Breakeven comparisons: Algebraic Given the price and cost data shown in the accompanying

table for each of the three firms, F, G, and H, answer the questions
that follow.

a. What is the operating breakeven point in units for each firm?

b. How would you rank these firms in terms of their risk?

a.
Particulars F G H
Sales(A) 18 21 30

Less variable cost (B) 6.75 13.5 12

Contribution(A-B) 11.25 7.5 18

Breakeven point (units) 45000/11.25 30000/7.50 90000/18

= =4000units =4000 units =5000units
Fixed Cost/Contribution
Breakeven point in $ $72,000 $84,000 $150,000

B )Ranking of firm in terms of

their risk
3 2 1

b. The firm with the lowest breakeven point has the least risk. The BEP of firm F is the lowest among the other firm this m
The breakeven point of H firm is highest so the risk in firm is the highest and it is ranked 1st .
 Firm F G H
Sale price per unit $ 18.00 $ 21.00 $ 30.00
Variable operating cost per unit 6.75 13.50 12.00
Fixed operating cost 45,000 30,000 90,000

among the other firm this means that it is ranked 3 rd .

Integrative: Leverage and risk Firm R has sales of 100,000 units at $2.00 per
unit, variable operating costs of $1.70 per unit, and fixed operating costs of
$6,000. Interest is $10,000 per year. Firm W has sales of 100,000 units at $2.50
per unit, variable operating costs of $1.00 per unit, and fixed operating costs of
$62,500. Interest is $17,500 per year. Assume that both firms are in the 40% tax
bracket.

a. Compute the degree of operating, financial, and total leverage for firm R.

b. Compute the degree of operating, financial, and total leverage for firm W.

c. Compare the relative risks of the two firms.

d. Discuss the principles of leverage that your answers illustrate.

Calculation of Leverage for Firm R

Degree of Operating Leverage = Contribution/ Contribution-Fixed Cost

30000/24000
1.25 times

Contribution =(Sales Price less Variable Cost ) Units

($2-$1.7)*100000
$30000

Contribution Less Fixed Cost =$30000-$6000

$24000

Degree Of financial Leverage = Earnings Before Interest and Taxes / Profit before taxes
= 24000/14000
= 1.7142 times
Earnings before interest and taxes = Contribution Less Fixed Cost
= $30000 - $6000
$24000

Profit Before Taxes = Earnings before interest and taxes Less Interest Cost
= $24000-$10000
= $14000

Degree Of Total Leverage = Degree Of operating Leverage * Degree of financial leverage

= 1.25*1.71
= 2.14 times
c. Firm R has less operating risk than Firm W but financial risk is more than Firm W.

d. If two firms have different capital structures then it is possible that they may be leveraged equally .
Total leverage is the product of operating leverage and finacial leverage, meaning if the firms have
different capital structures they may have same risk that would be associated with that capital structure
 Calculation of Leverage for Firm W

Degree of Operating Leverage = Contribution/ Contribution-Fixed Cost

150000/87500
1.714 times

Contribution =(Sales Price less Variable Cost ) Units

($2.5-$1)*100000
$150000

Contribution Less Fixed Cost =150000-62500

$87500

Degree Of financial Leverage = Earnings Before Interest and Taxes / Profit before taxes
= 87500/70000
= 1.25 times
Earnings before interest and taxes = Contribution Less Fixed Cost
= $150000-$62500
$87500

Profit Before Taxes = Earnings before interest and taxes Less Interest Cost
= $87500-$17500
= $70000

Degree Of Total Leverage = Degree Of operating Leverage * Degree of financial leverage

= 1.714*1.25
= 2.1425 times
EBIT–EPS and capital structure Data-Check is considering two capital structures. Source of capital
The key information is shown in the following table. Assume a 40% tax rate. Long-term debt $
Common stock
a. Calculate two EBIT–EPS coordinates for each of the structures by selecting any
two EBIT values and finding their associated EPS values. a.

b. Plot the two capital structures on a set of EBIT–EPS axes.

c. Indicate over what EBIT range, if any, each structure is preferred.

d. Discuss the leverage and risk aspects of each structure.

e. If the firm is fairly certain that its EBIT will exceed $75,000, which structure b. $16.00
would you recommend? Why?
$14.00

$12.00

$10.00

$8.00

$6.00

$4.00

$2.00

$-
$20,000 $40

c.

d.

e.
Source of capital Structure A Structure B
Long-term debt $100,000 at 16% coupon rate $200,000 at 17% coupon rate
Common stock 4,000 shares 2,000 shares

Structure A (EBIT = $60,000) Structure B (EBIT = $60,000)

60,000 - 16,000 = 44,000 60,000 - 34,000 = 26,000 EBIT
44,000 - (44,000 * .4) = 26,400 26,000 - (26,000 * .4) = 15,600 $ 40,000
26,400 / 4,000 = $6.60 per share 15,600 / 2,000 = $7.80 per share $ 50,000
Structure A (EBIT = $50,000) Structure B (EBIT = $50,000) $ 60,000
50,000 - 16,000 = 34,000 50,000 - 34,000 = 16,000 $ 70,000
34,000 - (34,000 * .4) = 20,400 16,000 - (16,000 * .4) = 9,600 $ 80,000
20,400 / 4,000 = $5.10 per share 9,600 / 2,000 = $4.80 per share
$16.00

