Unit 5

Breakeven Analysis, Capital structure, Leverage

Learning outcomes

After studying this unit, you should be able to:

• Differentiate between the three cost elements, namely, fixed cost, variable cost
and total cost.
• Describe how to use these three cost elements in breakeven analysis.
• Determine the breakeven value for a single project.
• Calculate the breakeven value between two alternatives and use it to select one
alternative.
• Use Excel to solve breakeven problems.
• Explain influence of debt in the capital structure of a company.
• Explain the different ratios in the financial statements and how those values can
support better decision-making.

1. INTRODUCTION

Reading:
To complete this unit, study the following sections in conjunction with chapter 9, titled
Breakeven Analysis on pages 310 and 368–370.

A worrying factor for management of any company is to be familiar with available safety
factors in case of a drop or increase in the sales price or the costs involved in the
profitability of a project for the company. The breakeven analysis can give some
guidance on the following:
• How much sales can drop before the project starts making a loss.
• What the increase in profits would be if the price is increased.
• How much costs would have to drop to ensure an increase in the
profitability of the project.
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 • How much costs can increase while still making a profit or just breaking
even.
The company management can also use this technique to determine the effect
of a change in the fixed cost if, for example, they are planning an upgrade or
modernisation of the production plant.

The capital structure of a company comprises equity and debt. The ratio of equity to
debt in the capital structure is of utmost importance for the profitability of the company.
The ratio of equity to debt determines the combined leverage. If the leverage is high, it
can be very profitable for the company if everything goes well in the economy.
Otherwise if there is a slump in the economy it can be a financial disaster.

2. VARIOUS TYPES OF COSTS

2.1. Fixed Cost

The cost for the basic operating capacity of a firm is known as fixed cost. Fixed costs
are those that are unaffected by changes in activity level over a feasible range of
operations for the capacity or capability available. Fixed cost therefore does not change
within a fixed period.

2.2. Variable Costs

Variable costs are those associated with an operation that will vary in total with the
quantity of output or other measure of activity level.

Typical examples of variable costs are:

• Material to be used to manufacture products.

• Electricity required for the manufacturing equipment.

• Labour required in the manufacturing process.

2.3. Incremental Cost

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An incremental cost or revenue, refers to the additional cost or revenue that will result
from increasing the output of a system by one or more units.

2.4. Recurring Costs

Recurring costs are those costs that are repetitive and occur when an organisation
produces similar goods or services on a continuous basis. An example of a recurring
cost is the timing belt of your car that must be replaced every 100 000 kilometres.

2.5. Non-recurring Costs

Non-recurring costs are those that are not repetitive even though the total expenditure
may be cumulative over a relatively short period of time. Non-recurring costs cannot be
planned for and cannot be foreseen and do not occur at specific periods. An example of
a non-recurring cost would be when you must replace a damaged tyre on your car.

2.6. Standard Costs

Standard costs are representative costs per unit of output that are established
in advance of actual production or service delivery. When you must get the alternator on
your car fixed, the motor dealer will quote you a fixed standard price to remove, fix and
re-assemble the alternator.

2.7. Cash Cost

Cash cost is a cost paid in cash and results in actual cash flow.

2.8. Non-cash Cost (Book Cost).

Non-cash or book costs are costs that do not involve cash payments, but rather
represent the recovery of past expenditure over a fixed period of time, e.g. depreciation.

2.9. Sunk Cost

Sunk cost is a cost that occurred in the past and has no relevance to estimates of future
costs and revenues related to an alternative course of action. The fact that you bought

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the car five years ago for R300 000 does not influence what the willing buyer is now
prepared to pay for it.

2.10. Opportunity Cost

Opportunity cost is incurred because of the use of limited resources such that the
opportunity to use those resources to monetary advantage in an alternative use, is
foregone.

You have R300 000 in a savings account and you earn 10% per year on the savings
account. That means you earn R30 000 per year in interest on the investment. You now
decide to buy a car to the value of R300 000 and pay cash for it. The R30 000 interest
that you now lose is the opportunity cost of buying the car for cash instead of leaving
the money in the savings account intact.

2.11. Life Cycle Cost

Life cycle cost refers to a summation of all the costs, both recurring and non-recurring,
related to a product, structure system or service during its life span.

You buy a car for R300 000. But this is not the only cost that you are going to fork out
during the period you own the car and before you sell it. Additional cost during the
period of your ownership of the car can be:

• New tyres after 50 000 kilometres

• New timing belt after 100 000 kilometres

• New exhaust

• Service every 15 000 kilometres

2.12. Total Cost

Total cost for a project or a production unit will be the sum total of fixed cost and total
variable cost as well as all the other relevant costs associated with the project.

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3. BREAKEVEN ANALYSIS

Let us look at how a breakeven analysis is applied in predicting cost-volume, profit and
loss.
When we perform a breakeven analysis for a project, we are asking how serious
the effect of lower revenues or higher costs will be on the project or manufacturing
profitability. Managers sometimes prefer to ask how much sales can decrease
below forecasts before the project begins to lose money. This type of analysis is
known as breakeven analysis.

