Discussion Questions

5-1. Such analysis allows the firm to determine at what level of operations it will break even
and to explore the relationship between volume, costs, and profits. Linear B/E assumes the
same percentage changes among variables. Non-linear B/E is more realistic because it
considers other factors (i.e. overtime labour costs, etc) that cause higher or lower
percentage variations.

5-2. 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.

5-3. A labour-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.

5-4. For break-even analysis based on accounting flows, amortization 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.

5-5. 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.

5-6. 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 greatest in industries that
are highly cyclical in nature.

5-7. The higher the interest rate on new debt, the less attractive financial leverage is to the firm.

5-8. Operating leverage primarily affects the operating income of the firm. At this point,
financial leverage takes over and determines the overall impact on earnings per share. A
delineation of the combined effect of operating and financial leverage is presented in Table
5-6 and Figure 5-5.

5-9. 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.
5-10. The starting level of sales is significant because we measure what can happen at that point.
Note that in formula 5-3, we must specify the quantity or beginning point at which degree
of operating leverage is being computed.

5-11. Financial leverage, or the use of debt, not only determines how much interest we must pay
but also the number of shares of common stock that we must issue to support the non-debt
portion of our capital structure. Only by examining “earnings per share” can we pick up
the effect of outstanding shares on the operation of the firm.

5-12. The indifference point 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.

5-13. Television broadcasters commit to production schedules, program purchases, etc., in the
spring, create the fall/winter program schedule, and then send the salespeople out to sell
advertising air time for the coming season. Thus, the costs are virtually 100% locked in
before any revenues are generated. A minor fluctuation in advertising revenue, therefore,
has a major effect on operating earnings.

5-14. Students may come up with many points worth discussing. Emphasis should be directed to
the tremendous debt load that required servicing. Consumer demand slowed down
affecting cash flows, and increased interest rates at the end of an economic cycle had the
same effect. Coupled with the excessive prices paid (particularly for Federated Stores) this
caused problems. There was only a small margin for error. Discussion may also include
Robert Campeau’s ego, failure to follow advice, and failure to achieve asset sales at
projected prices. Campeau’s gamble was risky but it was close.
LBOs in the 80’s and 90’s were financed at interest rates generally over 10% in comparison
to much lower rates of today. This makes the LBO less costly but there are fewer
opportunities.
Problems

5-1. SUS Appliances

FC $80,000 $80,000
a. BE = = = = 16,000 toasters
P - VC $20 − $15 $5

b. Sales $320,000 (16,000 × $20)

– variable costs 240,000 (16,000 × $15)
Contribution margin 80,000
– fixed costs 80,000
Total operating profit $ 0

5-2. Harmon Corporation

FC $40,000 $40,000
a. BE = = = = 3,636 bats
P - VC $25.00 − $14.00 $11.00

FC+Profit $𝟒𝟎,𝟎𝟎𝟎+$𝟐𝟓,𝟎𝟎𝟎 $𝟔𝟓,𝟎𝟎𝟎

b. 𝑸 = = = = 𝟓, 𝟗𝟎𝟗 bats
P-VC $𝟐𝟓.𝟎𝟎−$𝟏𝟒.𝟎𝟎 $𝟏𝟏.𝟎𝟎
5-5. Shawn Penn & Pencils

FC $80,000 $80,000
c. BE (before) = = = = 32,000 units
P - VC $5.00 − $2.50 $2.50
FC $120,000 $120,000
BE (after) = = = = 40,000 units
P - VC $5.00 − $2.00 $3.00

FC  Return $80,000  1.30 $104,000

d. Q (before) = = = = 41,600 units
P - VC $5.00 − $2.50 $2.50
FC  Return $120,000  1.30 $156,000
Q (after ) = = = = 52,000 units
P - VC $5.00 − $2.00 $3.00

5-8. Base Timber Company

Cash-related fixed costs = Total fixed costs – Amortization

= $6,500,000 – 10% (6,500,000)
= $6,500,000 – $650,000
= $5,850,000

5,850,000
BE = = 650,000 units
$9
5-11. Freudian Slips and Gowns, Inc.

Q = 30,000, P = $25, VC = $7, FC = $270,000, I = $170,000

e.
Q (𝑃 − VC) 30,000 ($25 − $7)
DOL = =
Q (𝑃 − VC) − FC 30,000 ($25 − $7) − $270,000
30,000 ($18) $540,000 𝐶𝑀
= = =
30,000 ($18) − $270,000 $270,000 𝐸𝐵𝐼𝑇
= 2.0 ×

𝐸𝐵𝐼𝑇 $270,000
f. 𝐷𝐹𝐿 = = $100,000 = 2.7 ×
𝐸𝐵𝑇

g.
Q (𝑃 − VC)
DCL =
Q (𝑃 − VC) − FC − 𝐼
30,000 ($25 − $7)
=
30,000 ($25 − $7) − $270,000 − $170,000
30,000 ($18) $540,000 𝐶𝑀
= = =
30,000 ($18) − $440,000 $100,000 𝐸𝐵𝑇
= 5.4 ×

A 30% increase in sales will increase eps by 162% (5.4 × 30% = 162%).
Financial leverage will have the greater impact (2.7 × versus 2.0×).

FC $27𝟎,𝟎𝟎𝟎 $270,𝟎𝟎𝟎
h. BE = = = = 15,000 𝑢𝑛𝑖𝑡𝑠
P-VC $25−$7 $18

FC $270,000+$170,000
i. BE = = = 24,444 𝑢𝑛𝑖𝑡𝒔
P-VC $18