Chapter 15 IM 10th Ed

CHAPTER15
AnalysisandImpact
ofLeverage
CHAPTERORIENTATION
This chapter focuses on useful aids for the financial manager in determining the firm's
properfinancialstructure.Itincludesthedefinitionsofthedifferentkindsofrisk,areview
of breakeven analysis, the concepts of operating leverage, financial leverage, the
combinationofbothleverages,andtheireffectonEPS(earningspershare).
CHAPTEROUTLINE
I.
Business risk and financial risk

A.
Risk is defined as the likely variability associated with expected revenue

streams.
1.
B.
C.
The variations in the income stream can be attributed to

a.
The firm's exposure to business risk
b.
The firm's decision to incur financial risk
Business risk is defined as the variability of the firm's expected earnings before
interest and taxes.
1.
Business risk is measured by the firm's corresponding expected

coefficient of variation.
2.
Dispersion in operating income does not cause business risk. It is the

result of several influences, such as the companys cost structure,
product demand characteristics, and intra-industry competition.
Financial risk is a direct result of the firm's financing decision. It refers to the
additional variability in earnings available to the firms common stockholders
and the additional chance of insolvency borne by the common shareholder
when financial leverage is used.
98
II.
1.
Financial leverage is the financing of a portion of the firm's assets with

securities bearing a fixed rate of return in hopes of increasing the
return to the common shareholders.
2.
Financial risk is passed on to the common shareholders who must bear

most of the inconsistencies of returns to the firm after the deduction of
fixed payments.
Break-even Analysis
A.
The objective of break-even analysis is to determine the break-even quantity

of output by studying the relationships among the firms cost structure,
volume of output, and operating profit.
1.
B.
C.
D.
The break-even quantity of output results in an EBIT level equal to

zero.
Use of the model enables the financial officer to

1.
Determine the quantity of output that must be sold to cover all

operating costs.
2.
Calculate the EBIT achieved at various output levels.
Some potential applications include

1.
Capital expenditure analysis as a complementary technique to

discounted cash flow evaluation models
2.
Pricing policy
3.
Labor contract negotiations
4.
Evaluation of cost structure
5.
Financial decision making
Essential elements of the break-even model

1.
2.
Production costs must be separated into fixed costs and variable costs.
Fixed costs do not vary as the sales volume or the quantity of output
changes. Examples include
a.
Administrative salaries
b.
Depreciation
c.
Insurance premiums
Property taxes
e.
Rent
Variable costs vary in total as output changes. Variable costs are fixed
per unit of output. Examples include
a.
Direct materials
b.
Direct labor
c.
Energy cost associated with production
d.
Packaging
99
3.
4.
E.
e.
Freight-out
f.
Sales commissions
In order to implement the break-even model, it is necessary for the

financial manager to
a.
Identify the most relevant output range for planning purposes.
b.
Approximate all costs in the semifixed and semivariable range

and allocate them to the fixed and variable cost categories.
Total revenue and volume of output

a.
Total revenue (sales dollars) is equal to the selling price per

unit multiplied by the quantity sold.
b.
Volume of output refers to the firms level of operations and is

expressed as a unit quantity or sales dollars.
Finding the break-even point

1.
The break-even model is just an adaptation of the firm's income

statement expressed as
sales - (total variable costs + total fixed costs) = profit
2.
Three ways to find the break-even point are explained.

a.
b.
c.
Trial and error

(1)
Select an arbitrary output level.
(2)
Calculate the corresponding EBIT amount.
(3)
When EBIT equals zero, the break-even point has been

found.
Contribution margin analysis

(1)
Unit selling price - unit variable cost = contribution

margin
(2)
Fixed cost divided by the contribution margin per unit

equals the break-even quantity in units.
Algebraic analysis
(l)
(2)
QB
= the break-even level of units sold,
= the unit sales price,
= the total fixed cost for the period,
= unit variable cost.
Then,
QB =
F
PV
100
F.
G.
III.
The break-even point in sales dollars

1.
It is convenient to calculate the break-even point in terms of sales

dollars if the firm deals with more than one product. It can be
computed by using data from the firm's annual report.
2.
Since variable cost and selling price per unit are assumed constant, the
ratio of total variable costs to total sales is a constant for any level of
sales.
Limitations of break-even analysis

1.
Assumes linear cost-volume-profit relationship.
2.
The total revenue curve is presumed to increase linearly with the

volume of output.
3.
Assumes constant production and sales mix.
4.
This is a static form of analysis.
Operating Leverage
A.
Operating leverage is the responsiveness of a firm's EBIT to fluctuations in

sales. Operating leverage results when fixed operating costs are present in the
firm's cost structure.
B.
This responsiveness can be measured as follows:

degree of operating
% change in EBIT
leverage from the = DOLs =
% change in sales
base sales level
C.
If unit costs are available, the DOL can be measured by

DOLs =
D.
Q(P V)
Q(P V) F
If an analytical income statement is the only information available, the

following formula is used:
DOLs =
revenue before fixed costs

EBIT
S VC
S VC F
Note: All three formulas provide the same results.

