Solutions Manual

CHAPTER 14

OPERATING AND FINANCIAL LEVERAGE

SUGGESTED ANSWERS TO THE REVIEW QUESTIONS AND PROBLEMS

I. Questions

1. The contribution margin (CM) ratio is the ratio of the total contribution
margin to total sales revenue. It can be used in a variety of ways. For
example, the change in total contribution margin from a given change in
total sales revenue can be estimated by multiplying the change in total
sales revenue by the CM ratio. If fixed costs do not change, then a dollar
increase in contribution margin results in a dollar increase in net
operating income. The CM ratio can also be used in target profit and
break-even analysis.

2. Incremental analysis focuses on the changes in revenues and costs that

will result from a particular action.

3. Operating leverage measures the impact on net operating income of a

given percentage change in sales. The degree of operating leverage at a
given level of sales is computed by dividing the contribution margin at
that level of sales by the net operating income at that level of sales.

4. The break-even point is the level of sales at which profits are zero.

5. (a) If the selling price decreased, then the total revenue line would rise
less steeply, and the break-even point would occur at a higher unit
volume. (b) If the fixed cost increased, then both the fixed cost line and
the total cost line would shift upward and the break-even point would
occur at a higher unit volume. (c) If the variable cost increased, then the
total cost line would rise more steeply and the break-even point would
occur at a higher unit volume.

6. The margin of safety is the excess of budgeted (or actual) sales over the
break-even volume of sales. It states the amount by which sales can drop
before losses begin to be incurred.

7. The sales mix is the relative proportions in which a companys products

are sold. The usual assumption in cost-volume-profit analysis is that the
sales mix will not change.

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8. A higher break-even point and a lower net operating income could result
if the sales mix shifted from high contribution margin products to low
contribution margin products. Such a shift would cause the average
contribution margin ratio in the company to decline, resulting in less total
contribution margin for a given amount of sales. Thus, net operating
income would decline. With a lower contribution margin ratio, the break-
even point would be higher because more sales would be required to
cover the same amount of fixed costs.

9. A utility is in a stable, predictable industry and therefore can afford to

use more financial leverage than an automobile company, which is
generally subject to the influences of the business cycle. An automobile
manufacturer may not be able to service a large amount of debt when
there is a downturn in the economy.

10. A labor-intensive company will have low-fixed costs and a

correspondingly low break-even point. However, the impact of operating
leverage on the firm is small and there will be little magnification of
profits as volume increases. A capital-intensive firm, on the other hand,
will have a higher break-even point and enjoy the positive influences of
operating leverage as volume increases.

11. For break-even analysis based on accounting flows, depreciation is

considered part of fixed costs. For cash flow purposes, it is eliminated
from fixed costs. The accounting flows perspective is longer-term in
nature because we must consider the problems of equipment
replacement.

12. Both operating and financial leverage imply that the firm will employ a
heavy component of fixed cost resources. This is inherently risky
because the obligation to make payments remains regardless of the
condition of the company or the economy.

13. Debt can only be used up to a point. Beyond that, financial leverage
tends to increase the overall costs of financing to the firm as well as
encourage creditors to place restrictions on the firm. The limitations of
using financial leverage tend to be the greatest in industries that are
highly cyclical in nature.

14. The higher the interest rate on new debt, the less attractive financial
leverage is to the firm.

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15. Operating leverage primarily affects thee operating income of the firm.
At this point, financial leverage takes over and determines the overall
impact on earnings per share.

16. At progressively higher levels of operation than the break-even point, the
percentage change in operating income as a result of a percentage change
in unit volume diminishes. The reason is primarily mathematical - as we
move to increasingly higher levels of operating income, the percentage
change from the higher base is likely to be less.

17. The point of equality only measures indifference based on earnings per
share. Since, our ultimate goal is market value maximization; we must
also be concerned with how these earnings are valued. Two plans that
have the same earnings per share may call for different price-earnings
ratios, particularly when there is a differential risk component involved
because of debt.