$14.00

$12.00

$10.00

$8.00 Structure A EPS

Structure B EPS
$6.00

$4.00

$2.00

$-
$20,000 $40,000 $60,000 $80,000 $100,000

If the EBIT is lower than $52,000 than the best choice would be Stucture A.
But if the EBIT is over $52,000 than Structure B will have a higher EPS.
The higher the EBIT the more chance you have of losing money in Structure
A, starting as low as $52,000 although Structure B EPS Increases substantially
as EBIT increases but also vice-versa. Therefore the risk on Structure B is much
larger but more rewarding as well.
Structure B would be the obvious choice if the EBIT exceeded $75,000 because
the EPS would have already climbed much over what Structure A would've
reached.
Structure A Structure B
EPS EPS
$ 3.60 $ 1.80
$ 5.10 $ 4.80
$ 6.60 $ 7.80
$ 8.10 $ 10.80
$ 9.60 $ 13.80
Integrative: Optimal capital structure The board of directors of Morales Publishing, a.
Inc., has commissioned a capital structure study. The company has total assets of
$40,000,000. It has earnings before interest and taxes of $8,000,000 and is taxed at
a rate of 40%.

a. Create a spreadsheet like the one in Table 13.10 showing values of debt and equity
as well as the total number of shares, assuming a book value of $25 per
share.

b.
b. Given the before-tax cost of debt at various levels of indebtedness, calculate the
yearly interest expenses.

c. Using EBIT of $8,000,000, a 40% tax rate, and the information developed in
parts a and b, calculate the most likely earnings per share for the firm at various
levels of indebtedness. Mark the level of indebtedness that maximizes EPS.

d. Using the EPS developed in part c, the estimates of required return, rs, and Equation
13.12, estimate the value per share at various levels of indebtedness. Mark
the level of indebtedness in the following table that results in the maximum price c.
per share, P0.

e. Prepare a recommendation to the board of directors of Morales Publishing that

specifies the degree of indebtedness that will accomplish the firm’s goal of optimizing
shareholder wealth. Use your findings in parts a through d to justify your
recommendation.
Max EPS ->

e. If you look at part (a) of this problem, it shows that the firm can obtain the most amount d.
of shares though no debt. But as we get more into our calculations, expecially more focused
towards the EPS, you can see that if we were to base our gains off of each share individually
then and 50% debt margin would be the best option. Although for the shareholders to get
the most out of each share, looking down to the value of each share is what we are looking Max P0 ->
for. Meaning that a 30% debt margin would best fit what this firm is looking for.
% Debt Total assets $ Debt $ Equity Number of shares @ $25
0% $40,000,000 0 40,000,000 1,600,000
10 40,000,000 4,000,000 36,000,000 1,440,000
20 40,000,000 8,000,000 32,000,000 1,280,000
30 40,000,000 12,000,000 28,000,000 1,120,000
40 40,000,000 16,000,000 24,000,000 960,000
50 40,000,000 20,000,000 20,000,000 800,000
60 40,000,000 24,000,000 16,000,000 640,000

% Debt $ Total debt Before-tax $ Interest

cost of debt, rd expense
0% 0 0.00% 0
10 4,000,000 7.5 300,000
20 8,000,000 8 640,000
30 12,000,000 9 1,080,000
40 16,000,000 11 1,760,000
50 20,000,000 12.5 2,500,000
60 24,000,000 15.5 3,720,000

% Debt EBIT EBT Taxes Net Income Number of

shares
0% $ 8,000,000 $ - $ 8,000,000 $ 3,200,000 $ 4,800,000 1,600,000
10 $ 8,000,000 $ 300,000 $ 7,700,000 $ 3,080,000 $ 4,620,000 1,440,000
20 $ 8,000,000 $ 640,000 $ 7,360,000 $ 2,944,000 $ 4,416,000 1,280,000
30 $ 8,000,000 $ 1,080,000 $ 6,920,000 $ 2,768,000 $ 4,152,000 1,120,000
40 $ 8,000,000 $ 1,760,000 $ 6,240,000 $ 2,496,000 $ 3,744,000 960,000
50 $ 8,000,000 $ 2,500,000 $ 5,500,000 $ 2,200,000 $ 3,300,000 800,000
60 $ 8,000,000 $ 3,720,000 $ 4,280,000 $ 1,712,000 $ 2,568,000 640,000

Debt EPS rs P0
0% 3 10% 30
10% 3.2083333333 10.30% 31.1488673139
20% 3.45 10.90% 31.6513761468
30% 3.7071428571 11.40% 32.5187969925
40% 3.9 12.60% 30.9523809524
50% 4.125 14.80% 27.8716216216
60% 4.0125 17.50% 22.9285714286
 EPS

3
3.208333
3.45
3.707143
3.9
4.125
4.0125