Figure 1 GENUINE MOTOR PRODUCTS Balance Sheet As of December 31, 20XW Assets Current assets $16,000,000 Capital assets Plant and equipment $20,000,000 Less: accumulated amortization 12,000,000 Net plant and equipment 8,000,000 Total assets $24,000,000 Liabilities and Shareholders Equity Current liabilities 10,000,000 Long-term liabilities: Bonds payable 10.75% 2,000,000 Total liabilities $12,000,000 Shareholders equity: Common stock, 2,000,000 shares $6,000,000 Retained earnings 6,000,000 Total shareholders equity $12,000,000 Total liabilities and shareholders equity $24,000,000

Figure 2 GENUINE MOTOR PRODUCTS Pro Forma Income Statement For 20XX Sales (1,000,000 units @ $30 per unit) $30,000,000 Total variable costs (1,000,000 units @$25 per unit) 25,000,000 Contribution margin 5,000,000 Fixed costs* 2,000,000 Operating income (EBIT) $3,000,000 Interest (10.75% x $2,000,000) 215,000 Earnings before taxes (EBT) $2,785,000 Taxes (35%) 974,750 Earnings after taxes $1,810,250 Shares 2,000,000 Earnings per share $ 0.91 * Fixed costs include$1,000,000 in amortization

In spite of Harrys arguments, Mike Anton was determined to show the impact of both operating and financial leverage on Genuine Motor Products operations. He reconstructed the year-end balance sheet for 20XW (previously shown in Figure 1), and the results are shown in Figure 3 based on the following assumptions.

That the firm would increase capital assets by $14 million dollars. That $10 million of the $14 would be funded through long-term debt in the form of additional bonds payable at an interest rate of 10.75%. The remaining $4 million would come from the sale of additional common shares at a net price to the corporation of $12.50. This would require the issuance of 320,000 new shares ($4 million/$12.50 = 320,000 shares).

The impact of these values on the balance sheet in Figure 3 shows substantially greater leverage both on the asset and liability side.

Figure 3 GENUINE MOTOR PRODUCTS

Revised Balance Sheet For the year ended December 31, 20XW

Assets Current assets $16,000,000 Capital Assets Plant and equipment $34,000,000 Less: Accumulated depreciation 12,000,000 Net plant and equipment 22,000,000 Total assets $38,000,000 Liabilities and Shareholders Equity Current liabilities 10,000,000 Long-term liabilities: Bonds payable 10.75% 12,000,000 Total liabilities $22,000,000 Shareholders equity: Common stock, 2,320,000 shares* $10,000,000** Retained earnings 6,000,000 Total shareholders equity $16,000,000 Total liabilities and shareholders equity $38,000,000 *2,000,000 old shares + 320,000 new shares = 2,320,000 shares **$6,000,000 + (320,000 new shares ($12.50 price) = = $4,000,000) The intent of using more leverage was to increase the potential profitability of the firm. You are called in as a financial analyst to rework the 20XX pro forma income statement based on the assumptions stated in Table 1. These primarily relate to the fact there are now more fixed assets, long-term debt, and shares outstanding.

Table 1 Assumptions for Revised Pro Forma Income Statement Sales will remain constant at 1,000,000 units at $30 per unit. Fixed costs will increase from $2,000,0000 to $5,800,000, a gain of $3,800,000. (Amortization expense will be $2,800,000 and this will be shown as a footnote in the 20XX pro forma income statement). Variable cost per unit will be reduced from $25 to $18.80. A total of 1,000,000 units will still be sold. The reduction in variable costs per unit is a direct result of the increased fixed costs and the associated automation. Interest expense will reflect that there is now $12 million in long-term debt in the form of bonds payable at 10.75%. Ten million dollars of new debt is being added to $2 million of old debt. Shares outstanding are now at a level of 2,320,000. Three hundred and twenty thousand new shares are being added to the 2,000,000 old shares currently outstanding.

Required Complete the revised pro forma income statement below. In the process, refer back to Figure 2, the original pro forma income statement for 20XX and the assumptions in Table 1. The new statement you are developing below will be referred to as Figure 4 for purposes of reference.

