceuticals
Lenow 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
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
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
5-25
5-16. (Continued)
b. Before-tax return on assets = 6.67 percent, 10 percent, and 40
percent at the respective levels of EBIT. When the before-tax
return on assets (EBIT/Total assets) is less than the cost of
debt (10 percent), Lenow 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%  $300,000 = $36,000 break-even level for EBIT.
17. P/E ratio (LO6) The capital structure for Cain Supplies is presented next. Compute the
stock price for Cain if it sells at 19 times earnings per share and EBIT is $50,000. The tax
rate is 20 percent.
Cain
Debt @ 9% .......................... $100,000
Common stock, $10 par ...... 200,000
Total ................................ $300,000
Common shares ................... 20,000
5-17. Solution:
Cain Supplies
Cain
EBIT $50,000
Less: Interest 9,000
EBT $41,000
Less: Taxes @ 20% 8,200
EAT $32,800
Shares 20,000
5-26
EPS $1.64
P/E 19x
Stock price $ 31.16
18. Leverage and stockholder wealth (LO4) Sterling Optical and Royal Optical both make
glass frames and each is able to generate earnings before interest and taxes of $105,600.
The separate capital structures for Sterling and Royal are shown next:
Sterling Royal
Debt @ 8%……………… $ 792,000 Debt @ 8%…………… $ 264,000
Common stock, $5 par…… 528,000 Common stock, $5 par 1,056,000
Total……………………… $1,320,000 Total…………………… $1,320,000
Common shares………….. 105,600 Common shares………... 211,200
a. Compute earnings per share for both firms. Assume a 20 percent tax rate.
b. In part a, you should have gotten the same answer for both companies’ earnings per
share. Assuming a P/E ratio of 19 for each company, what would its stock price be?
c. Now as part of your analysis, assume the P/E ratio would be 13 for the riskier
company in terms of heavy debt utilization in the capital structure and 23 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 will 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?
5-18. Solution:
Sterling Optical and Royal Optical
a.
Sterling Royal
EBIT $105,600 $105,600
EBT 42,240 84,480
Less: Taxes @ 20% 8,448 16,896
EAT 33,792 67,584
Shares 105,600 211,200
EPS $.32 $.32
5-27
b. Stock price = P/E ×EPS

19 × $.320 = $6.08
c. Sterling Royal
13 × $.320 = $4.16 23 × $.320 = $7.36
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, Royal Optical,
with the less risky plan, has a higher stock price.
19. Japanese firm and combined leverage (LO5) 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 Mitaka Company has a sales volume of
130,000 units at a price of $30 per unit; variable costs are $10 per unit and fixed costs are
$1,850,000. Interest expense is $405,000. What is the degree of combined leverage for this
Japanese firm?
5-19. Solution:
Mitaka Company
Q( P  VC)
DCL 
Q( P  VC)  FC  I
130,000 ($30  $10)


130,000 ($30  $10)  $1,850,000  $405,000
130,000 ($20)

130,000 ($20)  $2,255,000
$2,600,000

$2,600,000  $2,255,000
 7.54x
5-28
20. Combining operating and financial leverage (LO5) Sinclair Manufacturing and Boswell
Brothers Inc. are both involved in the production of brick for the homebuilding industry.
Their financial information is as follows:
Capital Structure
Sinclair Boswell
Debt @ 10%............................................................ $ 0
2,100,000
Common stock, $10 per share................................ $ 3,500,000
1,400,000
Total..................................................................... $ 3,500,000 $ 3,500,000
Common shares....................................................... 140,000 350,000
Operating Plan
Sales (75,000 units at $15 each).............................. $ 1,125,000 $ 1,125,000
Less: Variable costs............................................. 900,000 450,000
.................................................................................. ($12 per unit) ($6 per unit)
Fixed costs....... 0 325,000
Earnings before interest and taxes (EBIT)............... $ 225,000 $ 350,000
a. If you combine Sinclair’s capital structure with Boswell’s operating plan, what is the
degree of combined leverage? (Round to two places to the right of the decimal point.)
b. If you combine Boswell’s capital structure with Sinclair’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 percentage will EPS increase?
5-29
5-20. Solution:
Sinclair Manufacturing and Boswell Brothers
a.
Q( P  VC)
DCL 
Q( P  VC)  FC  I
75,000 ($15  $6)