Breakeven problems involving two alternatives can be approached

mathematically by equating an equivalent worth of two alternatives expressed as
a function of the factor of interest. See Example 2 of the breakeven analysis of the
Honda and Robin motors in this study unit 5.

The disadvantage of break-even analysis is that only one factor at a time can be
varied.

3.1. Common factors in a breakeven analysis study

The following factors can be used to calculate the breakeven point of a project or
process:
• Annual revenue and expense
• Rate of return
• Market or salvage value
• Equipment life
• Capacity utilisation
The following examples will illustrate how the breakeven point is calculated.

Example 1 illustrates how fixed cost, variable cost and revenue are used to calculate
the breakeven point for this manufacturing process. The mathematical equation is:

Income = Volume (Revenue per unit-variable cost per unit) – fixed cost

Example 1:

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A company is manufacturing 300 units per month. Production has dropped to 250 units
per month.
Fixed cost is: R30 000 per month

Variable cost is: R90 per unit

Revenue per unit: R200

It is now important for management to know if the company would still make a profit if
the sale or production drops to 250 units. They know that on sales of 300 units the
company is making a profit. The calculation below confirms that the 250 units are below
the breakeven point and they will therefore make a loss on this product. Figure 5.1
shows the graphical solution. The breakeven point is at 272 units where the total cost
(variable + fixed cost) is equal to the revenue. Management now know that below 272
units per month they will make a loss. More than 272 units per month will mean they are
making a profit.

80 000

66 000 Loss making domain Total cost

Variable cost Profitable domain

Fixed cost 30 000

20 000 Revenue

10 000

100 200 272 300 400 units per month

Production rate per month
Figure 5.1: Graph illustrating the breakeven point where total cost equals income

Mathematical solution

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 Income = [Volume X(Price per unit – Variable cost per unit} – Fixed cost

Fixed cost is: R30 000 per month

Variable cost per unit is: R90

Revenue per unit: R200

0 = X(200 – 90) – 30 000

X = 272

• Note that each time a unit is sold, it makes a contribution of: (Contribution
margin)

Contribution Margin = Selling price – Variable cost

= 200 – 90

= 110

Fixed Cost 30000

Break even po int = = = 272
Contribution m arg in 110

• If the breakeven point in rand sales is desired, then it will be necessary to

multiply the breakeven point in units by the unit sales price.

Sales in rand at breakeven point = 272(R200) = R54 400

• The same equation can be used to determine the impact of variations in sales
volume or prices that would be needed to attain a specific income level.

Fixed cost is: R30 000 per month

Variable cost is: R90 per unit

Revenue per unit: R200

Total sales: R90 000

Income = [Volume X(Price per unit – Variable cost per unit} – Fixed cost

90 000 = Volume (200 – 90) – 30 000

Volume = 1 091 units

This result can be verified as follows:

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 Sales 1 091(200) = R218 200
- Fixed cost = R30 000
- Variable cost 1 091(90) = 98 190
Income = R90 000

• If management would like to earn 5% of the sales as income, what would the
breakeven point be?

The sales price must be reduced by 5% to determine the sales price that will be
used in the calculation = R200 - (0.05)(R200) = R190 per unit

Income = [Volume X(Price per unit – Variable cost per unit} – Fixed cost
R190
0 = VolumeX (200-0.05{200} – 90) – 30 000
0 = 100X – 30 000
X = 300

This result can be verified as follows:

Sales 300(200) = R60 000

- Fixed cost =R30 000
- Variable cost 300(90) = R27 000
Income= R3 000 = 5% of sales revenue

3.2. Breakeven Analysis between two Alternatives

Figure 5.2 illustrates the graphical solution when two projects or processes are
compared.

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 Total cost Alt.1

Total cost Alt. 2

Use Alt 1 Use Alt 2

Breakeven point

Figure 5.2: The breakeven point between two alternatives

If the number of units of the common variable is greater than the breakeven amount,
alternative 2 is selected, since the total cost will be lower. A level of operation below the
breakeven point favours alternative 1.

Example 2:

Suppose there are two alternative electric motors that provide 100-hp output. A Honda
motor can be purchased for R25 000 and has an efficiency of 80%, an estimated useful
life of 10 years, and an estimated maintenance expense of R1 500 per year. A Robin
motor will cost R19 000, has an efficiency of 74%, a useful life of 10 years, and an
annual maintenance cost of R150. Annual taxes and insurance will be 1½% of the
investment for either motor. If the MARR = 15%, how many hours per year would the
motors have to be operated at full load for the annual costs to be equal? Assume the
market value at end of 10 years is negligible and that electricity cost is R0.05 per kilo-
Watt-hour and 1 hp = 0.746 kW.