Figure 4 GENUINE MOTOR PRODUCTS Revised Pro forma Income Statement For 20XX Sales (1,000,000 units @ $30 per unit) $30,000,000 Total variable costs (1,000,000 units @ $18.80 per unit Contribution margin Fixed costs* 5,800,000 Operating income (EBIT) Interest (10.75% x $12,000,000) Earnings before taxes (EBT) Taxes (35%) Earnings after taxes Shares 2,320,000 Earnings per share $ 1.15 * Fixed costs include $2,800,000 in amortization

Required Explain the primary reasons for the change in earnings per share between Figure 2 and Figure 4. To determine the extent the company is more leveraged than it was prior to changes suggested by Mike Anton, compute degree of operating leverage (DOL), degree of financial leverage (DFL), and degree of combined leverage (DCL) both for Figure 2 (before changes) and Figure 4 (after changes). Use equations 54, 56, and 510 from the text. Using the same financial statements (Figure 2 and Figure 4), compute the breakeven point before and after the changes. Use equation 52 from the text. Assume you use a different measure of break-even analysis. The answer to question 4 tells you the number of units the firm needs to sell to cover fixed costs. Assume you are interested in covering all cash outflows and, furthermore, will use only cash flow numbers rather than accounting numbers. The cash outflows to be covered are (Fixed costs amortization) plus interest payments.

The formula for the revised break-even (BE) point is:

"Revised BE "= (("Fixed costs - amortization" ) +" Interest" )/"Price " (P)" - " ("VC" )" variable cost per unit"

Apply this formula to Figure 2 to get the revised break-even point before the changes and Figure 4 to get the revised break-even point after the changes. (Note the value for amortization can be found as a footnote at the bottom of the two figures). Harry Engle suggests that the company could be in trouble if Mike Antons changes are put in place (as reflected in Figure 4) and sales volume is only 300,000 units. Using your revised break-even answers from question 5, do you agree? Finally, assume sales volume reaches 1,500,000 units after Mike Antons changes are put into place. What will the new figure be for earnings per share? Under the old plan, earnings per share at 1,500,000 units would be $1.72. Sales (1,500,000 units @ $30 per unit) $45,000,000 Total variable costs (1,500,000 units @ $18.80 per unit) Contribution margin Fixed costs 5,800,000 Operating income Interest (10.75% x $12,000,000) Earnings before taxes Taxes (35%) Earnings after taxes Shares 2,320,000 Earnings per share

After computing all the numbers in the case, are you inclined to agree with Mike Anton that the changes to automation would be a good idea or Harry Engle, the chief financial officer, that they would not be? What is likely to be the key variable in determining the success or failure of the new plan?

Figure 1 GENUINE MOTOR PRODUCTS Balance Sheet As of December 31, 20XW Assets Current assets $16,000,000 Capital assets Plant and equipment $20,000,000 Less: accumulated amortization 12,000,000 Net plant and equipment 8,000,000 Total assets $24,000,000 Liabilities and Shareholders Equity Current liabilities 10,000,000 Long-term liabilities: Bonds payable 10.75% 2,000,000 Total liabilities $12,000,000 Shareholders equity: Common stock, 2,000,000 shares $6,000,000 Retained earnings 6,000,000 Total shareholders equity $12,000,000 Total liabilities and shareholders equity $24,000,000

Figure 2 GENUINE MOTOR PRODUCTS Pro Forma Income Statement For 20XX Sales (1,000,000 units @ $30 per unit) $30,000,000 Total variable costs (1,000,000 units @$25 per unit) 25,000,000 Contribution margin 5,000,000 Fixed costs* 2,000,000 Operating income (EBIT) $3,000,000 Interest (10.75% x $2,000,000) 215,000 Earnings before taxes (EBT) $2,785,000 Taxes (35%) 974,750 Earnings after taxes $1,810,250 Shares 2,000,000 Earnings per share $ 0.91 * Fixed costs include$1,000,000 in amortization

In spite of Harrys arguments, Mike Anton was determined to show the impact of both operating and financial leverage on Genuine Motor Products operations. He reconstructed the year-end balance sheet for 20XW (previously shown in Figure 1), and the results are shown in Figure 3 based on the following assumptions.

That the firm would increase capital assets by $14 million dollars. That $10 million of the $14 would be funded through long-term debt in the form of additional bonds payable at an interest rate of 10.75%. The remaining $4 million would come from the sale of additional common shares at a net price to the corporation of $12.50. This would require the issuance of 320,000 new shares ($4 million/$12.50 = 320,000 shares).

The impact of these values on the balance sheet in Figure 3 shows substantially greater leverage both on the asset and liability side.