75,000 ($15  $6)  $325,000  $210,000
675,000

675,000  $325,000  $210,000
$675,000

$140,000
 4.82x
5-30
b.
Q( P  VC)
DCL 
Q( P  VC)  FC  I
75,000($15  $12)

75,000($15  $12)  0  0
75,000($3)

75,000($3)
$225,000

$225,000
 1x
5-31
5-20. (Continued)
c. The leverage factor is only lx because Boswell has no financial
leverage and Sinclair 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.
21. Expansion and leverage (LO5) 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
200X
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 at 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.)
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.
5-32
5-21. Solution:
DeSoto Tools Inc.
S  VC
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
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
5-33
5-21. (Continued)
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  TVC
c. 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
5-34
5-21. (Continued)
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
  2.17x
$808,000
$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.
5-35
22. Leverage analysis with actual companies (LO6) Using Standard & Poor’s data or annual
reports, compare the financial and operating leverage of Chevron, 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?
5-22. Solution:
The results for this problem change every year. This is primarily
an Internet/library assignment to facilitate class discussion.
23. Leverage and sensitivity analysis (LO6) Dickinson Company has $11.86 million in
assets. Currently half of these assets are financed with long-term debt at 9.3 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 9.3 percent. The tax
rate is 40 percent.
Under Plan D, a $2.965 million long-term bond would be sold at an interest rate of
11.3 percent and 370,625 shares of stock would be purchased in the market at $8 per share
and retired.
Under Plan E, 370,625 shares of stock would be sold at $8 per share and the $2,965,000
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 4.65 percent? Increased
to 14.3 percent? Consider the current plan and the two new plans.
c. If the market price for common stock rose to $10 before the restructuring, which plan
would then be most attractive? Continue to assume that $2.965 million in debt will be
used to retire stock in Plan D and $2.965 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 9.3
percent.
5-36
5-23. Solution:
Dickinson Company
Income Statements
a. Return on assets = 9.3% EBIT = $ 1,102,980
Current Plan D Plan E

EBIT $1,102,980 $1,102,980 $1,102,980
Less: Interest 551,4901 886,5352 275,7453
EBT 551,490 216,445 827,235
Less: Taxes
220,596 86,578 330,894
(40%)
EAT 330,894 129,867 496,341
4
Common shares 741,250 370,625 1,111,875
EPS $ .45 $ .35 $ .45
1
$5,930,000 debt @ 9.30%
2
$551,490 interest + ($2,965,000 debt @ 11.3%)
3
($5,930,000 – $2,965,000 debt retired)  9.3%
4
($5,930,000 common equity)/($8 par value) = 741,250
shares
Plan E and the original plan provide the same earnings per
share because the cost of debt at 9.3 percent is equal to the
operating return on assets of 9.3 percent. With Plan D, the
cost of increased debt rises to 11.3 percent, and the firm
incurs negative leverage reducing EPS and also increasing
the financial risk to Dickinson.
5-37
5-23. (Continued)
b. Return on assets = 4.65% EBIT = $551,490
EBIT $551,490 $551,490 $ 551,490
Less: Interest 551,490 886,535 275,745
EBT 0 (335,045) 275,745
Less: Taxes @
--- (134,018) 110,298
40%
EAT 0 $(201,027) $ 165,447
Common shares 741,250 370,625 1,111,875
EPS 0 $ (.54) $ .15
Return on assets = 14.3% EBIT = $1,695,980