X = number of hours operation

AW for Honda motor:

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Capital recovery =25 000(A/P,15,10) = 25 000(0.1993) = R4 982.50 per year

Operating expense for power =100(0.746)(0.05)X/0.8 = R4.6625X per year

Maintenance expense = R150 per year
Taxes and insurance = 25 000(0.015) =R375 per year

AW for Robin motor

Study the illustration in figure 5.3.

Capital recovery = 19 000(A/P,15,10) = 19 000(0.1993) = R3 786.7 per year

Operating expense for power =100(0.746)(0.05)X/0.74 = R5.0405X per year
Maintenance expense = R750 per year
Taxes and insurance = 19 000(0.015) =R285 per year
At the breakeven point:
4 982.5 + 4.6625X + 150 + 375 =3 786 + 5.0405X + 750 + 285
X = 18 082 hours per year
Robin
Honda

AW

Select Robin Select Honda

18 082 Operational hours

Figure 5.3: Illustration of the breakeven point between Honda and
Robin motors

• Once the breakeven number of units has been sold, each additional unit
sold will add its contribution margin to the profit.

• The question now is which cost structure is preferred?

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 There is no correct answer to this question. The riskier option offers greater
return if sales are up but also greater losses if sales are down. It is worth
noting that managers do not have total control over the degree of leverage.
Often the nature of the industry prescribes the extent to which the business
must incur fixed costs.

Self-test Calculation

Scenario
Your company must procure a drill for exploration purposes; the two alternatives
available are illustrated in table 5.1.

Table 5.1: The data for the two alternative drills

Alternative A Alternative B
Cost to procure drill R250 000 R350 000
Useful life 6 years 8 years
Exploration holes/year 20 20
Depth of holes 100 m 100 m
Drill rate 5 m/hour 6.5 m/hour
Energy consumption 3.4Kw/hour 3.8 Kw/hour
Cost of electricity R1.64 Kw R1.64 Kw
MARR 20% 20%
Cost of one drill bit R23 000 R28 000
Life of one drill bit 230 m 300 m

Question

What would be the breakeven point in terms of metres drilled per year?

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4. DIFFERENCES BETWEEN OPERATIONAL, FINANCIAL AND COMBINED
LEVERAGE

The breakeven analysis demonstrates to management the risk if there is a change in

the revenue, variable cost and fixed cost.

Paragraph 4 demonstrates the risk that originates from the financing of the project. The
capital structure is composed of different financial instruments. Management can
use:

• Common stock/Equity

• Preferred stock

• Loans

• Bonds

Each one of these financial instruments has a cost of capital. Management must
therefore be very careful to determine what the optimum structure should be. The
capital structure implies a risk to the profitability of the project and the company.
The cost of capital has an important information value to investors as well. The
earnings per share is used by investors to decide if the value of a share is over or
underpriced. That will determine if the investor would be interested to invest in
the company. The capital structure therefore implies a financial risk for both
management and investors.

Paragraph 4.1 discusses the influence of the capital structure on the financial risk
of a company and how different financial instruments would influence the
earnings after tax and the earnings per share.

4.1. The impact of Alternative Financial instruments

It is often necessary to perform an analysis in which alternative leverage structures are

being considered along with additional financing, which increases the company’s
amount of the investment and the size of total assets.

Company XXX contemplates an extension to the production capacity at a cost of R2

000 000. The present capital structure consists of 500 000 bonds at a 10% coupon
rate and 500 000 common shares (Equity capital).

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There are two financing options to acquire the additional capital:

• Finance with 10% coupon rate bonds

• Finance additional R2 000 000 with R1 000 000 bonds and R1 000 000 common
stock at R20.
• Finance additional R2 000 000 with R2 000 000 common stock at R20.

The first calculation to be done is the earnings before interest and taxes (EBIT).
Table 5.2 illustrates the calculation of EBIT together with probability of the sales
X1 000

Table 5.2: The capital structure for structure 1

Probability of sales 0.10 0.3 0.4 0.20

Total Sales R 3 000 6 000 10 000 15 000
-Fixed costs 2 500 2 500 2 500 2 500
-Variable costs (40% of sales) 1 200 2 400 4 000 6 000
Total cost 3 700 4 900 6 500 8 500

(excluding interest )
Earnings before (700) 1 100 3 500 6 500

interest and taxes (EBIT)

Structure 1 Total investment Cost of capital Number of

In capital structure common stock

Bonds R10 (500 000) 10% 500 000

R10 par value = R5 000 000

Bonds R10 (200 000) 15% 200 000

R10 Face value = R2 000 000 New bonds

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The second step is to determine the net profit after tax and after all the interest to be
paid on the 500 000 +200 000 = 700 000 bonds. The interest to be paid on the bonds
are 10%. Table 5.3 illustrates the net profit and earnings per share.

