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Genuine Motor Products Genuine Motor Products, located highly labour intensive as indicated by the in Southern Ontario, manufactures fact that capital assets (net plant and precisjon measuring devices to monitor equipment) represented only $8 mitlion exhanst emission systems for new and out of total assets of $24 million (Figure 1) used automobiles. Its products are sold and that variable costs per unit were \$25 in worldwide. comparison to a sales price of $30 per unit The firm hired Mike Anton in Jamuary (Figure 2). of 20XX as vice president in charge of Although he thought the pro forma manufactuning operations. Make had a income statement for 20XX as shown in bachelor's degree in industrial engineering Figure 2 looked reasonably good, he from Ryerson University and an MBA believed returns could be better if the firm from Westem University. He had spent the went to greater automation and was less last 15 years working for General Motors, dependent on labour and expensive Toyota Motor Corp. and Volvo. Atage 38, materials. he had established a good reputation for When be shared his thoughts with innovarion within the auto and auto parts Harry Engle, the chief financial officer, the industry. response he received was lukewam. Harry Upon being hired, he began looking had been with the firm in good limes as over the financial statements, particulatly well as bad over the hast 20 years and was the balance sheet as of December 31. quick to point out the advantages of not 20XW and the pro forma income statement_ being tied up with a lot of capital coss and for 20XX as shown in Figure 1 and 2 . debr during a slowdown in sales in the auto respectively. His imanediate reaction was industry. As Harry was fond of saying. that the firm had not made the move to "Geauine Motor Products does not have a automation that others in the industry had. Labour uaion and when business is bad. we The company's manufacturing process was lay people off. By gosh, you can't lay machinery and equipment off," Genuine Motor Products In spite of Hamy's arguments, Mike Anton was determinod 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 rexuls ase shown in Figure 3 based on the following assumptions. 1. That the firm would increase capital assets by $14 mallion dollars. 2. 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% 3. The remaining $4 million would come from the sale of additional common shares at a net price to the corpomtion of $12.50. This would require the issuance of 320,000 new shares ( 34 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. 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-tem debt, and shares outstanding. Table 1 Assumprions for Revised Pro Forma Income Statement 1. Sales will remain constant at 1,000,000 units at $30 per uait, 2. 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 foma income statement). 3. Variable cost per unit will be redaced 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 matomation. 4. 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 milliea of old debt. 5. 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 1. 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 Figare 4 for purposes of reference, ( 30 marks) 2. Explain the primary reasons for the change in earnings per share between Figure 2 and Figure 4. (10 marks) 3. To determine the extent the company is more leveraged than it was prior to changes suggested by Mike Aaton, compute degree of operating leverage (DOL), degree of financial leverage (DFL), and degree of combined leverage (DCT) both for Figure 2 (before changes) and Figure 4 (after changes). ( 10 marks) 4. Using the same financial statements (Figure 2 and Figure 4), compute the breakeven point before and after the changes. ( 5 marks) 5. Assume you use a different measure of break-even analysis. The answer to question 4 tells you the mumber of units the firm needs to sell to cover fixed costs. Assume you are interested in covering all cash cutflows and. funthermore, will use only cash flow numbers mather than accounting numbers. The cash outflows to be covered are (Fixed costs -ansortization) plus interest payments. The formula for the revised break-even (BE) point is: Revised BE=Price(P)(VC)variablecostperunit(Fivedcosts-amortization)+Interest Apply this fonmula to Figure 2 to get the revised break-even point before the changes and Figare 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). ( 5 marks) 6. Hamy Engle suggests that the company could be in trouble if Mike Anton's 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? Explain. ( 5 manks) 7. Assume sales volume reaches 1,500,000 units after Mike Anton's changes are put imo place. What will the new figure be for eamings per share? Under the old plan, eamings per share at 1, 500,000 units would be $1.72, ( 5 marks) 8. 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 saccess or fathre of the new plan? ( 5 marks)