EBIT $1,695,980 $1,695,980 $1,695,980
Less: Interest 551,490 886,535 275,745
EBT 1,144,490 809,445 1,420,235
Less: Taxes @
40% 457,796 323,778 568,094
EAT $ 686,694 $ 485,667 $ 852,141
Common shares 741,250 370,625 1,111,875
EPS $ .93 $ 1.31 $ .77
If the return on assets decreases to 4.65 percent, Plan E

provides the best EPS, and at 14.3 percent return, Plan D
provides the best EPS. Plan D is still risky, having an interest
coverage ratio of less than 2.0.
5-38
5-23. (Continued)
c. Return on Assets = 9.3% EBIT = $1,102,980
EBIT $1,102,980 $1,102,980 $1,102,980
EAT 330,894 129,867 496,341
Common shares 741,250 444,7501 1,037,7502
EPS $ .45 $ .29 $ .48
1
741,250 – ($2,965,000/$10 per share)
= 741,250 – 296,500 = 444,750 shares
2
741,250 + ($2,965,000/$10 per share)
= 741,250 + 296,500 = 1,037,750 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.
24. Leverage and sensitivity analysis (LO6) Edsel Research Labs has $27 million in assets.
Currently, half of these assets are financed with long-term debt at 5 percent and half with
common stock having a par value of $10. Ms. Edsel, the 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 5 percent. The tax rate is
30 percent.
Under Plan D, a $6.75 million long-term bond would be sold at an interest rate of 11
percent and 675,000 shares of stock would be purchased in the market at $10 per share and
retired. Under Plan E, 675,000 shares of stock would be sold at $10 per share and the
$6,750,000 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. Which plan(s) would produce the highest EPS? Note that due
to tax loss carry-forwards and carry-backs, taxes can be a negative number.
b. Which plan would be most favorable if return on assets increased to 8 percent?
Compare the current plan and the two new plans. What has caused the plans to give
different EPS numbers?
c. Assuming return on assets is back to the original 5 percent, but the interest rate on
new debt in Plan D is 7 percent, which of the three plans will produce the highest
EPS? Why?
5-39
5-24. Solution:
Edsel Research Labs
Income Statement
a. Return on assets = 5% EBIT = $1,350,000
EBIT $1,350,000 $1,350,000 $1,350,000

Less: Interest 675,0001 1,417,5002 337,5003
EBT 675,000 67,500 1,012,500
L Less: Taxes (30%) 202,500 20,250 303,750
EAT 472,500 47,250 708,750
Common shares 1,350,0004 675,0005 2,025,0006
EPS $.35 $0.07 $0.35
1
$13,500,000 debt @ 5% = $675,000
2
$675,000 interest + ($6,750,000 new debt @ 11%) =
$1,417,500
3
($13,500,000  $6,750,000 debt retired)  5% = $337,500
4
($13,500,000 common equity / $10 par value) = 1,350,000
shares
5
($6,750,000 common equity / $10 par value) = 675,000
shares
6
($20,250,000 common equity / $10 par value) = 2,025,000
shares
The current plan and Plan E provide the highest return of $0.35.
5-40
5-24. (Continued)
b. Return on assets = 8% EBIT = $2,160,000
EBIT $2,160,000 $2,160,000 $2,160,000

Less: Interest 675,000 1,417,500 337,500
EBT 1,485,000 742,500 1,822,500
Less: Taxes 445,500 222,750 546,750
(30%)
EAT 1,039,500 519,750 1,275,750
Common shares 1,350,000 675,000 2,025,000
EPS $0.77 $0.77 $0.63
The current plan and Plan D provides the highest return.
The % EBIT (12%) is higher than the interest rate (8%
and 10%). Thus, the more debt the firm takes on, the
higher the EPS.
c. Return on assets = 5% EBIT = $1,350,000
EBIT $1,350,000 $1,350,000 $1,350,000
Less: Interest 675,000 1,147,5001 337,500
EBT 675,000 202,500 1,012,500
Less: Taxes 202,500 60,750 303,750
(30%)
EAT 472,500 141,750 708,750
Common shares 1,350,000 675,000 2,025,000
EPS $0.35 $0.21 $0.35
1
$675,000 + (6,750,000  7%) = 1,147,500
The current plan and Plan E provides the highest return.
The % EBIT (8%) is higher than the cost of new debt
(6%).
5-41
25. Leverage and sensitivity analysis (LO6) The Lopez-Portillo Company has $11.6 million
in assets, 60 percent financed by debt, and 40 percent financed by common stock. The
interest rate on the debt is 14 percent and the par value of the stock is $10 per share.
President Lopez-Portillo is considering two financing plans for an expansion to $23 million
in assets.
Under Plan A, the debt-to-total-assets ratio will be maintained, but new debt will cost a
whopping 17 percent! Under Plan B, only new common stock at $10 per share will be
issued. The tax rate is 30 percent.
a. If EBIT is 11 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.
5-25. Solution:
Lopez-Portillo Company
a. Return on Assets = 11%
Current Plan A Plan B