E.
Implications of operating leverage

1.
At each point above the break-even level, the degree of operating

leverage decreases.
2.
At the break-even level of sales, the degree of operating leverage is

undefined.
3.
Operating leverage is present when the percentage change in EBIT

divided by the percentage change in sales is greater than one.
4.
The degree of operating leverage is attributed to the business risk that

a firm faces.
101
IV.
Financial Leverage
A.
To see if financial leverage has been used to benefit the common shareholder,
the focus will be on the responsiveness of the company's earnings per share
(EPS) to changes in its EBIT.
B.
The firm is using financial leverage and is exposing its owners to financial risk
when
% change in EPS
% change in EBIT
C.
is greater than 1.00
A measure of the firm's use of financial leverage is as follows:

degree of financial
% change in EPS
leverage from the = DFLEBIT =
% change in EBIT
base EBIT level
D.
1.
The degree of financial leverage concept can be either in the positive

or negative direction.
2.
The greater the degree of financial leverage, the greater the

fluctuations in EPS.
An easier way to measure financial leverage is

DFLEBIT =
EBIT
EBIT I
where I is the sum of all fixed financing costs

V.
Combining operating and financial leverage

A.
Changes in sales revenues cause greater changes in EBIT. If the firm chooses
to use financial leverage, changes in EBIT turn into larger variations in both
EPS and EAC. Combining operating and financial leverage causes rather large
variations in EPS.
B.
One way to measure the combined leverage can be expressed as

degree of combined
leverage from the = DCLs =
base sales level
% change in EPS
% change in sales
If the DCL is equal to 5.0 times, then a 1% change in sales will result in a 5%
change in EPS.
C.
The degree of combined leverage is the product of the two independent

leverage measures. Thus:
DCLS = (DOLS ) x (DFLEBIT)
102
D.
Another way to compute DCLs is with the following equation:

Q(P V)
DCLs =
Q(P V) F I
E.
Implications of combining operating and financial leverage

1.
Total risk can be managed by combining operating and financial

leverage in different degrees.
2.
Knowledge of the various leverage measures helps to determine the

proper level of overall risk that should be accepted.
ANSWERS TO
END-OF-CHAPTER QUESTIONS
15-1. Business risk is the uncertainty that envelops the firm's stream of earnings before
interest and taxes (EBIT). One possible measure of business risk is the coefficient of
variation in the firm's expected level of EBIT. Business risk is the residual effect of
the: (1) company's cost structure, (2) product demand characteristics, (3) intraindustry competitive position. The firm's asset structure is the primary determinant of
its business risk. Financial risk can be identified by its two key attributes: (1) the
added risk of insolvency assumed by the common stockholder when the firm chooses
to use financial leverage; (2) the increased variability in the stream of earnings
available to the firm's common stockholders.
15-2. Financial leverage is financing a portion of the firm's assets with securities bearing a
fixed (limited) rate of return. Anytime the firm uses preferred stock to finance assets,
financial leverage is employed.
15-3. Operating leverage is the use of fixed operating costs in the firm's cost structure.
When operating leverage is present, any percentage fluctuation in sales will result in a
greater percentage fluctuation in EBIT.
15-4. Break-even analysis, as it is typically presented, categorizes all operating costs as
being either fixed or variable. Based upon this division of costs, the break-even point
is computed. The computation procedure for the cash break-even point omits any
noncash expenses that the firm might incur. Typical examples of noncash expenses
include depreciation and prepaid expenses. The ordinary break-even point will always
exceed the cash break-even point, provided some noncash charges are present.
15-5. The most important shortcomings of break-even analysis are:
(1)
The cost-volume-profit relationship is assumed to be linear over the entire

range of output.
(2)
All of the firm's production is assumed to be salable at the fixed selling price.
(3)
The sales mix and production mix is assumed constant.
(4)
The level of total fixed costs and the variable cost to sales ratio is held
constant over all output and sales ranges.
103
15-6. Total risk exposure is the result of the firm's use of both operating leverage and
financial leverage. Business risk and financial risk produce this total risk. A company
that is normally exposed to a high degree of business risk may manage its financial
structure in such a way as to minimize financial risk. A firm that enjoys a stable
pattern in its earnings before interest and taxes might reasonably elect to use a high
degree of financial leverage. This would increase both its earnings per share and its
rate of return on the common equity investment.
15-7. By taking the degree of combined leverage times the sales change of a negative 15
percent, the earnings available to the firm's common shareholders will decline by 45
percent.
15-8. As the sales of a firm increase, two things occur that bias the cost and revenue
functions toward a curvilinear shape. First, sales will increase at a decreasing rate.
As the market approaches saturation, the firm must cut its price to generate sales
revenue. Second, as production approaches capacity, inefficiencies occur that result
in higher labor and material costs. Furthermore, the firm's operating system may have
to bear higher administrative and fixed costs. The result is higher per unit costs as
production output increases.
SOLUTIONS TO
END-OF-CHAPTER PROBLEMS
Solutions To Problem Set A
15-1A.
Product Line
Piano
Violin
Cello
Flute
Sales
61,250
37,500
98,750
52,500
V.C.
41,650
22,500
61,225
25,725
C.M.
19,600
15,000
37,525
26,775
C.M. Ratio
32%
40%
38%
51%
Total
250,000
151,100
98,900
40%
Break-even Point
S* = F/(1-VC/S) = 50,000/(1-VC/S) = 50,000/.4 = 125,000
F
S* = 1 VC
50,000
= 1 $151,100
$250,000
104
50,000
= 125,000
.4
15-2A. Break-even Quantity
QB
QB
F
(P V)
QB
$360,000
$30 - (.70)($30)
QB
40,000 bottles
15-3A. Degree of Operating Leverage = DOLS