II. Multiple Choice Questions

1. A 11. C 21. B 31. A

2. A 12. B 22. D 32. B
3. B 13. B 23. B 33. A
4. D 14. D 24. B 34. D
5. B 15. A 25. B 35. B
6. C 16. B 26. D 36. B
7. D 17. D 27. A 37. A
8. C 18. B 28. A 38. D
9. D 19. A 29. A 39. D
10. B 20. C 30. D

III. Problems

Problem 1 (Computing and Using the CM Ratio)

1. The companys contribution margin (CM) ratio is:

Total sales.................................................. 200,000

Total variable expenses.............................. 120,000
= Total contribution margin....................... 80,000
Total sales............................................... 200,000
= CM ratio................................................. 40%

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2. The change in net operating income from an increase in total sales of

1,000 can be estimated by using the CM ratio as follows:

Change in total sales.........................................................................

1,000
CM ratio........................................................................................
40 %
= Estimated change in net operating income.................................... 400

This computation can be verified as follows:

Total sales........................................ 200,000

Total units sold.............................. 50,000 units
= Selling price per unit..................... 4.00 per unit

Increase in total sales....................... 1,000

Selling price per unit..................... 4.00 per unit
= Increase in unit sales..................... 250 units
Original total unit sales.................... 50,000 units
New total unit sales.......................... 50,250 units

Original New
Total unit sales................................. 50,000 50,250
Sales................................................. 200,000 201,000
Variable expenses............................. 120,000 120,600
Contribution margin......................... 80,000 80,400
Fixed expenses................................. 65,000 65,000
Net operating income....................... 15,000 15,400

Problem 2 (Compute the Break-even Point)

1. The equation method yields the break-even point in unit sales, Q, as

follows:

Profit = Unit CM Q Fixed expenses

0 = (15 12) Q 4,200
0 = (3) Q 4,200
3Q = 4,200
Q = 4,200 3
Q = 1,400 baskets

2. The equation method can be used to compute the break-even point in

sales pesos as follows:

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Unit contribution margin

CM =
Unit selling price

CM = 3/15 = 0.20

Profit = CM ratio Sales Fixed expenses

0 = 0.20 Sales 4,200
0.20 Sales = 4,200
Sales = 4,200 0.20
Sales = 21,000

3. The formula method gives an answer that is identical to the equation

method for the break-even point in unit sales:

Fixed expenses
Unit sales to break even =
Unit CM

Unit sales to break even = 4,200/3 = 1,400 baskets

4. The formula method also gives an answer that is identical to the equation
method for the break-even point in peso sales:

Fixed expenses
Peso sales to break even =
CM ratio

Peso sales to break even = 4,200/0.20 = 21,000

Problem 3 (Compute the Margin of Safety)

1. To compute the margin of safety, we must first compute the break-even

unit sales.

Profit = Unit CM Q Fixed expenses

0 = (30 20) Q 7,500
0 = (10) Q 7,500
10Q = 7,500
Q = 7,500 10
Q = 750 units

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Sales (at the budgeted volume of 1,000 units)............ 30,000

Less break-even sales (at 750 units)........................... 22,500
Margin of safety (in pesos)........................................ 7,500

2. The margin of safety as a percentage of sales is as follows:

Margin of safety (in pesos)........................................ 7,500

Sales....................................................................... 30,000
Margin of safety percentage....................................... 25%

Problem 4 (Compute and Use the Degree of Operating Leverage)

1. The companys degree of operating leverage would be computed as

follows:

Contribution margin................................................... 48,000

Net operating income.............................................. 10,000
Degree of operating leverage..................................... 4.8

2. A 5% increase in sales should result in a 24% increase in net operating

income, computed as follows:

Degree of operating leverage..................................... 4.8

Percent increase in sales......................................... 5%
Estimated percent increase in net operating income... 24%

3. The new income statement reflecting the change in sales is:

Amount Percent of Sales

Sales............................................. 84,000 100%
Variable expenses.......................... 33,600 40%
Contribution margin...................... 50,400 60%
Fixed expenses.............................. 38,000
Net operating income.................... 12,400