EBIT $1,276,000 $2,530,000 $2,530,000
Less: Interest 974,400(a) 2,137,200(c) 974,400(e)
EBT 301,600 392,800 1,555,600
Less: Taxes 90,480 117,840 466,680
(30%)
EAT $211,120 $ 274,960 $ 1,088,920
Common shares 464,000(b) 920,000(d) 1,604,000(f)
EPS $0.46 $0.30 $0.68
(a) (60%  $11,600,000)  14% = $6,960,000  14% = $974,400
(b) (40%  $11,600,000)/$10 = $4,640,000/$10 = 464,000 shares
(c) $974,400 (current)  (60%  $11,400,000)  17% =
$974,400  $1,162,800 = $2,137,200
(d) 464,000 shares (current) + (40%  $11,400,000)/$10 =
464,000 + 456,000 = 920,000 shares
(e) Unchanged
5-42
(f) 464,000 shares (current) + $11,400,000/$10 = 464,000 +

1,140,000 = 1,604,000 shares
EBIT
b. DFL 
EBIT  I
$1,276,000
DFL (Current)   4.23x
$1,276,000  $974,400
$2,530,000
DFL (Plan A)   6.44x
$2,530,000  $2,137,200
$2,530,000
DFL (Plan B)   1.63x
$2,530,000  $974,400
c.
Plan A Plan B
EAT $274,960 $1088,920
Common shares 692,0001 1,034,0002
EPS $ 0.40 $ 1.05
1
464,000 shares (current) + (40%  $11,400,000)/$20
= 464,000 + 228,000 = 692,000 shares
2
464,000 shares (current) + $11,400,000/$20
= 464,000 + 570,000 = 1,034,000 shares
Plan B would continue to provide the higher earnings per
share. The difference between plans A and B is even greater
than that indicated in part (a).
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 finance
projects at a high or low cost of capital. Cost of capital will
5-43
be discussed in Chapter 10, and one will see the impact that
the cost of capital has on capital budgeting decisions.
26. Operating leverage and ratios (LO6) Mr. Gold is in the widget business. He currently
sells 1.5 million widgets a year at $6 each. His variable cost to produce the widgets is $4
per unit, and he has $1,550,000 in fixed costs. His sales-to-assets ratio is six times, and 30
percent of his assets are financed with 10 percent debt, with the balance financed by
common stock at $10 par value per share. The tax rate is 35 percent.
His brother-in-law, Mr. Silverman, says he is doing it all wrong. By reducing his price
to $5.00 a widget, he could increase his volume of units sold by 60 percent. Fixed costs
would remain constant, and variable costs would remain $4 per unit. His sales-to-assets
ratio would be 7.5 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 Gold plan.
b. Compute earnings per share under the Silverman plan.
c. Mr. Gold’s wife, the chief financial officer, does not think that fixed costs would
remain constant under the Silverman plan but that they would go up by 15 percent.
If this is the case, should Mr. Gold shift to the Silverman plan, based on earnings per
share?
5-26. Solution:
Gold-Silverman
a. Gold Plan
Sales ($1,500,000 units  $6) $9,000,000
 Fixed costs 1,550,000
 Variable costs 6,000,000
Operating income (EBIT) $ 1,450,000
 Interest1 45,000
EBT $ 1,405,000
 Taxes @ 35% 491,750
EAT $ 913,250
Shares2 105,000
Earnings per share $ 8.70
5-44
Sales $9,000,000
Assets    $1,500,000
Asset turnover 6
1
Debt = 30% of Assets = 30% × $1,500,000 = $450,000
Interest = 10% × $450,000 = $45,000
2
Stock = 70% of $1,500,000 = $1,050,000
Shares = $1,050,000/$10 = 105,000 shares
5-26. (Continued)
b. Silverman Plan
Sales ($2,400,000 units at $5.00) $12,000,000