DOLS =
Q(P V)
[Q(P V) F]
70% x $30
=$21
DOLS =
50,000($30 $21)
[50,000($30 $21) $360,000]
DOLS =
5 times
15-4A.
(a)
Sales
Variable Costs
Revenue before
fixed costs
Fixed costs
EBIT
Jake's
Lawn Chairs
$600,640.00
$326,222.60
Sarasota
Sky Lights
$2,450,000
$1,120,000
Jefferson
Wholesale
$1,075,470
$957,000
$274,417.40
$120,350.00
$ 154,067.40
$1,330,000
$850,000
$ 480,000
$118,470
$89,500
$ 28,970
(b)
Jake's Lawn Chairs: QB =
$120,350
F
=
$32 $17.38
PV
$120,350
= 8,232
$14.62
$850,000
= $850,000 = 1,789
$875 $400
$475
Jefferson Wholesale: QB =
$89,500
= $89,500 = 8,310
$97.77 $87
$10.77
Sarasota Skylights: QB
(c)
Jake's
Lawn Chairs
105
Sarasota
Skylights
Jefferson
Wholesale
Revenue Before
Fixed Costs
=
EBIT
=
(d)
$274,417.40
$154,067.40
$1,330,000
$480,000
$118,470
$28,970
1.78 times
2.77 times
4.09 times
Jefferson Wholesale, since its degree of operating leverage exceeds that of the
other two companies.
15-5A.
(a)
Revenue Before Fixed Costs

EBIT
(b)
EBIT
=
EBIT I
$13,750,000
$13,750,000 $1,350,000
$13,750,000
$12,400,000
(c)
(d)
DCL45,750,000
S*
$22,950,000
$13,750,000
1.67 times
=
= 1.11 times
= (1.67) (1.11) = 1.85 times
F
VC
1
S
$9,200,000
.502
$9,200,000
$22,800,000
1
$45,750,000
$9,200,000
1 .498
$18,326,693.23
(e)
(25%) (1.85) = 46.25%
(a)
QB =
(b)
F
$170,000
S* = 1 VC = 1 $58 =
S
$85
15-6A.
$170,000
$170,000
F
=
=
= 6,296 pairs of shoes
$85 $58
$27
PV
$170,000
=
1 .682
$170,000
= $534,591.20
.318
(c)
Sales
Variable Costs
Revenue before
fixed costs
Fixed costs
EBIT
7,000
Pairs of Shoes
$595,000
406,000
$189,000
170,000
$ 19,000
106
9,000
Pairs of Shoes
$765,000
522,000
$243,000
170,000
$ 73,000
15,000
Pairs of Shoes
$1,275,000
870,000
$405,000
170,000
$ 235,000
(d)
7,000
Pairs of Shoes
9,000
Pairs of Shoes
15,000
Pairs of Shoes
$189,000
$19,000
$243,000
$73,000
$405,000
$235,000
9.95 times
3.33 times
1.72 times
Notice that the degree of operating leverage decreases as the firm's sales level
rises above the break-even point.
15-7A.
(a)
QB
$630,000
$630,000
F
=
=
$
180
$
110
$70
PV
(b)
S*
9000 units $180 = $1,620,000
= 9000 Units
Alternatively,
S*
=
Note:
F
$630,000
VC =
$110
1
1
S
$180
$630,000
=
1 0.6111
$1,619,954 differs from $1,620,000 due to rounding.
(c)
Sales
Variable Costs
Revenue before
fixed costs
Fixed costs
EBIT
(d)
$630,000
= $1,619,954
.3889
12,000
units
$2,160,000
1,320,000
15,000
units
$2,700,000
1,650,000
20,000
units
$3,600,000
2,200,000
840,000
630,000
$ 210,000
1,050,000
630,000
$ 420,000
1,400,000
630,000
$ 770,000
12,000 units
15,000 units
20,000 units
$840,000
$210,000
$1,050,000
$420,000
$1,400,000
$770,000
4 times
2.5 times
1.82 times
15-8A. (a)
107
Sales
Variable costs
Revenue before
fixed costs
Fixed costs
EBIT
Blacksburg
Furniture
$1,125,000
926,250
Lexington
Cabinets
$1,600,000
880,000
$198,750
35,000
$163,750
$720,000
100,000
$620,000
Williamsburg
Colonials
$520,000
188,500
$331,500
70,000
$261,500
(b)
Blacksburg
Furniture :
QB
$35,000
$35,000
F
=
=
= 13,208
$
15
.
00
$
12
.
35
$2.65
PV
QB
$100,000
$400 $220
Williamsburg
QB
Colonials :
$70,000
$70,000
=
= 2745 units
$40.00 $14.50
$25.50
units
Lexington
Cabinets :
$100,000
= 556 units
$180
(c)
Blacksburg
Furniture
Lexington
Cabinets
Revenue Before $198,750

Fixed Costs
$163,750
EBIT
=
(d)
1.21 times
Williamsburg
Colonials
$720,000
$620,000
$331,500
$261,500
1.16 times
1.27 times
Williamsburg Colonials, since its degree of operating leverage exceeds

that of the other two companies.
15-9A.
(a)
{S- (VC + F)} (1-T) = $50,000
VC

F 1 T = $50,000
S S
S

[S VC - } (1 T) = $50,000
{$375,000 - $206,250 F} (0.6) = $50,000
($168,750 - F) (0.6) = $50,000
F = $85,416.67
(b)
QB =
F
PV
$85,416.67
= $85,416.67
$27.00 $14.85
$12.15
108
= 7,030 units
S* = 1 VC
15-10A.(a)
$85,416.67
= $189,815
1 .55
Find the EBIT level at the forecast sales volume:

EBIT
= .26
S
Therefore, EBIT = (0.26) ($3,250,000) = $845,000

Next, find total variable costs:
VC
= 0.5,
S
so,
VC = (0.5) $3,250,000 = $1,625,000
Now, solve for total fixed costs:

S - (VC + F) = $845,000
$3,250,000 - ($1,625,000 + F) = $845,000
F = $780,000
(b)
S* =
$780,000
= $1,560,000
1 0.5
15-11A.
(a)
$16,500,000
Revenue before Fixed costs
=
$8,500,000
EBIT
(b)
EBIT
EBIT I
(c)
DCL$30,000,000= (1.94) (1.13) = 2.19 times
(d)
F
S* = 1 VC
S
$8,500,000
$7,500,000
= 1.94 times
= 1.13 times
$8,000,000
= 1 $13.5m
$30.0m
$8,000,000
1 0.45
$8,000,000
0.55
$14,545,455
(e)
(25%) (2.19) = 54.75%
15-12A.Given the data for this problem, several approaches are possible for finding the
break-even point in units. The approach below seems to work well with students.
Step (1)
Compute the operating profit margin:
109
Operating Profit Margin x Operating Asset Turnover = Return

on operating assets
(M) x (5) = 0.25
M = .05
Step (2)
Compute the sales level associated with the given output level:
Sales
= 5
$20,000,000
Sales = $100,000,000
Step (3)
Compute EBIT:
(.05) ($100,000,000) = $5,000,000
Step (4)
Compute revenue before fixed costs. Since the degree of

operating leverage is 4 times, revenue before fixed costs (RBF)
is 4 times EBIT as follows:
RBF = (4) ($5,000,000) = $20,000,000
Step (5)
Compute total variable costs:

(Sales) - (Total variable costs) = $20,000,000
$100,000,000 - (Total variable costs) = $20,000,000
Total variable costs = $80,000,000
Step (6)
Compute total fixed costs:

RBF - Fixed costs = $5,000,000
$20,000,000 - fixed costs = $5,000,000
Fixed costs = $15,000,000
Step (7)
Find the selling price per unit, and the variable cost per unit:
Step (8)
P =
$100,000,000
= $10.00
10,000,000
V =
$80,000,000
= $8.00
10,000,000
Compute the break-even point:

QB =
units
F
= $15,000,000 = $15,000,000 = 7,500,000
($10) ($8)
$2
PV
110
15-13A.
(a)
(b)
QB
S*
$540,000 = $540,000 = 10,000 units

F =
$180 $126
$54
PV
F
VC =
1
S
$540,000
$126
1
$180
$540,000
$540,000
=
1 0.7
.3
= $1,800,000
(c)
Sales
Variable costs
Revenue before fixed costs
Fixed costs
12,000
Units
$2,160,000
1,512,000
$ 648,000
540,000
15,000
Units
$2,700,000
1,890,000
$ 810,000
540,000
20,000
Units
$3,600,000
2,520,000
$1,080,000
540,000
EBIT
$ 108,000
$ 270,000
$ 540,000
(d)
12,000 units
15,000 units
20,000 units
$648,000
= 6 times
$108,000
$810,000
= 3 times
$270,000
$1,080,000
= 2 times
$540,000
15-14A.
(a)
Sales
Variable costs
Fixed costs
EBIT
(b)
Oviedo Seeds: QB
Oviedo
Seeds
$1,400,000
1,120,000
$280,000
25,000
Gainesville
Sod
$2,000,000
1,300,000
$ 700,000
100,000
Athens
Peaches
$1,200,000
840,000
$ 360,000
35,000
$ 255,000
$ 600,000
$ 325,000
$25,000
F
=
= $25,000
$14.00 $11 .20
$2.80
PV
8,929 units
Gainesville Sod: QB =
=
Athens Peaches: QB =
=
$100,000
$100,000
=
$200 $130
$70
1,429 units
$35,000
= $35,000
$25.00 $17.50
$7.50
4,667 units
(c)
111
Oviedo
Seeds
Gainesville
Sod
$280,000
= 1.098 times
$255,000
$700,000
= 1.167 times
$600,000
Athens
Peaches
$360,000
= 1.108 times
$325,000
(d)
Gainesville Sod, since its degree of operating leverage exceeds that of the
15-15A.
(a)
{S - [VC + F]} (1 - T) = $40,000
VC

F 1 T = $40,000
S S
S

{($400,000) - ($160,000) - F} (0.6) = $40,000

($240,000 - F) (0.6) = $40,000
F = $173,333.33
(b)
S*
F
= $173,333.33 = 14,444 units
$12
PV
F
VC
1
S
$173,333.33
1 0.40
= $288,888.88
15-16A.
(a)
{S - [VC + F] } (1-T) = $80,000
VC

F 1 T = $80,000
S S
S

{($2,000,000) - (1,400,000) - F} (.6) = $80,000

($600,000 - F) (.6) = $80,000
$360,000 - .6F = $80,000
F = $466,666.67
(b)
QB
F
= $466,666.67 = 19,444 units
$24
PV
112
S*
F
$466,666.67
$466,666.67
VC =
=
1
1 .7
.3
S
$1,555,555.57
15-17A.
(a)
S (1 - 0.75) - $300,000 = $240,000

