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Chapter 2: 20BP_c (page 150)

Sinclair Manufacturing and Boswell Brothers Inc. are both involved in the production of brick for the homebuilding industry. Their financial information is as follows:

Capital Structure

Sinclair

Boswell

Deb @11%

\(900,000

0

Common stock, \)10 per share

600,000

\(1,500,000

Total

\)1,500,000

\(1,500,000

Common shares

60,000

150,000

Operating plans

Sales (55,000 units at \)20 each)

\(1,100,000

\)1,100,000

Less: variable cost

880,000

(\(16 per unit)

550,000

(\)10 per unit)

Fixed cost

0

305,000

Earnings before interest and taxes (EBIT)

\(220,000

\)245,000

c. Explain why you got the results you did in part b.

Short Answer

Expert verified

The degree of combined leverage computed in part b is 1, because the contribution is equal to the EBT. Contribution and EBT are equal because the fixed cost of Sinclair is nil and the boswell did not include debt in its capital structure. Hence, the contribution is equal to the EBT.

Step by step solution

01

EBT

Earning before tax is computed by deducting the interest cost and the fixed cost from the contribution. If the company is not incurring any fixed cost or the interest cost, then the contribution and EBT of the company are equal.

02

Degree of operating leverage

Degree of operating leverage is computed by dividing the contribution with the earning before tax. If the contribution is equal to the EBT of the company, then the degree of operating leverage of the company is 1.

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Most popular questions from this chapter

Perez Corporation has the following financial data for the years 20X1 and 20X2:

20X1

20X2

Sales

\(8,000,000

\)10,000,000

Cost of goods sold

6,000,000

9,000,000

Inventory

800,000

1,000,000

c. What conclusions can you draw from part a and part b?

Frantic Fast Foods had earnings after taxes of $420,000 in 20X1 with 309,000 shares outstanding. On January 1, 20X2, the firm issued 20,000 new shares. Because of the proceeds from these new shares and other operating improvements, earnings after taxes increased by 30 percent.

a. Compute earnings per share for the year 20X1.

b. Compute earnings per share for the year 20X2.

Lemon Auto Wholesalers had sales of \(1,000,000 last year, and cost of goods sold represented 78 percent of sales. Selling and administrative expenses were 12 percent of sales. Depreciation expense was \)11,000 and interest expense for the year was \(8,000. The firm’s tax rate is 30 percent.

a. Compute earnings after taxes.

b. Assume the firm hires Ms. Carr, an efficiency expert, as a consultant. She suggests that by increasing selling and administrative expenses to 14 percent of sales, sales can be increased to \)1,050,900. The extra sales effort will also reduce cost of goods sold to 74 percent of sales. (There will be a larger markup in prices as a result of more aggressive selling.) Depreciation expense will remain at \(11,000. However, more automobiles will have to be carried in inventory to satisfy customers, and interest expense will go up to \)15,800. The firm’s tax rate will remain at 30 percent. Compute revised earnings after taxes based on Ms. Carr’s suggestions for Lemon Auto Wholesalers. Will her ideas increase or decrease profitability?

Amigo Software Inc. has total assets of \(889,000, current liabilities of\)192,000, and long-term liabilities of \(154,000. There is \)87,000 in preferredstock outstanding. Thirty thousand shares of common stock have been issued.

a. Compute book value (net worth) per share.

b. If there is $56,300 in earnings available to common stockholders and the

firm’s stock has a P/E of 23 times earnings per share, what is the currentprice of the stock?

c. What is the ratio of market value per share to book value per share? (Round

to two places to the right of the decimal point.)

Stein Books Inc. sold 1,900 finance textbooks for \(250 each to High Tuition University in 20X1. These books cost \)210 to produce. Stein Books spent \(12,200 (selling expense) to convince the university to buy its books. Depreciation expense for the year was \)15,200. In addition, Stein Books borrowed $104,000 on January 1, 20X1, on which the company paid 12 percent interest. Both the interest and principal of the loan were paid on December 31, 20X1. The publishing firm’s tax rate is 30 percent. Did Stein Books make a profit in 20X1? Please verify with an income statement.
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