Figure 3 GENUINE MOTOR PRODUCTS

Revised Balance Sheet For the year ended December 31, 20XW

Assets Current assets $16,000,000 Capital Assets Plant and equipment $34,000,000 Less: Accumulated depreciation 12,000,000 Net plant and equipment 22,000,000 Total assets $38,000,000 Liabilities and Shareholders Equity Current liabilities 10,000,000 Long-term liabilities: Bonds payable 10.75% 12,000,000 Total liabilities $22,000,000 Shareholders equity: Common stock, 2,320,000 shares* $10,000,000** Retained earnings 6,000,000 Total shareholders equity $16,000,000 Total liabilities and shareholders equity $38,000,000 *2,000,000 old shares + 320,000 new shares = 2,320,000 shares **$6,000,000 + (320,000 new shares ($12.50 price) = = $4,000,000) The intent of using more leverage was to increase the potential profitability of the firm. You are called in as a financial analyst to rework the 20XX pro forma income statement based on the assumptions stated in Table 1. These primarily relate to the fact there are now more fixed assets, long-term debt, and shares outstanding.

Table 1 Assumptions for Revised Pro Forma Income Statement Sales will remain constant at 1,000,000 units at $30 per unit. Fixed costs will increase from $2,000,0000 to $5,800,000, a gain of $3,800,000. (Amortization expense will be $2,800,000 and this will be shown as a footnote in the 20XX pro forma income statement). Variable cost per unit will be reduced from $25 to $18.80. A total of 1,000,000 units will still be sold. The reduction in variable costs per unit is a direct result of the increased fixed costs and the associated automation. Interest expense will reflect that there is now $12 million in long-term debt in the form of bonds payable at 10.75%. Ten million dollars of new debt is being added to $2 million of old debt. Shares outstanding are now at a level of 2,320,000. Three hundred and twenty thousand new shares are being added to the 2,000,000 old shares currently outstanding.

Required Complete the revised pro forma income statement below. In the process, refer back to Figure 2, the original pro forma income statement for 20XX and the assumptions in Table 1. The new statement you are developing below will be referred to as Figure 4 for purposes of reference.

Figure 4 GENUINE MOTOR PRODUCTS Revised Pro forma Income Statement For 20XX Sales (1,000,000 units @ $30 per unit) $30,000,000 Total variable costs (1,000,000 units @ $18.80 per unit Contribution margin Fixed costs* 5,800,000 Operating income (EBIT) Interest (10.75% x $12,000,000) Earnings before taxes (EBT) Taxes (35%) Earnings after taxes Shares 2,320,000 Earnings per share $ 1.15 * Fixed costs include $2,800,000 in amortization

Required Explain the primary reasons for the change in earnings per share between Figure 2 and Figure 4. To determine the extent the company is more leveraged than it was prior to changes suggested by Mike Anton, compute degree of operating leverage (DOL), degree of financial leverage (DFL), and degree of combined leverage (DCL) both for Figure 2 (before changes) and Figure 4 (after changes). Use equations 54, 56, and 510 from the text. Using the same financial statements (Figure 2 and Figure 4), compute the breakeven point before and after the changes. Use equation 52 from the text. Assume you use a different measure of break-even analysis. The answer to question 4 tells you the number of units the firm needs to sell to cover fixed costs. Assume you are interested in covering all cash outflows and, furthermore, will use only cash flow numbers rather than accounting numbers. The cash outflows to be covered are (Fixed costs amortization) plus interest payments.

The formula for the revised break-even (BE) point is:

"Revised BE "= (("Fixed costs - amortization" ) +" Interest" )/"Price " (P)" - " ("VC" )" variable cost per unit"

Apply this formula to Figure 2 to get the revised break-even point before the changes and Figure 4 to get the revised break-even point after the changes. (Note the value for amortization can be found as a footnote at the bottom of the two figures). Harry Engle suggests that the company could be in trouble if Mike Antons changes are put in place (as reflected in Figure 4) and sales volume is only 300,000 units. Using your revised break-even answers from question 5, do you agree? Finally, assume sales volume reaches 1,500,000 units after Mike Antons changes are put into place. What will the new figure be for earnings per share? Under the old plan, earnings per share at 1,500,000 units would be $1.72. Sales (1,500,000 units @ $30 per unit) $45,000,000 Total variable costs (1,500,000 units @ $18.80 per unit) Contribution margin Fixed costs 5,800,000 Operating income Interest (10.75% x $12,000,000) Earnings before taxes Taxes (35%) Earnings after taxes Shares 2,320,000 Earnings per share

After computing all the numbers in the case, are you inclined to agree with Mike Anton that the changes to automation would be a good idea or Harry Engle, the chief financial officer, that they would not be? What is likely to be the key variable in determining the success or failure of the new pl