0.25S = $540,000
S = $2,160,000 = (P Q)
Now, solve the above relationship for P:
(b)
200,000 (P)
$2,160,000
$10.80
Sales
Less: Total variable costs
Less: Total fixed costs
EBIT
$2,160,000
1,620,000
$540,000
300,000
$ 240,000
15-18A.
(a)
S (1 - .6) - $300,000 = $250,000

.4S = $550,000
S = $1,375,000 = (P Q)
Solve the above relationship for P.
(b)
200,000 (P)
$1,375,000
$6.875
Sales
EBIT
$1,375,000
825,000
$550,000
300,000
$ 250,000
113
15-19A.
(a)
First, find the EBIT level at the forecast sales volume:

= 0.28
So:
EBIT = (0.28) $3,750,000 = $1,050,000

= 0.5
So:
VC = (0.50) $3,750,000 = $1,875,000

Then, solve for total fixed costs:
S - (VC + F) = $1,050,000
$3,750,000 - ($1,875,000 + F) = $1,050,000
F = $825,000
(b)
S*
$825,000 = $1,650,000
1 0.5
15-20A.
(a)
QB
$180,000
F
=
= 1,200 units
$150
PV
F
$180,000
VC =
= $600,000
1
1 0.70
S
(b)
S*
(c)
DOL$2,500,000 =
5,000($500 $350)
5,000($500 $350) $180,000
$750,000
= 1.316 times
$570,000
(d)
(20%) x (1.316) = 26.32% Increase
114
15-21A.
(a)
QB =
F
= $50,000 = $50,000 = 5,000 units
$25 $15
$10
PV
(b)
$50,000
S* = 1 VC = 1 $15
S
$25
(c)
Sales
Variable costs
Fixed costs
EBIT
(d)
4000 units
$40,000
= -4X
$10,000
(e)
15-22A.
$50,000
$50,000
=
= $125,000
1 0.6
.4
4000 units
$100,000
60,000
$ 40,000
50,000
6000 units
$150,000
90,000
$ 60,000
50,000
8000 units
$200,000
120,000
$ 80,000
50,000
$-10,000
$ 10,000
$ 30,000
6000 units
$60,000
= 6X
$10,000
8000 units
$80,000
= 2.67X
$30,000
The degree of operating leverage decreases as the firm's sales level rises above
the break-even point.
Compute the present level of break-even output:
Q
F
= $120,000 = 24,000 units
$12 $7
PV
Compute the new level of fixed costs at the break-even output:

SVF=0
($12) (24,000) - ($5) (24,000) - F = 0
$288,000 - $120,000 - F = 0
$168,000 = F
Compute the addition to fixed costs:
$168,000 - $120,000 = $48,000 addition
115
15-23A.
DOL$360,000
30,000($12 $7)
30,000($12 $7) $120,000
$150,000
= 5 times
$30,000
Any percentage change in sales will magnify EBIT by a factor of 5.

15-24A.
(a)
DOL$480,000
40,000($12 $7)
40,000($12 $7) 120,000
$200,000
$80,000
= 2.5 times
(b)
DFL$80,000
$80,000
$80,000 $30,000
(c)
DCL$480,000
40,000($12 $7)
40,000($12 $7) $120,000 $30,000
$200,000
= 4 times
$50,000
= 1.6 times
Alternatively:
(DOLS) x (DFLEBIT) = DCLS
(2.5) x (1.6) = 4 times
15-25A.
The task is to find the break-even point in units for the firm. Several
approaches are possible, but the one presented below makes intuitive sense to
students.
Step (1)

(Operating Profit Margin) x (Operating Asset Turnover) =
Return on Operating Assets
(M) x (5) = 0.15
M = 0.03
Step (2)
Sales
= 5
$3,000,000
Sales = $15,000,000
Step (3)
Compute EBIT:
(0.03) ($15,000,000) = EBIT = $450,000
116
Step (4)
Compute revenue before fixed costs. Since the degree of

operating leverage is 8 times, revenue before fixed costs (RBF)
is 8 times EBIT as follows:
RBF = (8) ($450,000) = $3,600,000
Step (5)

Sales - Total variable costs = $3,600,000
$15,000,000 - Total variable costs = $3,600,000
Step (6)

RBF - Fixed costs = $450,000
$3,600,000 - Fixed costs = $450,000
Step (7)
Step (8)
P =
$15,000,000
1,600,000
V =
$11,400,000
= $7.125
1,600,000
= $9.375

QB =
$3,150,000
F
= ($9.375) ($7.125) =
PV
$3,150,000
= 1,400,000 units
$2.25
15-26A.

QB =
F = $300,000 = 50,000 units

$20 $14
PV
Compute the new level of fixed costs at the break-even output.