X1000

Table 5.3: Net profit after tax and earnings per share

Probability of sales 0.10 0.30 0.40 0.20

Interest on
EBIT (700) 1 100 3 500 6 500
700 000 bonds
(Dividend 10%+15%) 800 800 800 800
Earnings before taxes (1 500) 300 2 700 5 700
(Taxes 30%) 450 (90) (810) (1 710)
Net profit after tax (1 050) 210 1 890 3 990
Earnings/Share (R) -2.2 0.42 3.78 7.98
Expected EPS(500) R3.014

Number of common shares (500)

0000)
Expected EPS = 0.10(-2.20)+0.30(0.42)+0.40(3.78)+0.20(7.98) = R3.014 per share

In structure 2, 50% of the new bonds is replaced by R100 000 common stock shares at
R20 par value. That means the total common stock is now 550 000. Table 5.4 illustrates
structure 2.

Table 5.4: Structure 2: Net profit after tax and earnings per share

Structure 2 Total investment Cost of capital Number of

In capital structure common stock
Bonds R5 000 000 10% Dividend
R10 par value
New bonds
Bonds R1 000 000 15% Dividend reduced to
R10 par value R1 000 000
Common stock R1 000 000 10% Dividend 50 000
R20 par 50 000 new
shares
0.1 0.3 0.4 0.2
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 EBIT (700) 1 100 3 500 6 500
Less: interest(10% x5 000+15%x1 000) 650 650 650 650
Earnings before taxes (1 350) 450 2 850 5 850
Less: Income tax (30%) 405 (315) (855) (1755)
Net profit after taxes (945) 135 1 995 4 095 Exp
EPS 550 shares (R) (-1.718) 0.2454 3.6272 7.4454
ecte
Expected EPS(550) 2.8398
d
EPS = 0.10(-1.7364)+0.30(0.2454)+0.40(3.6272)+0.20(7.4454) = R2.8398 per share.

In structure 3, all the new bonds are replaced by common stock. The only deductions
now, are the dividends for the bonds and common stock as illustrated in table 5.5.

Table 5.5: Structure 3, Net profit after tax and earnings per share

Structure 3 Total investment Cost of capital Number of

In capital structure common stock
Bonds R5 000 000 10% Dividend 500 000
R10 par value
Common stock R2 000 000 10% Dividend 100 000
R20 par

0.1 0.3 0.4 0.2

EBIT (700) 1 100 3 500 6 500
Less: Interest (10% x500) 500 500 500 500
Earnings before taxes (1 200) 600 3 000 6 000
Less: Income tax (30%) 360 (180) (900) (1 800)
Net profit after taxes (840) 420 2 100 4 200
EPS 600 shares (R) (-1.4) 0.7 3.5 7.0
Expected EPS(600) 1.61

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Expected EPS = 0.10(-1.4)+0.30(0.7)+0.40(3.5)+0.20(7.0) = R1.61 per share.

As the bonds are replaced by common stock the EPS becomes lower. The reason is:
• The tax advantage is diminished because lower interest is received from the bonds.
• The number of outstanding common shares are increasing to replace the bonds in
the capital structure.

5. RELATIONSHIP BETWEEN RATES OF RETURN ON TOTAL ASSETS (BEFORE

TAX) AND RATES OF RETURN ON NET WORTH (AFTER TAX) UNDER
DIFFERENT LEVERAGE CONDITIONS

Study this relationship in figure 5.4 below. Degree of

Leverage

Rate of Return Debt/Total assets = 80%

on net worth Debt/Total assets = 50%

(after tax) Debt/Total assets = 0%

Rate of return on total assets (before tax)

- Before-tax cost of capital

Figure 5.4: The influence of debt/total assets ratio on degree of leverage

• When the returns on assets are higher than the before-tax cost of capital,
then the after-tax rate of return will be positive.

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 • Whenever the return on assets exceeds the cost of debt, leverage is
favourable, and the higher the leverage factor, the higher the rate of return on
common stock.

5.1. Relationship of Financial Leverage to Operating Leverage

5.1.1. Definition of Operating Leverage

The degree of operating leverage is defined as the percentage change in operating

income that results from a percentage change in units sold. Study the illustration in figure
5.5.

Income from sales

Income

Change in units

Costs

Q( P − vc)
Operatingleverage effect =
Q( P − vc) − FC

Q = number of units

vc = variable cost per unit

P = Sales price per unit

FC = Fixed cost

Figure 5.5: Change of operating income to change in units sold

Derivation of formula:

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 The change in output is defined as ∆Q.

The change in profits is: {Q2 (P − vc) − FC} − {Q1 (P − vc) − FC})

= (Q2 − Q1 )(P − vc)

=∆Q(P – vc)

The initial profit is: Q1 (P − vc) − FC

Q( P − vc)
The percentage change in profit is:
Q( P − vc) − FC

Q( P − vc)
Q( P − vc) − FC Q( P − vc)
The percentage change in output is: =
Q Q( P − vc) − FC
Q

5.1.2. Definition: Degree of Financial Leverage

The degree of financial leverage is defined as the percentage change in earnings

available to common stockholders that is associated with a given change in earnings
before interest and taxes (EBIT).