Net operating income reflecting change in sales........ 12,400

Original net operating income.................................... 10,000
Percent change in net operating income..................... 24%

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Problem 5 (Target Profit and Break-Even Analysis; Margin of Safety;

CM Ratio)

1. Profit = Unit CM Q Fixed expenses

0 = (30 12) Q $216,000
0 = (18) Q 216,000
18Q = 216,000
Q = 216,000 18
Q = 12,000 units, or at 30 per unit, 360,000

Alternative solution:

Fixed expenses
Unit sales to break even =
Unit CM

Unit sales to break even = 216,000/18 = 12,000 units

or at 30 per unit, 360,000

2. The contribution margin is 216,000 because the contribution margin is

equal to the fixed expenses at the break-even point.

Target profit + Fixed expenses

Unit sold to attain target profit =
Unit CM

90,000 + 216,000
Unit sold to attain target profit =
18

Unit sold to attain target profit = 17,000 units

3. Total Unit
Sales (17,000 units 30 per unit)............ 510,000 30
Variable expenses
(17,000 units 12 per unit).................. 204,000 12
Contribution margin................................... 306,000 18

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Fixed expenses........................................... 216,000

Net operating income................................. 90,000

4. Margin of safety in peso terms:

Margin of safety in pesos = Total sales Break even sales

Margin of safety in pesos = 450,000 360,000 = 90,000

Margin of safety in percentage terms:

Margin of safety in pesos

Margin of safety percentage =
Total sales

Margin of safety percentage = 90,000/450,000 = 20%

5. The CM ratio is 60%.

Expected total contribution margin: (500,000 60%).... 300,000

Present total contribution margin: (450,000 60%)....... 270,000
Increased contribution margin.......................................... 30,000

Alternative solution:

50,000 incremental sales 60% CM ratio = 30,000

Given that the companys fixed expenses will not change, monthly net
operating income will also increase by 30,000.

Problem 6 (Operating Leverage)

1. Total Per Unit

Sales (15,000 games)................. 3,000,000 200
Variable expenses....................... 900,000 60

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Contribution margin.............................. 2,100,000 140

Fixed expenses...................................... 1,820,000
Net operating income............................ 280,000

The degree of operating leverage is:

Contribution margin
Degree of operating leverage =
Net operating income

Degree of operating leverage = 2,100,000/280,000 = 7.5

2. a. Sales of 18,000 games represent a 20% increase over last years

sales. Because the degree of operating leverage is 7.5, net
operating income should increase by 7.5 times as much, or by
150% (7.5 20%).

b. The expected total amount of net operating income for next year
would be:

Last years net operating income............................. 280,000

Expected increase in net operating income
next year (150% 280,000).............................. 420,000
Total expected net operating income....................... 700,000

Problem 7 (Multiproduct Break-even Analysis)

1.
Super Fast Dynamic Shot Total Company
Amount % Amount % Amount %
Sales............................. 150,000 100 250,000 100 400,000 100.0
Variable expenses......... 30,000 20 160,000 64 190,000 47.5
Contribution margin..... 120,000 80 90,000 36 210,000 52.5*
Fixed expenses............. 183,750
Net operating income.... 26,250
2. The break-even point for the company as a whole is:
*210,000 400,000 = 52.5%
Fixed expenses
Peso sales to break even =
Overall CM ratio

Peso sales to break even = 183,750 = 350,000

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0.525

3. The additional contribution margin from the additional sales is computed

as follows:

100,000 52.5% CM ratio = 52,500

Assuming no change in fixed expenses, all of this additional contribution

margin of 52,500 should drop to the bottom line as increased net
operating income.

This answer assumes no change in selling prices, variable costs per unit,
fixed expense, or sales mix.