SVF=0
($20) (50,000) - ($12) (50,000) F = 0
$400,000 = F
$400,000 - $300,000 = $100,000 addition
15-27A.
(a)

EBIT
117
$3,000,000
$1,000,000
= 3 times
(b)
$1,000,000
EBIT
=
= 1.25 times
$800,000
EBIT I
(c)
DCL$12,000,000 = (3) (1.25) = 3.75 times
(d)
F
$2,000,000
S* = 1 VC = 1 $9m =
S
$12m
$2,000,000
$2,000,000
=
= $8,000,000
1 0.75
0.25
15-28A.
(a)
$8,000,000
=
= 2 times
$4,000,000
EBIT
(b)
$4,000,000
EBIT
=
= 1.6 times
$2,500,000
EBIT I
(c)
DCL$16,000,000 = (2) (1.6) = 3.2 times
(d)
(20%) (3.2) = 64% Increase
(e)
F
$4,000,000
S* = 1 VC = 1 $8m =
S
$16m
$4,000,000
= $8,000,000
1 0.5
118
15-29A.a.
A
Sales
$40,000
Variable costs*
24,000
Contribution margin
$16,000
Contribution margin ratio
40%
B
$50,000
34,000
$16,000
32%
C
$20,000
16,000
$ 4,000
20%
D
$10,000
4,000
$ 6,000
60%
Total
$120,000
78,000
$ 42,000
35%
*Variable costs = (Sales) (1 - contribution margin ratio)

b.
35%
c..
Break-even point in sales dollars:

F
$29,400
$29,400
S* = 1 VC =
=
= $84,000
1 0.65
0.35
S
15-30A.
A
Sales
$30,000
Variable costs*
18,000
Contribution margin
$12,000
40%
B
$44,000
29,920
$14,080
32%
C
$40,000
32,000
$ 8,000
20%
D
$6,000
2,400
$ 3,600
60%
Total
$120,000
82,320
$ 37,680
31.4%
*Variable costs = (sales) (1- contribution margin ratio).

b.
31.4%
c..

F
$29,400
S* = 1 VC =
= $93,631
0.314
S
Toledo's management would prefer the sales mix identified in problem 15-29A. That
sales mix provides a higher EBIT ($12,600 vs. $8,280) and a lower break-even point
($84,000 vs. $93,631).
SOLUTION TO INTEGRATIVE PROBLEM:

In solving for the break-even point in units, the following step-by-step approach seems to be
the most logical to students and the easiest for them to understand.
COMPUTE BREAK-EVEN POINT:
STEP 1:

Operating Profit Margin [M] x Operating Asset Turnover = Return on
operating assets
M x 7 = 35%
M = 5%
119
STEP 2:
Operating Assets x Operating Asset Turnover = Sales
$2,000,000 x 7 = Sales
Sales = $14,000,000
STEP 3:
Compute EBIT:
Sales [STEP 2] x Operating Profit Margin [STEP 1] = EBIT
$14,000,000 x 5% = EBIT
EBIT = $700,000
STEP 4:
Compute revenue before fixed costs:

EBIT [STEP 3] x Degree of Operating Leverage = Revenue before Fixed
Costs
$700,000 x 5 = Revenue before Fixed Costs
Revenue before Fixed Costs = $3,500,000
STEP 5:

Sales [STEP 2] - Revenue before Fixed Costs [STEP 4] = Total Variable Costs
$14,000,000 - $3,500,000 = Total Variable Costs
Total Variable Costs = $10,500,000
STEP 6:

Revenue before Fixed Costs [STEP 4] - EBIT [STEP 3] = Fixed Costs
$3,500,000 - $700,000 = Fixed Costs
Fixed Costs = $2,800,000
STEP 7:
Find selling price per unit (P) and variable cost per unit (V):
P = Sales [STEP 2] / Output in Units
P = $14,000,000 / 50,000 units
P = $280.00
V = Total Variable Costs [STEP 5] / Output in Units
V = $10,500,000 / 50,000 units
V = $210.00
120
STEP 8:
Compute break-even point (in units):

QB = F [STEP 6] / (P - V) [STEP 7]
QB = $2,800,000 / ($280.00 - $210.00)
QB = 40,000 units
After determining the break-even point using the approach described above, the students
have the information necessary to prepare an analytical income statement as follows:
Sales [STEP 2]
Variable Costs [STEP 5]
Revenue before Fixed Costs
Fixed Costs [STEP 6]
EBIT
Interest Expense
Earnings Before Taxes
Taxes (35%)
Net Income
$14,000,000
10,500,000
$3,500,000
2,800,000
$700,000
400,000
$300,000
105,000
$195,000
Thereafter, the students have the data they need to answer questions (a) - (e) as follows:
(a)
Degree of financial leverage:

DFLEBIT = EBIT / (EBIT - Interest)
DFLEBIT = $700,000 / ($700,000 - $400,000)
DFLEBIT = 2.33
(b)
Degree of Combined Leverage:

DCLS = DOLS x DFLEBIT
DCLS = 5 x 2.33
DCLS = 11.65
(c)
F
S* =
1 VC
$2,800,000
S* =
1 - $10,500,000
$14,000,000
S* = $11,200,000
(d)
If sales increase 30%, by what percent would EBT increase?

% increase in EBT = % increase in Sales x DCLS
% increase in EBT = 30% x 11.65
% increase in EBT = 350%
121
(e)
Analytical Income Statement to verify effect of 30% increase in sales:

Sales]
$18,200,000
Variable Costs
13,650,000
Revenue Before Fixed Costs
$4,550,000
Fixed Costs [STEP 6]
2,800,000
EBIT
$1,750,000
Interest Expense
400,000
Earnings Before Taxes
$1,350,000
Taxes (35%)
472,500
Net Income
$877,500
It may be useful to develop the following proof to assist in explaining the inter-relationships
of the various values:
% change in EBT = (EBTafter - EBTbefore) / EBTbefore
% change in EBT = ($1,350,000 - $300,000) / $300,000
% change in EBT = 350%
which agrees with the following:
% change in EBT = % change in Sales x DCLS
% change in EBT = 30% x 11.65
% change in EBT = 350%
Solutions To Problem Set B

