Operating Leverage

13-12. Faber Corporation, a basketball hoop manufacturing firm in Hickory, Indiana, plans to branch out and begin producing basketballs in addition to basketball hoops. It has a choice of two different production methods for the basketballs. Method 1 will have variable costs of $6 per ball and fixed costs of $700,000 for the high-tech machinery, which requires little human supervision. Method 2 employs many people to hand-sew the basketballs. It has variable costs of $16.50 per ball, but fixed costs are estimated to be only $100,000. Regardless of which method CEO Norman Dale chooses, the basketballs will sell for $30 each. Marketing research indicates sales in the first year will be 50,000 balls. Sales volume is expected to increase to 60,000 in year 2.

a. Calculate the sales revenue expected in years 1 and 2.

b. Calculate the percentage change in sales revenue.

c. Calculate the earnings before interest and taxes for each year for both production methods.

d. Calculate the percentage change in EBIT for each method.

e. Calculate the year 1 degree of operating leverage for each method, using your answers from parts b and d.

f. Calculate the degree of operating leverage again. This time use only revenue, fixed costs and variable costs from year 1 (your base year) for each production method.

g. Under which production method would EBIT be more adversely affected if the sales volume did not reach the expected levels?

h. What would drive this adverse effect on EBIT?

i. Recalculate the year 1 base year EBIT and the degree of operating leverage for both production methods if year 2 sales are expected to be only 53,000 units.

Challenge Problem

13-16. Fanny Brice, owner of Funny Girl Comics, has sales revenue of $200,000, earnings before interest and taxes of $95,000, and net income of $30,000 this year. She is expecting sales to increase to $225,000 next year. The degree of operating leverage is 1.35 and the degree of financial leverage is relatively low at 1.09.

a Calculate the percentage change in EBIT Ms. Brice can expect between this year and next year.

b. How much will EBIT be next year in dollars?

c. Calculate the percentage change in net income Ms. Brice can expect between this year and next year.

d. How much net income should Ms. Brice expect next year?

e. Calculate this years degree of combined leverage (DCL).

f. Ms. Brice is considering a price increase. This would mean the percentage change in sales revenue between this year and next year would be 20 percent. If this is true, what net income (in dollars) can she expect for next year?

14-8. Two years ago a company issued $10 million in bonds with a face value of $1,000 and a maturity of 10 years. The company is supposed to put aside $1 million in a sinking fund each year to pay off the bonds. Dolly Frisco, the finance manager of the company, has found out that the bonds are selling at $800 apiece in the open market now when a deposit to the sinking fund is due. How much would Dolly save (before transaction costs) by purchasing 1,000 of these bonds in the open market instead of calling them in at $1,000 each?

Bond Conversion

14-15. Jaime Lannister invested in a $1,000 par, 10-year maturity, 11 percent coupon rate convertible bond with a conversion ratio of 30 issued by a company five years ago. The current market price for the companys common stock is $30 per share. The current required rate of return on similar but nonconvertible bonds is 13 percent. Should Mr. Lannister consider converting the bond into common stock now?

Challenge Problem

14-18. Hot Box Insulators, a public company, initially issued investment-grade, 20-year maturity, 8 percent annual coupon rate bonds 10 years ago at $1,000 par. A group of investors bought all of Hot Boxs common stock through a leveraged buyout, which turned the bonds overnight into junk bonds. Similar junk bonds are currently yielding 25 percent in the market. Calculate the current price of the original bonds.

Challenge Problem

15-17. Armand Goldman owns 60 shares of East Asia Shipping Company stock and has $750 in cash for investment. The company has offered a rights issue in which purchasing a new stock would require four rights plus $50 in cash. Current market value of the stock is $62.

a. Calculate the value of a right if the stock is selling rights-on.

b. Should Armand participate in the rights offering by buying as many shares as he can, or sell his rights and keep the shares he already owns at a diluted value?

Comprehensive Problem

15-19. The current market price of Digicomms common stock is $40 per share. The company has 600,000 common shares outstanding. To finance its growing business, the company needs to raise $2 million. Due to its already high debt ratio, the only way to raise the funds is to sell new common stock. Alvin C. York, the vice president of finance of Digicomm, has decided to go ahead with a rights issue, but he is not sure at what price the existing shareholders would be willing to buy a share of new stock. Digicomms investment banker has suggested that an analysis based on a wide range of possible prices be carried out, and the subscription prices agreed upon were $36, $33, $29, and $26 per share of new stock. Digicomms net income for the year is $1 million.

Based on the preceding information, Mr. York has asked you to carry out the following analysis:

a. For each of the possible subscription prices, calculate the number of shares that would have to be issued and the number of rights required to buy one share of new stock.

b. For each of the possible subscription prices, calculate the earnings per share immediately before and immediately after the rights offering.

c. Guy Hamilton owns 10,000 shares of Digicomm stock. For each of the possible subscription prices, calculate the maximum number of new shares Guy would be able to buy. Under each of these cases, calculate Guys total claim to earnings before and after the offering.