PRACTICE 1

Q1.

Healthy Foods Inc. sells 50-pound bags of grapes to the military for $10 a bag. The fixed costs of this
operation are $80,000, while the variable costs of grapes are $0.10 per pound.

a. What is the break-even point in bags?

b. Calculate the profit or loss on 12,000 bags and on 25,000 bags.

c. What is the degree of operating leverage at 20,000 bags and at 25,000 bags? Why does the degree of
operating leverage change as the quantity sold increases?

d. If Healthy Foods has an annual interest expense of $10,000, calculate the degree of financial leverage
at both 20,000 and 25,000 bags.

e. What is the degree of combined leverage at both sales levels?

Q2.

DeSoto Tools Inc. is planning to expand production. The expansion will cost $300,000, which can be
financed either by bonds at an interest rate of 14 percent or by selling 10,000 shares of common stock
at $30 per share. The current income statement before expansion is as follows:

After the expansion, sales are expected to increase by $1,000,000. Variable costs will remain at 30
percent of sales, and fixed costs will increase to $800,000. The tax rate is 34 percent.

a. Calculate the degree of operating leverage, the degree of financial leverage, and the degree of
combined leverage before expansion.

b. Construct the income statement for the two alternative financing plans.

c. Calculate the degree of operating leverage, the degree of financial leverage, and the degree of
combined leverage, after expansion.
d. Explain which financing plan you favor and the risks involved with each plan

Q3. Cox Media Corporation pays an 11 percent coupon rate on debentures that are due in 10 years. The
current yield to maturity on bonds of similar risk is 8 percent. The bonds are currently callable at $1,110.
The theoretical value of the bonds will be equal to the present value of the expected cash flow from the
bonds.

a. Find the market value of the bonds using semiannual analysis.

b. Do you think the bonds will sell for the price you arrived at in part a? Why?

Q4. A $1,000 par value bond was issued 25 years ago at a 12 percent coupon rate. It currently has 15
years remaining to maturity. Interest rates on similar obligations are now 8 percent.

a. What is the current price of the bond? (Look up the answer in Table 16-2.)

b. Assume Ms. Bright bought the bond three years ago when it had a price of $1,050. What is her dollar
profit based on the bond’s current price?