15-1B. Break-even Quantity
QB
QB
F
(P V)
$20,000,000
40,000,000 units
$.50 per unit
$16,000,000
40,000,000 units
$.40 per unit
QB
$2,400,000
($0.50 $0.40)
QB
24,000,000 units
thus,
122
15-2B.
Degree of Combined Leverage

Degree of Operating Leverage
Degree of Financial Leverage
=
=
=
DCLS
DOLS
DFLEBIT
DOLS
Q(P V)
[Q(P V) F]
$20,000,000
=
40,000,000 units
$.50 per unit
$16,000,000
=
40,000,000 units
$.40 per unit
DOLS
40,000,000 ($0.50 $0.40)

40,000,000 ($0.50 $0.40) $2,400,000
DOLS
2.50 times
DFLEBIT
EBIT
(EBIT 1)
DFLEBIT
$1,600,000
($1,600,000 $800,000)
DFLEBIT
2.00 times
DCLS
Q(P V)
[Q(P V) F I]
DCLS
DCLS
$4,000,000
$800,000
DCLs
5.00 times
thus,
and
40,000,000 ($0.50 $0.40)

40,000,000 ($0.50 $0.40) $2,400,000 $800,000
15-3B.
(a)
QB
$650,000
$650,000
F
=
=
= 10,833 Units
$175 $115
$60
PV
123
(b)
S*
(10,833 units) ($175) = $1,895,775
Alternatively,
S*
F
VC
1
S
$650,000
=
1 0.6571
Note:
$650,000
= 1 $115
$175
$1,895,596 differs from $1,895,775 due to rounding.
(c)
Sales
Variable costs
Fixed costs
EBIT
(d)
$650,000
= $1,895,596
.3429
10,000
units
$1,750,000
1,150,000
600,000
650,000
-$50,000
10,000 units
16,000
units
$2,800,000
1,840,000
960,000
650,000
$ 310,000
16,000 units
$600,000
= -12 times
$50,000
20,000
units
$3,500,000
2,300,000
1,200,000
650,000
$ 550,000
20,000 units
$960,000
= 3.1 times
$310,000
$1,200,000
= 2.2
$550,000
times
15-4B.
(a)
Sales
Variable costs
Revenue before
fixed costs
Fixed costs
EBIT
(b)
QB
6,400 units
Durham
Furniture
$1,600,000
1,100,000
Raleigh
Cabinets
$1,957,500
1,080,000
$500,000
40,000
$460,000
$877,500
150,000
$727,500
F
PV
$40,000
$20.00 $13.75
QB =
$150,000
$435 $240
QB =
$60,000
$35.00 $15.75
(c)
124
Charlotte
Colonials
$525,000
236,250
$288,750
60,000
$228,750
=
$40,000
$6.25
$150,000
= 769 units
$195
= $60,000
$19.25
= 3,117 units
Durham
Furniture
=
$500,000
$460,000
= 1.09 times
Raleigh
Furniture
Charlotte
Colonials
$877,500
=
$727,500
$288,750
$228,750
1.21 times
1.26 times
(d)
Charlotte Colonials, since its degree of operating leverage exceeds that of the
(a)
{S - [VC + F]} (1 - T) = $55,000
15-5B.
VC

F 1 T = $55,000
S S
S

{$400,008 - [257,148 + F ]} (0.55) = $55,000

($142,860 - F) (0.55) = $55,000
F = $42,860
(b)
15-6B. (a)
QB
$42,860
F
=
= $42,860 = 4,286 units
$28.00 $18.00
$10.00
PV
S*
F
VC
1
S
$42,860
1 0.643
= $120,056
Find the EBIT level at the forecast sales volume:

EBIT
= .28
S
Therefore, EBIT = (0.28) ($3,750,000) = $1,050,000

VC
= 0.55,
S
so:
VC = (0.55) $3,750,000 = $2,062,500

Now, solve for total fixed costs:
S - (VC + F) = $1,050,000
$3,750,000 - ($1,687,500 + F) = $1,050,000
F = $637,500
(b)
S*
$637,500
= $1,416,667
1 0.55
125
15-7B.
$24,000,000
= 1.71 times
$14,000,000
(a)
(b)
EBIT
EBIT I
(c)
DCL$40,000,000= (1.71) (1.09) = 1.86 times
(d)
S*
(e)
$14,000,000
$12,850,000
= 1.09 times
F
$10,000,000
VC =
$16m
1
1
S
$40m
$10,000,000
=
1 0.4
$10,000,000
= $16,666,667
0.6
(20%) (1.86) = 37.2%
15-8B. Given the data for this problem, several approaches are possible for finding the
break-even point in units. The approach below seems to work well with students.
Step (1)

(Operating Profit Margin) x (Operating Asset Turnover) = Return on
Operating Assets
(M) x (5) = 0.25
M = .05
Step (2)
Compute the sales level relative to the given output level:

Sales
= 5
$18,000,000
Sales = $90,000,000
Step (3)
Compute EBIT:
(.05) ($90,000,000) = $4,500,000
Step (4)
Compute revenue before fixed costs. Since the degree of operating

leverage is 6 times, revenue before fixed costs (RBF) is 6 times EBIT
as follows:
RBF = (6) ($4,500,000) = $27,000,000
126
Step (5)

(Sales) - (Total variable costs) = $27,000,000
$90,000,000 - (Total variable costs) = $27,000,000
Step (6)