 Fixed costs 1,550,000
 Variable costs (2,400,000 units  $4) 9,600,000
Operating income (EBIT) $ 850,000
 Interest3 104,000
EBT $ 746,000
Taxes @ 35% 261,100
EAT $ 484,900
Shares4 80,000
Sales $12,000,000
Assets    $1,600,000
Asset turnover 7.50
3
Debt = 50% of Assets = 50% × $1,600,000 = $800,000
Interest = 13% × $800,000 = $104,000
4
Stock = 50% of $1,600,000 = $800,000
Shares = $800,000/$10 = 80,000 shares
5-45
5-26. (Continued)
c. Silverman Plan (based on Mrs. Gold’s Assumption)
Sales ($2,400,000 units at $5.00) $12,000,000

 Fixed costs ($1,550,000  1.15) 1,782,500
 Variable costs (2,400,000 units  $4) 9,600,000
Operating income (EBIT) $ 617,500
 Interest 104,000
EBT $ 513,500
 Taxes @ 35% 179,725
EAT $ 333,775
Shares 80,000
No! Gold should not shift to the Silverman Plan if Mrs.
Gold’s assumption is correct.
27. Expansion, break-even analysis, and leverage (LO2, 3, and 4) Delsing Canning
Company is considering an expansion of its facilities. Its current income statement is as
follows:
Sales .................................................................. $6,500,000

Less: Variable expense (50% of sales) ........... 3,250,000
Fixed expense .............................................. 1,950,000
Earnings before interest and taxes (EBIT) ........ 1,300,000
Interest (10% cost) ............................................ 500,000
Earnings before taxes (EBT) ............................. 800,000
Tax (30%) .......................................................... 240,000
Earnings after taxes (EAT) ................................ $ 560,000
Shares of common stock—350,000 ..................
Earnings per share ............................................. $1.60
The company is currently financed with 50 percent debt and 50 percent equity (common
stock, par value of $10). In order to expand the facilities, Mr. Delsing estimates a need for
$3.5 million in additional financing. His investment banker has laid out three plans for him
to consider:
1. Sell $3.5 million of debt at 11 percent.
5-46
2. Sell $3.5 million of common stock at $25 per share.

3. Sell $1.75 million of debt at 10 percent and $1.75 million of common stock at $40 per
share.
Variable costs are expected to stay at 50 percent of sales, while fixed expenses will
increase to $2,450,000 per year. Delsing is not sure how much this expansion will add to
sales, but he estimates that sales will rise by $1.75 million per year for the next five years.
Delsing 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 $6.5
million before expansion and $7.5 million after expansion. Use the formula in
footnote 2 of the chapter.
c. The degree of financial leverage before expansion and for all three methods of
financing after expansion. Assume sales of $7.5 million for this question.
d. Compute EPS under all three methods of financing the expansion at $7.5 million in
sales (first year) and $10.4 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?
5-27. Solution:
Delsing Canning 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  $1,950,000  .50 Sales
.50 Sales  $1,950,000
Sales  $3,900,000
At break-even after expansion:
5-47
Sales  $2,450,000  .50 Sales

.50 Sales  $2,450,000
Sales  $4,900,000
b. Degree of operating leverage, before expansion, at sales of

$6,500,000
Q  P  VC  S  TVC
DOL = 
Q  P  VC   FC S  TVC  FC
$6,500,000  $3, 250,000

$6,500,000  $3, 250,000  $1,950,000
$3, 250,000
  2.50x
$1,300,000
Degree of operating leverage after expansion at sales of

$7,500,000
$7,500,000  $3,750,000
DOL =
$7,500,000  $3,750,000  $2,450,000
$3,750,000
  2.88x
$1,300,000
This could also be computed for subsequent years.
c. DFL before expansion:
EBIT
DFL =
EBIT  1
5-48
$1,300,000

$1,300,000  $500,000
$1,300,000
  1.63x
$800,000
DFL after expansion:

Compute EBIT and I for all three plans:
(50% Debt
(100% Debt) (100% and 50%
(1) Equity) (2) Equity) (3)
Sales $7,500,000 $7,500,000 $7,500,000
– TVC (.50) 3,750,000 3,750,000 3,750,000
– FC 2,450,000 2,450,000 2,450,000
EBIT $ 1,300,000 $ 1,300,000 $ 1,300,000
I – Old debt 500,000 500,000 500,000
I – New debt 385,000 0 175,000
Total
$ 885,000 $ 500,000 $ 675,000
interest
EBIT
DFL =
EBIT  I
(1) (2) (3)

$1,300,000 $1,300,000 $1,300,000
 $1,300,000  $885,000   $1,300,000  $500,000   $1,300,000  $675,000 
DFL = 3.13x 1.63x 2.08x

d. EPS @ sales of $7,500,000
5-49
(refer back to part c to get the values for EBIT and Total I)
(50% Debt
(100% (100% and 50%
Debt) (1) Equity) (2) Equity) (3)
EBIT $ $ $
1,300,000 1,300,000 1,300,000
Total I 885,000 500,000 675,000
EBT $415,000 $800,000 $625,000
Taxes (30%)
240,000 187,500
124,500
EAT $290,500 $560,000 $437,500
Shares (old) 350,000 350,000 350,000
Shares (new) 0 140,000 43,750
Total shares 350,000 490,000 393,750
EPS
(EAT/Total
shares) $0.83 $1.14 $1.11
EPS @ sales of $10,400,000

(50% Debt
(100% (100% and 50%
Debt) (1) Equity) (2) Equity) (3)
Sales $10,400,000 $10,400,000 $10,400,000
– TVC 5,200,000 5,200,000 5,200,000
– FC 2,450,000 2,450,000 2,450,000
EBIT $ 2,750,000 $ 2,750,000 $ 2,750,000
Total I 885,000 500,000 675,000
EBT $ 1,865,000 $ 2,250,000 $2,075,000
Taxes (30%) 559,500 675,000 622,500
EAT $1,305,500 $1,575,000 $1,452,500
Total shares 350,000 490,000 393,750
5-50
EPS
(EAT/Total
shares) $3.73 $3.21 $3.69
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 $10.5 million, financial
leverage begins to produce results as EBIT increases and
Plan 1 (100% debt) is the highest yielding alternative.
COMPREHENSIVE PROBLEM
Comprehensive Problem 1.
Ryan Boot Company (review of Chapters 2 through 5) (multiple LO’s from Chapters 2
through 5)
RYAN BOOT COMPANY

Balance Sheet
December 31, 2013
Assets Liabilities and Stockholders’ Equity
Cash .......................................... $ 50,000 Accounts $2,200,000
payable
..............................................
Marketable securities ............... 80,000 Accrued 150,000
expenses
..............................................
Accounts receivable ................. 3,000,000 Notes payable 400,000
(current)
..............................................
Inventory .................................. 1,000,000 Bonds 2,500,000
(10%)
..............................................
Gross plant and equipment 6,000,00 Common stock (1.7 million 1,700,000
Less ....................................... shares, par value
$1)
..............................................
5-51
Accumulated depreciation .. 2,000,000 Retained 1,180,000

earnings
..............................................
Total liabilities and $8,130,000
stockholders’
equity
Total assets ............................... $8,130,000 ..............................................
Income Statement—2013
Sates (credit) ........................................................................... $7,000,000
Fixed costs* ............................................................................ 2,100,000
Variable costs (0.60) .............................................................. 4,200,000
Earnings before interest and taxes .......................................... 700,000
Less: Interest ....................................................................... 250,000
Earnings before taxes ............................................................. 450,000
Less: Taxes @ 35% ............................................................. 157,500
Earnings after taxes ................................................................ $ 292,500
Dividends (40% payout)...................................................... 117,000
Increased retained earnings .................................................... $ 175,500
5-52
*Fixed costs include (a) lease expense of $200,000 and (b) depreciation of
$500,000.
Note: Ryan Boots also has $65,000 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.
Comprehensive Problem 1 (Continued)

