Genuine Motor Products, located

in Southern Ontario, manufactures precision measuring devices to monitor exhaust emission systems for new and used automobiles. Its products are sold worldwide.

The firm hired Mike Anton in January of $20$XX as vice president in charge of manufacturing operations. Mike had a bachelor$$s degree in industrial engineering from Ryerson University and an MBA from Western University. He had spent the last $15$ years working for General Motors, Toyota Motor Corp., and Volvo. At age $38,$ he had established a good reputation for innovation within the auto and auto parts industry.

Upon being hired, he began looking over the financial statements, particularly the balance sheet as of December $31,20$XW and the pro forma income statement for $20$XX as shown in Figure $1$ and $2,$ respectively. His immediate reaction was that the firm had not made the move to automation that others in the industry had. The company$$s manufacturing process was

highly labour intensive as indicated by the fact that capital assets $($net plant and equipment$)$ represented only $$8$ million out of total assets of $$24$ million $($Figure $1)$ and that variable costs per unit were $$25$ in comparison to a sales price of $$30$ per unit $($Figure $2).$

Although he thought the pro forma income statement for $20$XX as shown in Figure $2$ looked reasonably good, he believed returns could be better if the firm went to greater automation and was less dependent on labour and expensive materials.

When he shared his thoughts with Harry Engle, the chief financial officer, the response he received was lukewarm. Harry had been with the firm in good times as well as bad over the last $20$ years and was quick to point out the advantages of not being tied up with a lot of capital costs and debt during a slowdown in sales in the auto industry. As Harry was fond of saying, $$Genuine Motor Products does not have a labour union and when business is bad, we lay people off. By gosh, you can$$t lay machinery and equipment off.$$

Figure $1$

GENUINE MOTOR PRODUCTS

Balance Sheet

As of December $31,20$XW

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 $10\mathrm{.}75\%2,000,000$

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 $20$XX

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$

$$ Interest $(10\mathrm{.}75\%$ x $$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 $ $0\mathrm{.}91$

$*$ Fixed costs include$$1,000,000$ in amortization

In spite of Harry$$s 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 $20$XW $($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 $10\mathrm{.}75\%.$

The remaining $$4$ million would come from the sale of additional common shares at a net price to the corporation of $$12\mathrm{.}50.$ This would require the issuance of $320,000$ new shares $($$$4$ million$/$$$12\mathrm{.}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 $31,20$XW

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 $10\mathrm{.}75\%12,000,000$

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

$**$$$6,000,000+(320,000$ new shares $\backslash$times $($$$12\mathrm{.}50$ price$)=$

$=$ $$4,000,000)$

The inten