EBIT
Degree of financial leverage =
EBIT − iB

i = cost of capital B = total debt

Derivation of formula:

The EBIT is: Q (P − vc) − FC

( EBIT − iB)(1 − T )
The earnings per share is:
N

EBIT (1 − T )
N EBIT
The percentage change in EPS is: =
( EBIT − iB)(1 − T ) EBIT − iB
N

Percentage change in EPS

The degree of financial leverage is: =
Percentage change in EBIT
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 Alternative formula to calculate DFL:

EBIT
DFL at base level EBIT =
 1 
EBIT − I −  PD x 
 1−T 

Example: The following example illustrates the calculation of the degree of financial
leverage.

EBIT R200 000

Less interest R20 000

Net profit before tax R80 000

Less tax (20%) R16 000

Net profit after tax R64 000

Less Preference share dividends (PD) R30 000

Earnings available for ordinary shareholders R34 000

Earnings per share (10 000) R3.40 per share

EBIT 200000
DFL at base level EBIT = =
 1   1 
EBIT − I −  PD x  200000− 20000 −  30000x 
 1− T   1 − 0.2 
=1.403

Financial leverage is such that an increase in the company`s EBIT results in a more
than proportional increase in the company`s earnings per share. A decrease in the EBIT
results in a more-than-proportional decrease in EPS.

Whenever the percentage change in EPS which results from a given percentage

change in EBIT is greater than the percentage change in EBIT, then financial leverage

exists. As long as DFL>1 then financial leverage exists. If it is going well with this

business, it will make lots of money because of the high value of the DFL. If things in

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the economy take a turn for the worse this company will be in trouble and suffer huge

losses.

5.1.3. Combining Operating and Financial Leverage

Q( P − vc)
Combined leverage effect =
Q( P − vc) − FC − iB

Derivation of formula:

EBIT Q( P − vc) − FC
=
EBIT − iB Q( P − vc) − FC − iB

The total leverage is equal to the degree of operating leverage times degree of financial
leverage.

Q( P − vc) Q( P − vc) − FC
Combined leverage = •
Q( P − vc) − FC Q( P − vc) − FC − iB

Q( P − vc) − FC
=
Q( P − vc) − FC − iB

Alternative calculation:
Q(P − VC )
DTL at base saleslevel Q =
 1 
Q(P − VC ) − FC − I −  PD x 
 1− T 

Sales (units) 25 000

Revenue 250 000

Less: Variable operating costs 100 000

Less: Fixed operating costs 50 000

Earnings before interest and taxes 100 000
Less: Interest 20 000
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 Net profit before taxes 80 000
Less: Tax (20%) 16 000
Net profit after tax 64 000
Less: Preference share dividends 35 000
Earnings available for ordinary shares 29 000

29000
Earnings per share( EPS ) = = 1.45
20000
25000(10 − 4)
DTL at base saleslevelQ =
 1 
25000(10 − 4) − 50000 − 20000 −  35000 x 
 1 − 0.2 

=4.1379
Companies with low fixed costs have higher variable costs. The slope of the total
cost vs. quantity graph will be fairly steep. The company with high fixed costs
has lower variable costs because of automation. Study the illustration in figure 5.7
below.

Low Fixed Cost High Fixed Cost

Figure 5.7: The influence of a change of fixed cost on the leverage

• The breakeven point for the low fixed cost, high variable company is lower
than for the higher fixed cost, low variable company.

However, it can be seen that once the higher fixed-cost company reaches its breakeven
point, its profits will be rising at a faster rate than the lower fixed-cost company. After the
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breakeven point, a small change in quantity can have a large impact on the income and
vice versa. The higher fixed-cost company therefore has the higher operating leverage.

Self-test exercise 1

1.1a. How does capital structure affect the cost of capital?

b. Should different industries, and different companies within industries, have different
capital structures and, if so, what factors lead to the differences?

c. Identify factors that lead to different business risk in different companies.

d. Propose strategies to mitigate the influence of the factors you identified in (c) to
influence the business risk.

1.2. Companies can use either debt or equity capital to finance their assets. Is one of
the two better than the other? If so, should projects be financed with all debt or all
equity? Or if the best choice is a mix of debt and equity, what is the optimal mix?

1.3a. Explain operating leverage and the influence on the profitability of a company if
there is a change in sales.

b. Use the breakeven analysis method to explain the operating leverage.

1.4. How does operating leverage affect business risk?

1.5. How does operating leverage affect the budget?

1.6. To what extent can companies control their operating leverage?

1.7. The use of debt or financial leverage concentrates the company`s business risk on
its stockholders. Is this statement correct? Motivate your decision.

1.8. What is the general relationship between operating, financial and total leverage?
Do they complement each other?

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 1.9. Is it an advantage for a company to have a high operating leverage? Motivate your
decision and explain the risk for the company.