Ratios
Ryan Boot
(to be filled in) Industry
Profit margin ................................... _____________ 5.75%
Return on assets .............................. _____________ 6.90%
Return on equity ............................. _____________ 9.20%
Receivables turnover ...................... _____________ 4.35X
Inventory turnover .......................... _____________ 6.50X
Fixed-asset turnover ....................... _____________ 1.85X
Total-asset turnover ........................ _____________ 1.20X
Current ratio .................................... _____________ 1.45X
Quick ratio ...................................... _____________ 1.10X
Debt to total assets .......................... _____________ 25.05%
Interest coverage ............................. _____________ 5.35X
Fixed charge coverage .................... _____________ 4.62X
a. Analyze Ryan Boot Company, using ratio analysis. Compute the ratios on the prior
page for Ryan 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 sales dollars and the cash
break-even point. Also compute the degree of operating leverage, degree of financial
leverage, and degree of combined leverage. (Use footnote 2 for DOL and footnote 3
in the chapter for DCL.)
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 Ryan Boot.
Ryan Boot Company is trying to plan the funds needed for 2014. The management
anticipates an increase in sales of 20 percent, which can be absorbed without increasing
fixed assets.
d. What would be Ryan’s needs for external funds based on the current balance sheet?
Compute RNF (required new funds). Notes payable (current) and bonds are not part
of the liability calculation.
5-53
e. What would be the required new funds if the company brings its ratios into line with
the industry average during 2014? Specifically examine receivables turnover,
inventory turnover, and the profit margin. Use the new values to recompute the
factors in RNF (assume liabilities stay the same).
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 5-1. Solution:
Ryan Boot Company
a. Ratio analysis Ryan Industry
Profit margin $292,500/$7,000,000 4.18% 5.75%
Return on assets $292,500/$8,130,000 3.60% 6.90%
Return on equity $292,500/$2,880,000 10.16% 9.20%
Receivable turnover $7,000,000/$3,000,000 2.33x 4.35x
Inventory turnover $7,000,000/$1,000,000 7.00x 6.50x
Fixed asset turnover $7,000,000/$4,000,000 1.75x 1.85x
Total asset turnover $7,000,000/$8,130,000 .86x 1.20x
Current ratio $4,130,000/$2,750,000 1.50x 1.45x
Quick ratio $3,130,000/$2,750,000 1.14x l.l0x
Debt to total assets $5,250,000/$8,130,000 64.58 25.05
Interest coverage $700,000/$250,000 2.80x 5.35x
Fixed charge coverage See calculation below* 1.64x 4.62x
$700,000+200,000(Lease)
*  1.64x
$250,000  200,000  65,000 / (1  .35)
Lease expense of $200,000 and sinking fund of $65,000
5-54
a. The company has a lower profit margin than the industry and
the problem is further compounded by the slow turnover of
assets (.86x versus an industry norm of 1.20x). 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 accounts receivable. The firm’s
accounts receivable turnover ratio is only 2.33x, versus an
industry norm of 4.35x. Actually, the firm does quite well
with inventory turnover and it 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)
Sales BE  $2,100,000  .60 Sales
.40 S  $2,100,000
S  $2,100,000 / .40
S  $5,250,000
5-55
Cash break-even
Sales  (Fixed costs  Noncash expenses*) + Variable costs
Sales BE  ($2,100,000  $500,000) + .60 Sales
Sales BE  $1,600,000  .60 Sales
.40 S  $1,600,000
S  $1,600,000 / .40
S  $4,000,000
*Depreciation
S  TVC
DOL 
S  TVC  FC
$7,000,000  $4,200,000

$7,000,000  $4,200,000  $2,100,000
$2,800,000
  4x
$700,000
EBIT $700,000
DFL  
EBIT  I $700,000  $250,000
$700,000
  1.56x
$450,000
S  TVC
DCL 
S  TVC  FC  I
$7,000,000  $4,200,000