Problem 8 (Break-even Analysis)

2,000,000
a. BE = = 4,000 units
1,200 700

Profit + FC 1,500,000 + 2,000,000

b. Q = =
(P VC) 1,200 700

3,500,000
Q= = 7,000 units
500

Problem 9 (Break-even Analysis)

70,000 70,000
BE (before) = = = 50,000 units
4.00 2.60 1.40

105,000 105,000
BE (after) = = = 60,000 units
4.00 2.25 1.75

The break-even point will go up.

Problem 10 (Degree of Leverage)

Q = 20,000, P = 60, VC = 30, FC = 400,000, I = 50,000

Q (P VC) 20,000 (60 30)

a. DOL = =
Q (P VC) FC 20,000 (60 30) 400,000

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20,000 (30) 600,000

= =
20,000 (30) 400,000 600,000 400,000

600,000
DOL = = 3x
200,000

EBIT 200,000
b. DFL = =
EBIT I 200,000 50,000

200,000
DFL = = 1.33x
150,000

Q (P VC)
c. DCL =
Q (P VC) FC I

20,000 (60 30)

=
20,000 (60 30) 400,000 50,000

600,000
=
600,000 400,000 50,000

600,000
DCL = = 4x
150,000

400,000 400,000
d. BE = = = 13,333 units
60 30 30

Problem 11 (Break-even Point and Degree of Leverage)

80,000 80,000
a. BE = = = 16,000 pieces
15 10 5

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b. 15,000 pieces 30,000 pieces

Sales @ 15 per piece 225,000 450,000
Less: Variable costs (10) (150,000) (300,000)
Fixed costs (80,000) (80,000)
Profit or Loss (5,000) (70,000)

Q (P VC)
c. DOL =
Q (P VC) FC

20,000 (15 10)

DOL at 20,000 =
20,000 (15 10) 80,000

100,000
DOL at 20,000 = = 5x
20,000

30,000 (15 10)

DOL at 30,000 =
30,000 (15 10) 80,000

150,000
DOL at 30,000 = = 2.14x
70,000

Leverage goes down because we are further away from the break-even
point, thus the firm is operating on a larger profit base and leverage is
reduced.
EBIT
d. DFL =
EBIT I

First, determine the profit or loss (EBIT) at 20,000 pieces. As indicated

in part (b), the profit (EBIT) at 30,000 pieces is 70,000.

20,000 pieces
Sales @ 15 per piece 300,000
Less: Variable costs (10) (200,000)
Fixed costs (80,000)
Profit or Loss (20,000)

20,000
DFL at 20,000 =
20,000 10,000

20,000
DFL at 20,000 = = 2x
10,000

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70,000
DFL at 30,000 =
70,000 10,000

70,000
DFL at 30,000 = = 1.17x
60,000

Q (P VC)
e. DCL =
Q (P VC) FC I

20,000 (15 10)

DCL at 20,000 =
20,000 (15 10) 80,000 10,000

100,000
DCL at 20,000 = = 10x
10,000

30,000 (15 10)

DCL at 30,000 =
30,000 (15 10) 80,000 10,000

150,000
DCL at 30,000 = = 2.50x
60,000

Problem 12 (Japanese Firm and Combined Leverage)

Q (P VC)
DCL =
Q (P VC) FC I

125,000 (25 5)
=
125,000 (25 5) 1,800,000 400,000

125,000 (20)
=
125,000 (20) 2,200,000

2,500,000
DCL = = 8.33x
2,500,000 2,200,000

Problem 13 (Leverage and Sensitivity Analysis)

Income Statements

a. Return on assets = 10% EBIT = 1,200,000

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Current Plan D Plan E

EBIT 1,200,000 1,200,000 1,200,000
Less: Interest 600,0001 960,0002 300,0003
EBT 600,000 240,000 900,000
Less: Taxes (45%) 270,000 108,000 405,000
EAT 330,000 132,000 495,000
Common shares 750,0004 375,000 1,125,000
EPS .44 .35 .44

(1) 6,000,000 debt @ 10%

(2) 600,000 interest + (3,000,000 debt @ 12%)
(3) (6,000,000 3,000,000 debt retired) x 10%
(4) (6,000,000 common equity) (8 par value) = 750,000 shares