1.10. Explain the influence of the three different types of leverage on the breakeven
point with reference to the risk for the company.

1.11. If the MARR = 20%, how many items must be produced for the two processes to
break even?

Table 5.6 below provides the data available to calculate the breakeven point.

Table 5.6: The data to calculate the breakeven point for the two processes

Machine A Machine B
Price of machine R50 000 R30 000
Useful life 8 years 5 years
Salvage value R0 R0
Installation cost/ I R5 000 R2 000
Production time/item 12 minutes 18 minutes
(0.2 hours) (0.3 hours)
Electricity consumption 1.1 Kw 1.2 Kw

Cost of electricity R1.64/Kw R1.64/Kw

Maintenance cost R1 000 every 3 000 items R2 000 every 3 500 items
produced. produced.

Labour cost R11.40/item R12.60/item

1.12. The following basic information is assumed as having been budgeted for the next
year:

Estimated sales volume: 1 000 000 units at R8,00 per unit

Variable cost: R4,80 per unit

Fixed cost: R2 500 000 per year

In order to present the effect of selling price changes on net income and the
breakeven point, it is assumed that management wishes to examine the probable
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 effect of the various price and volume conditions by looking at the following
scenarios:

1.12.1. If prices were increased by 15% and there was no change in the
volume of sales, what would be the effect on income and the breakeven point?

1.12.2. If prices were increased by 15% and the volume of sales decreased
by 10%, what would be the effect on income and the breakeven point?

1.12.3. If prices were decreased by 20% and there was no change in the
volume of sales, what would be the effect on income and the breakeven point?

1.12.4. If prices were increased by 25% and the volume of sales increased
by 20%, what would be the effect on income and the breakeven point?

1.13. Index Engineering can produce maximum 840 000 units per year. At
present, it is operating at 60% of maximum production capacity. Index
Engineering`s annual income is R504 000. The annual fixed cost is R212 000.
The variable cost is R0.392 per unit.

1.13a. What is the firm`s annual profit or loss? (Answer: R94 432)

1.13b. At what volume does the firm break even? (Answer: 348 684 or
41.51% of capacity)

1.13c. What will the profit or loss be at 75%, 85% and 90% of capacity
on the basis of constant income per unit and constant variable cost per unit of
production?

(Answer: 75% profit = R171 040 85% profit = R222 112 90% profit = 247 648)

1.14. The capital structure of a company at present is composed of 100 000 common
shares (equity) at R14 per share. The total fixed cost is therefore R1 400 000. If 50% of
the equity capital is replaced with bonds with a coupon rate (interest rate) of 10%, the
tax rate is 18%. The data available to solve the problem is provided in table 5.7 below.
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Table 5.7: The data to calculate the expected earnings per share, standard deviation and
coefficient of variance

Probability 0.1 0.35 0.4 0.15

Sales/year (R) 2 000 000 4 000 000 6 000 000 8 000 000

Fixed cost 1 400 000 1 400 000 1 400 000 1 400 000

Variable cost (40% of sales) 800 000 1 600 000 2 400 000 3 200 000

Total cost 2 200 000 3 000 000 3 800 000 4 600 000

Determine the earnings per share, the standard deviation and the coefficient of variance for the
two cases and make a recommendation as to which option should be exercised.

Feedback

Table 5.8: Answers to problem 1.14

-164 000 820 000 1 804 000 2 788 000

ATCF
-1.64 8.2 18.04 27.88
EPS(100 000)
14.104
Expected earnings per share
8.465
Standard deviation
0.6
CV

1.15. The capital structure of your company at present is composed of 50 000 common
shares (equity) at R27.50 per share. The total worth of the company is therefore
R1 375 000. The chief accountant feels that the wealth of the shareholders can be
improved by replacing 25% of the common stock capital with a loan. The interest
is 10% and the tax rate is 25%. The data available for the project under
consideration is illustrated in table 5.9 below.

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Table 5.9: Data to solve problem 1.15

Probability 0.1 0.3 0.5 0.1

Sales per year (R) 5 000 000 7 000 000 10 000 000 15 000 000
- Fixed cost 1 375 000 1 375 000 1 375 000 1 375 000
- Variable cost (30% of sales) 1 500 000 2 100 000 3 000 000 4 500 000
Total Costs 2 875 000 3 475 000 4 375 000 5 875 000

Questions

1.15.1 If the debt/assets ratio is equal to 25% (25% of equity is replaced with a loan with
interest at 10%), what would the expected earnings per share be? (Take note that the
number of common shares is now 37 500.)

1.15.2 If the debt/assets ratio is equal to 25% (25% of equity is replaced with a loan with
interest at 10%), what would the standard deviation of the expected earnings per share
be?

1.15.3 If the debt/assets ratio is equal to 25%, what would the coefficient of variation
be?
1.15.4 If the debt/assets ratio is equal to 25%, what would the return on equity be?

