Operating and Financial Leverage 1. Mix Sweet Shop bakes and sells pies. Mix has annual fixed costs of $880,000 and a variable cost per pie of $7.50. Each pie sells for $15.50 each. The firm expects to sell 500,000 pies annually. What is the break-even point in sales dollars? 2. Voellers Upholstery Co. produces inexpensive leather chairs. The average selling price for one of the chairs is $400. The variable cost per chair is $250. Voellers' has average fixed costs per year of $450,000. a.What is the break-even point in units? b.What is the break-even point in dollar sales? c.What would be the operating profit or loss associated with the production and sale of (1) 3,000 chairs, (2) 4,000 chairs? 3. Wheely Bike Manufacturers expects to produce and sell 9,000 made-to-order bicycles this year. Variable costs are 40 percent of sales while fixed costs total $600,000. At what price must each bicycle be sold for Wheely to earn EBIT of $450,000? 4. ACME, Inc. reported the following income statement for 2009: Sales $2,500,000 Variable Costs 900,000 Fixed Operating Costs 700,000 EBIT 900,000 Interest Expense 200,000 EBT 700,000 Taxes (30%) 210,000 Net Income $490,000 Earnings Per Share $4.90 If ACME's sales next year increase by 20%, ACME's EBIT will increase by %? 5. Amalgamated Mining, Inc. has very high operating leverage due to the capital intensive nature of the steel business. The firm's CEO is concerned about the variability in the firm's EPS if sales should drop, and decides to take action. Which action will reduce the variability in the firm's EPS for a given change in sales? 6. If a firm has no operating leverage and no financial leverage, then a 10% increase in sales will have what effect on EPS? 7. ) The following information pertains to the Classic Burger Restaurant chain: Sales $600,000 Variable costs 300,000 Total contribution margin 300,000 Fixed costs 100,000 EBIT 200,000 Interest expense 50,000 Earnings before taxes 150,000 Taxes (30%) 45,000 Net income $105,000 a.If sales increase by 10%, what will be the new level of EPS if the firm has 100,000 shares outstanding? b.What is the percentage increase in EPS? Explain the difference between the percentage increase in sales and the percentage increase in EPS. 8. ) The MAX Corporation is planning a $4,000,000 expansion this year. The expansion can be financed by issuing either common stock or bonds. The new common stock can be sold for $60 per share. The bonds can be issued with a 12 percent coupon rate. The firm's existing shares of preferred stock pay dividends of $2.00 per share. The company's corporate income tax rate is 46 percent. The company's balance sheet prior to expansion is as follows: MAX Corporation Current Assets $2,000,000 Fixed Assets 8,000,000 Total Assets $10,000,000 Current Liabilities $1,500,000 Bonds: (8%, $1,000 par value) 1,000,000 (10%, $1,000 par value) 4,000,000 Preferred Stock: ($100 par value) $500,000 Common Stock: ($2 par value) 700,000 Retained Earnings 2,300,000 Total Liabilities and Equity $10,000,000 a. Calculate the indifference level of EBIT between the two plans. 9. Balon Plastics, Inc. is trying to decide how best to finance a proposed $10,000,000 capital investment. Under Plan I, the project will be financed entirely with long-term 9 percent bonds. The firm currently has no debt or preferred stock. Under Plan II, common stock will be sold to net the firm $20 a share; presently, 1,000,000 shares are outstanding. The corporate tax rate for Roberts is 40 percent. a.Calculate the indifference level of EBIT associated with the two financing plans. b.Prepare an EBIT-EPS analysis chart, showing the intersection of the two financing plan lines. c.Which financing plan would you expect to cause the greatest change in EPS relative to a change in EBIT? Why? d.If EBIT is expected to be $3.1 million, which plan will result in a higher EPS? Test Questions 1. Which of the following transactions will lower a company's financial leverage? A) A mortgage loan is obtained and the proceeds are used to pay off existing short-term debt. B) Preferred stock is sold and the proceeds are used to pay off existing short-term debt. C) Common stock is sold and the proceeds are used to pay off existing short-term debt. D) Short-term debt is obtained to get the company through a period of negative net income and cash flow. 2. Dakota Oil, Inc. reported that its sales and EBIT increased by 10%, but its EPS increased by 30%. The much larger change in earnings per share could be the result of A) high operating leverage. B) high financial leverage. C) a high percentage of credit sale collections from prior years. D) high fixed costs of production. 3. A firm that uses large amounts of debt financing in an industry characterized by a high degree of business risk would have ____ earnings per share fluctuations resulting from changes in levels of sales. A) no B) constant C) large D) small 4.) Financing a portion of a firm's assets with securities bearing a fixed rate of return in hopes of increasing the return to stockholders refers to A) business risk. B) financial leverage. C) operating leverage. D) combined leverage. 5. Operating leverage refers to A) financing a portion of the firm's assets with securities bearing a fixed rate of return. B) the additional chance of insolvency borne by the common shareholder. C) the incurrence of fixed operating costs in the firm's income stream. D) a high degree of variable costs of production. 6. Financial leverage is distinct from operating leverage since it accounts for A) use of debt and preferred stock. B) variability in fixed operating costs. C) variability in sales. D) changes in EBIT. 7. Which of the following statements about operating leverage is true? A) Operating leverage reduces a firm's risk. B) Operating leverage is the responsiveness of the firm's EBIT to fluctuations in sales. C) Operating leverage involves the usage of fixed cost financial securities in the operation of a business. D) Operating leverage is the responsiveness of the firm's EPS to fluctuations in sales. 8. Which of the following statements about financial leverage is true? A) Financial leverage is the responsiveness of the firm's EBIT to fluctuations in sales. B) Financial leverage involves the incurrence of fixed operating costs in the firm's income stream. C) Financial leverage is the responsiveness of the firm's EPS to fluctuations in EBIT. D) Financial leverage reduces a firm's risk. 9. Which of the following statements about combined (operating & financial) leverage is true? A) If a firm employs both operating and financial leverage, any percent change in sales will produce a larger percent change in earnings per share. B) A firm that is in a capital-intensive industry should use a higher level of financial leverage than a firm that employs low levels of operating leverage. C) Usage of both operating and financial leverage reduces a firm's risk. D) High operating leverage and high financial leverage offset one another, meaning that if sales increase by 10%, then EPS will also increase by 10%.