Plan E and the original plan provide the same earnings per share because
the cost of debt at 10 percent is equal to the operating return on assets of
10 percent. With Plan D, the cost of increased debt rises to 12 percent,
and the firm incurs negative leverage reducing EPS and also increasing
the financial risk to Dream Company.

b. Return on assets = 5% EBIT = 600,000

Current Plan D Plan E

EBIT 600,000 600,000 600,000
Less: Interest 600,000 960,000 300,000
EBT 0 (360,000) 300,000
Less: Taxes (45%) 0 (162,000) 135,000
EAT 0 (198,000) 165,000
Common shares 750,000 375,000 1,125,000
EPS 0 (.53) .15

Return on assets = 15% EBIT = 1,800,000

Current Plan D Plan E

EBIT 1,800,000 1,800,000 1,800,000
Less: Interest 600,000 960,000 300,000
EBT 1,200,000 840,000 1,500,000

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Less: Taxes (45%) 540,000 378,000 675,000

EAT 660,000 462,000 825,000
Common shares 750,000 375,000 1,125,000
EPS .88 1.23 .73

If the return on assets decreases to 5%, Plan E provides the best EPS, and
at 15% return, Plan D provides the best EPS. Plan D is still risky, having
an interest coverage ratio of less than 2.0.

c. Return on assets = 10% EBIT = 1,200,000

Current Plan D Plan E

EBIT 1,200,000 1,200,000 1,200,000
EAT 330,000 132,000 495,000
Common shares 750,000 500,0001 1,000,0002
EPS .44 .26 .50

(1) 750,000 (3,000,000/12 per share)

= 750,000 250,000 = 500,000

(2) 750,000 + (3,000,000/12 per share)

= 750,000 + 250,000 = 1,000,000

As the price of the common stock increases, Plan E becomes more

attractive because fewer shares can be retired under Plan D and, by the
same logic, fewer shares need to be sold under Plan E.

Problem 14 (Leverage and Sensitivity Analysis)

a. Return on assets = 12%

Current Plan A Plan B

EBIT 1,500,000 2,250,000 2,250,000

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Less: Interest 1,200,0001 1,920,0003 1,200,0005

EBT 300,000 330,000 1,050,000
Less: Taxes (40%) 120,000 132,000 420,000
EAT 180,000 198,000 630,000
Common shares 200,0002 300,0004 700,0006
EPS .90 .66 .90

(1) (80% x 10,000,000) x 15% = 8,000,000 x 15% = 1,200,000

(2) (20% x 10,000,000)/ 10 = 2,000,000/10 = 200,000 shares

(3) 1,200,000 (current) + (80% x 5,000,000) x 18%

= 1,200,000 + 720,000 = 1,920,000

(4) 200,000 shares (current) + (20% x 5,000,000)/ 10

= 200,000 + 100,000 = 300,000 shares

(5) Unchanged

(6) 200,000 shares (current) + 5,000,000/10

= 200,000 + 500,000 = 700,000 shares

EBIT
b. DFL =
EBIT I

1,500,000
DFL (Current) = = 5x
1,500,000 1,200,000

2,250,000
DFL (Plan A) = = 6.82x
2,250,000 1,920,000

2,250,000
DFL (Plan B) = = 2.14x
2,250,000 1,200,000

c.
Plan A Plan B
EAT 198,000 630,000
Common shares 250,0001 450,0002
EPS .79 1.40

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(1) 200,000 shares (current) + (20% x 5,000,000)/ 20

= 200,000 + 50,000 = 250,000 shares

(2) 2000,000 shares (current) + 5,000,000/20

= 200,000 + 250,000 = 450,000 shares

Plan B would continue to provide the higher earnings per shares. The
difference between Plans A and B is even greater than that indicated in
part (a).

d. Not only does the price of the common stock create wealth to the
shareholder, which is the major objective of the financial manager, but it
greatly influences the ability to finance projects at a high or low cost of
capital.

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