Feedback

1.15.1. 99.21
1.15.2. 36.74
1.15.3. 0.3704
1.15.4. 360.72

6. FINANCIAL INFORMATION AND STATEMENTS

After all the planning and approvals have been done, the final objective will be to deliver
a cost-effective solution. Every company needs an information system to highlight the
costs and revenue of a project. These results must be compared with the budget

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figures. Engineers are responsible for the capital expenditure. This task requires
dedicated acquisition, because these costs will have a profound effect on the
profitability of the project and therefore the profit for the company. The financial
information system should raise a timely warning of an imminent financial problem that
is developing. Management will then have to implement corrective action.

The information system measures business activities, processes information into

reports, and communicates the results to decision-makers. The resulting documents
report the present performance and what the financial standing of the company is. This
is vital information for management and investors.

The financial system comprises a series of three financial documents, namely

• The balance sheet

• Income statement and

• Statement of cash flow.

6.1. The balance sheet

The balance sheet reports on assets, liabilities, and stockholders` equity. The assets
are listed in order of their liquidity, or the length of time it takes to convert them to cash.
The claims are listed in the order in which they must be paid. The balance sheet is not
linked to a specific date but the date of the balance sheet should be visible. There
should always be a balance sheet at the end of the fiscal year.

The assets (current assets and long-term assets) are reported in the left column of the
balance sheet. The liabilities (current liabilities, long-term liabilities, and equity) are
shown on the right side of the balance sheet. The equity component comprises owner
contributions, such as shares in the company and retained earnings. The total value of
the assets should always be equal to the total liabilities.

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6.1.1. Elements of Cash

Of all the different elements that comprises “cash”, only cash represents actual money.
Marketable securities with a very short time until maturity that can be converted into
cash very quickly, are included in the balance sheet as cash. Receivables are bills not
yet paid by customers. Inventories show the investment in raw material, work-in-process
and finished goods.

6.1.2. Elements of liabilities

Liabilities comprise that which the company owes in money terms as well as
stockholders’ equity.

1. Preferred stock

Preferred stock ranks below debt but above common stock, in the case of bankruptcy.
The dividend payable on preferred stock, is fixed. Preferred stockholders will therefore
not benefit if the company`s earnings are increasing.

2. Common stock

The dividends declared each fiscal year are not fixed. The dividend is dependent on the
after-tax profit and the decision by management regarding what the value of the
retained earnings should be. The risk for investors is higher than for preferred stock. In
case of bankruptcy, the common stockholders are last in the queue to recuperate some
of their investment.

3. Retained earnings

Retained earnings are built up over time as the company holds back part of its earnings
rather than paying out all earnings as dividends.

4. Inventory

A company can decide to use the FIFO (first-in-first out) method of accounting. It could
also decide to use the LIFO (last-in-first-out) method. The inventory valuation method

28
can have a significant effect on financial statements. This is important when comparing
different companies.

5. Depreciation

Companies generally always use the depreciation method that will result in maximum
tax advantage within the law. In South Africa a company can use the straight-line
depreciation method or the declining balance method whichever results in the best tax
advantage for the company within the law.

6. The time dimension

The balance sheet reports the status of the assets and liabilities at any point in time. As
the company is doing business, the balance sheet will be changing all the time. There
must be a balance sheet available at the end of the fiscal year.

An example of a balance sheet can be found on page 461 in your textbook.

6.2. The income statement

The income statement will indicate if the company is making a profit or a loss during and
at the end of the fiscal year.

Net sales are shown at the top of each statement, after which various costs, including
income taxes, are subtracted to obtain the net income available to common
stockholders. A report on earnings and dividends per share is given at the bottom of the
statement. While the balance sheet can be thought of as a snapshot in time, the income
statement reports on operations over a period of time, for example the fiscal year.

An example of an income statement is shown on page 465 of your textbook.

6.3. The cash flow statement

A large net income during a year may be the same or even lower than its beginning
cash. The reason is that its net income can be used in a variety of ways. The cash flow
statement reports on what the company did with this cash flow. They could, for example

29
have invested in another venture. The cash position as reported on its balance sheet is
affected by many factors:

• Net income:

A positive net income will lead to more money in the bank.

• Noncash adjustments to net income

Net income must be adjusted to reflect noncash revenues and expenses, such
as depreciation and deferred taxes.

• Changes in working capital

Increase in current assets other than cash, such as inventories, and accounts
receivable, decrease cash. If inventories are to increase, the company must use
some of its cash available to pay for the additional inventory. This situation
occurs when a company decides to increase its production rate.

• Fixed assets

Investment in fixed assets will reduce its cash position. The sale of fixed assets
will increase cash.

• Security transactions

If a company issues stocks or bonds during the year, the funds raised will
increase its cash position.