$7,000,000  $4,200,000  $2,100,000  $250,000
$2,800,000
  6.22x
$450,000
5-56
5-57
c. Ryan is operating at a sales volume that is $1,750,000 above

the traditional break-even point and $3,000,000 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 1.56x is attributed to high debt reliance. Actually, if
we were to include the lease payments of $200,000 with the
interest payments of $250,000, 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 accounts
receivable rather than increase the level.
One possible use of the funds might be to pay off part of the
current notes payable of $400,000. 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 down its accounts receivable position back in line and
improve its profitability.
5-58
A L
d. Required new funds =  S   S  PS2 1  D 
S S
Change in Sales = 20%  $7,000,000= $1,400,000
$4,130,000 $2,350,000
RNF   $1,400,000    $1,400,000 
$7,000,000 $7,000,000
 4.18%  $8,400,000  (1  .4)
RNF = .590  $1,400,000   .336  $1,400,000   $351,120 .6 

 $826,000  $470,400  $210,672
 $144,928
e. Required funds if selected industry ratios were applied
Receivables = Sales/Receivable turnover
Receivables = $7,000,000/4.35
Receivables = $1,609,195
Revised A (assets)
 $50,000  $80,000  $1,609,195  $1,000,000
 $2,739,195
Profit Margin = 5.75%
A L
RNF =  S   S  PS2 1  D 
S S
5-59
$2,739,195 $2,350,000
RNF=  $1,400,000    $1,400,000 
$7,000,000 $7,000,000
 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
Required new funds (RNF) is negative, indicating there will
actually be an excess of funds equal to $212,180. This is due to
the much more rapid turnover of accounts receivable and the
higher profit margin.
f. (1) If Ryan Boots was 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.
(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.
5-60

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Chapter 05: Operating and Financial Leverage

Solution Manual for Corporate Finance Foundations

Test bank: https://testbankpack.com/p/test-bank-for-corporate-finance-

Solution manual: https://testbankpack.com/p/solution-manual-for-corporate-

Such analysis allows the firm to determine at what level of operations it

A utility is in a stable, predictable industry and therefore can afford to use

A labor-intensive company will have low fixed costs and a correspondingly

5-4. What role does depreciation play in break-even analysis based on

For break-even analysis based on accounting flows, depreciation is

The accounting flows perspective is longer term in nature because we must

5-6. Discuss the limitations of financial leverage.

Operating leverage primarily affects the operating income of the firm. At

5-9. Explain why operating leverage decreases as a company increases sales

At progressively higher levels of operations than the break-even point, the

b. Sales $284,000 (4,000 units × $71)

Profit  FC $262,500  $97,500

Rent ............................................ $230,000

Factory labor .............................. $12.50 per unit

Executives under contract .......... $514,600

Raw material .............................. $2.90 per unit

Raw materials 2.90

Revenue and costs Revenue and costs

Units produced and sold Units produced and sold

Eaton Tool Company

The break-even level decreases.

The break-even point will go up.

Calloway Cab Company

Cash-related fixed costs = Total fixed costs – Depreciation

= $2,650,000 – 10% (2,650,000)

STERLING TIRE COMPANY

Given this income statement, compute the following:

Given this income statement, compute the following:

$200,000 $200, 000

Profit or loss $36,000

35,000 ($15  $9)

7,000 bags 20,000 bags

24,000 ($20  $7.50)

a. Sales (120,000  $8) ......................................... $960,000

Total variable costs (120,000  $4) .................. 480,000

Fixed costs ........................................................ 70,000

Operating income ............................................. $410,000

b. Sales (220,000  $1,276,000

Total variable costs (220,000  990,000

a. Compute DOL based on the following formula:

Total revenue $360,000

Total variable costs $120,000

60,000 ($6  $2) $240,000

b. Stock price = P/E ×EPS

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

130,000 ($30  $10)

75,000 ($15  $6)

DESOTO TOOLS Inc.

d. The debt financing plan provides a greater earnings per share

Current Plan D Plan E

Current Plan D Plan E

If the return on assets decreases to 4.65 percent, Plan E

EBIT $1,350,000 $1,350,000 $1,350,000

Current Plan D Plan E

EBIT $2,160,000 $2,160,000 $2,160,000

Current Plan A Plan B

(f) 464,000 shares (current) + $11,400,000/$10 = 464,000 +

Sales ($2,400,000 units at $5.00) $12,000,000

Sales ($2,400,000 units at $5.00) $12,000,000

Sales .................................................................. $6,500,000