Each of the above factors is reflected in the statement of cash flows, which
summarises the changes in a company`s cash position. The statement
comprises the following three categories:

1. Operating activities

Includes net income, depreciation, and changes in current assets and liabilities
other than cash and short-term debt.
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 2. Investing activities

Includes investments and sale of assets.

3. Financing activities

Includes raising cash by issuing short-term debt, long-term debt or stock.

Dividends and cash used to buy back outstanding debt or stock reduce cash.

An example of a cash flow statement can be found on page 469 in your

textbook.

7. DEBT MANAGEMENT ANALYSIS

The basic methods of financing a company`s debt, influence the capital structure of the
company. The capital structure will have a significant influence on the profit and the
perceived risk by investors. The management and investors will therefore require
information about the company. The management needs this information to determine
the financial status of the company. The investors need this information to determine
the long-term outlook for the company and the probability of profit and also the
probability that the company can go bankrupt.

There are numerous ratios that can be derived from the company`s financial statements
and each one can convey a message to management and investors regarding the
financial status and economic outlook for the future.

Some of the most relevant ratios are:

• Debt ratio

The debt ratio gives an indication of what proportion of the total assets of the
company is financed by debt.

The total debt = current liabilities and long-term debt

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 Total debt
Debt ratio =
Total assets
If the debt ratio becomes = 1, it means the company is financed with 100% debt. This
will scare investors as there is a risk of possible bankruptcy. If things go well, the
company would make a nice profit for its owners. If things turn for the worst, the
company would not be able to service the debt and bankruptcy is inevitable.

• Times-Interest-Earned Ratio

This ratio gives an indication of how many times the earnings before interest and taxes
cover the yearly interest.

Earnings before int erest and taxes(EBIT )

Times − int erest − earned ratio =
Interest exp enses

This ratio gives an indication as to how far operating income can decline before the
company is unable to meet its annual interest costs. Failure to meet the interest
obligation can lead to bankruptcy.

8. LIQUIDITY ANALYSIS

• Current Ratio

Current assets
Current Ratio =
Current liabilities

If current liabilities are increasing at a faster rate than the current assets, then it will only
be a matter of time before the company is in trouble.

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 • Quick (Acid-Test) Ratio

This ratio tells us whether a company could pay all of its current liabilities if they became
due immediately. It is a more stringent test than the current ratio test.

Current assets − Inventories

Current Ratio =
Current liabilities

9. ASSET MANAGEMENT ANALYSIS

• Inventory Turnover

The inventory turnover gives an indication of how many times the company sold and
had to replace its inventory over a specific period, for example, during the fiscal year.

Sales
Inventory turnover ratio =
Average inventory balance

The average level of inventory is the average of the beginning and ending inventory. A
low inventory turnover ratio indicates that the company is holding back on inventory.

• Day`s Sales Outstanding (Accounts Receivable Turnover)

This ratio is an indication of how many times a company`s accounts receivable

have been turned into cash during the year.

Re ceivables Re ceivables
DSO = =
Average sales per day Annual sales / 365

This ratio indicates how many days it takes to collect an account. This figure
relates very closely to the credit policy of the company.

• Total Asset Turnover

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 This ratio indicates how effectively a company uses its total assets to generate
its revenue.

Sales
Total assets turnover ratio =
Total assets

10. PROFITABILITY ANALYSIS

• Profit Margin on Sales

This ratio indicates the profit per rand of sales.

Net income available to common stockholders

Pr ofit m arg in on sales =
Sales

• Return on Total Assets

This ratio indicates the company`s success in using its assets to earn a profit.

Net income + int erest exp ence(1 − tax rate)

Re turn on total assets =
Average total assets

• Return on Common Equity

This ratio shows the relationship between net income and common stockholders`
investment in the company.

Net income available to common stockholders

Re turn on common equity =
Average common equity

11. MARKET VALUE ANALYSIS

• Price-to-Earnings Ratio

34
This ratio shows how much investors are prepared to pay per rand of reported profits.

Pr ice per share

P / E ratio =
Earnings per share

• Book Value per Share

The amount that would be distributed to holders of each share of common stock if all
assets were sold at their balance-sheet carrying amounts and if all creditors were paid.

Total stockholders`equity − preferred stock

Book value per share =
Average shares outs tan ding

Self-test Exercise 2

Task

2.1. Use the balance sheet on page 461, the income statement on page 465 and the
cash flow statement on page 469 of your textbook to calculate the different ratios.

2.2. Discuss your results.

Self-test Exercise 3

3.1. Explain the implications of debt in the capital structure for the profitability for equity
holders and the financial stability of the company where you are employed.

3.2. Explain the influence of the inventory policy on the financial statement.

3.3. Explain the importance of the three financial statements and how engineers would
use these statements.

3.4. Identify five different costs that you think are most important for engineers.

3.5. Discuss the importance of ratio analysis for engineers.

Reflection on study unit 5

35
1.1. Describe what you have learned from study unit 5.

1.2. How does this concur with your experience in your working environment?