RBF - Fixed costs = $4,500,000
$27,000,000 - fixed costs = $4,500,000
Step (7)
Step (8)
P =
$90,000,000
= $12.86
7,000,000
V =
$63,000,000
= $9.00
7,000,000

QB
$22,500,000
($12.86) ($9)
F
PV
$22,500,000
$3.86
F
PV
= 5,829,016 units
15-9B.
(a)
QB
units
(b)
S*
$550,000
= $550,000 = 15,714
$175 $140
$35
F
$550,000
VC =
$140
1
1
S
$175
$550,000
1 0.8
(c)
Sales
Variable costs
Fixed costs
EBIT
$550,000
.2
= $2,750,000
12,000
Units
$2,100,000
1,680,000
$ 420,000
550,000
15,000
Units
$2,625,000
2,100,000
$ 525,000
550,000
20,000
Units
$3,500,000
2,800,000
$700,000
550,000
-$130,000
-$25,000
$ 150,000
127
(d)
12,000 units
15,000 units
$420,000
= -3.2 times
$130,000
20,000 units
$525,000
= -21 times
$25,000
$700,000
= 4.67
$150,000
times
15-10B.
(a)
(b)
Sales
Variable costs
Fixed costs
Farm City
Seeds
$1,800,000
1,410,000
$390,000
30,000
Empire
Sod
$1,710,000
1,305,000
$ 405,000
110,000
Golden
Peaches
$1,400,000
950,000
$ 450,000
33,000
EBIT
$ 360,000
$ 295,000
$ 417,000
Farm City: QB
units
$30,000
F
=
= $30,000 = 9,231
$15.00 $11.75
$3.25
PV
Empire Sod: QB
$110,000
$110 ,000
=
$190 $145
$45
Golden Peaches: QB
$33,000
$33,000
=
= 3,667 units
$28.00 $19
$9
(c)
Farm City
Empire
Golden
Seeds
Sod
Peaches
$390,000
= 1.083 times
$360,000
(d)
15-11B.
(a)
= 2,444 units
$405,000
= 1.373 times
$295,000
$450,000
= 1.079 times
$417,000
Empire Sod, since its degree of operating leverage exceeds that of the other
two companies.
{S [VC + F]} (1-T) = $38,000
VC

F 1 T = $38,000
S S
S

[($420,002) - ($222,354) - F] (0.65) = $38,000

($197,648 - F) (0.65) = $38,000
F = $139,186.46
128
(b)
QB
S*
15-12B.
(a)
F
= $139,186.46 = 17,398 units
$8
PV
F
$139,186.46
VC =
= $295,764
1
1 0.5294
S
{S [VC + f]} (1 T) = $70,000
VC

F 1 T = $70,000
S S
S

[ ($2,500,050) - (1,933,372) - F ] (.55) = $70,000

($566,678 - F) (.55) = $70,000
($311,672.9 - .55F) = $70,000
F = $439,405.27
(b)
QB
S*
15-13B.
(a)
F = $439,405.27 = 25,847 units

$17
PV
F
$439,405.27
$439,405.27
VC =
=
1
1 .7733
.2267
S
$1,938,268
$439,405.27
.2267
S (1 - 0.8) - $335,000 = $270,000

0.2S = $605,000
S = $3,025,000 = (P Q)
Now, solve the above relationship for P:
(b)
175,000 (P)
$3,025,000
$17.29
Sales
$3,025,750
2,420,600
$605,150
335,000
EBIT
$ 270,150
129
15-14B.
(a)
(b)
S (1-.75) - $300,000 = $250,000

.25S = $550,000
S = $2,200,000 = (P Q)
Solve the above relationship for P:
190,000 (P) = $2,200,000
P = $11.58
Sales
$2,200,000
1,650,000
$550,000
300,000
EBIT
$ 250,000
15-15B.
(a)
First, find the EBIT level at the forecast sales volume:

EBIT
= 0.25
S
So:
EBIT = (0.25) $4,250,000 = $1,062,500

= 0.4
So:
VC = (0.40) $4,250,000 = $1,700,000

Then, solve for total fixed costs:
S - (VC + F) = $1,062,500
$4,250,000 - ($1,700,000 + F) = $1,062,500
F = $1,487,500
(b)
15-16B.
(a)
(b)
S* = $1,487,500
1 .4
QB =
F
PV
F
S* = 1 VC
S
= $2,479,167
$200,000 = 1,600 units

$125
$200,000
= $759,878
1 0.7368
130
(c)
DOL$2,850,000
$750,000
$550,000
(d)
6,000($475 $350)
6,000($475 $350) $200,000
1.364 times
(13%) x (1.364) =
17.73% Increase
15-17B.
(a)
QB
F
= $55,000 = $55,000 = 5,000 units
$28 $17
$11
PV
(b)
S*
F
$55,000
$55,000
$55,000
VC =
$17 =
=
=
1
1
1 0.607
.393
S
$28
$139,949
(c)
Sales
Variable costs
Fixed costs
4,000 units
$112,000
68,000
$ 44,000
55,000
6,000 units
$168,000
102,000
$ 66,000
55,000
EBIT
-$11,000
$ 11,000
(d)
4000 units
$44,000
= -4X
$11,000
(e)
15-18B.
6000 units
$66,000
= 6X
$11,000
8,000 units
$224,000
136,000
$ 88,000
55,000
$ 33,000
8000 units
$88,000
= 2.67X
$33,000
The degree of operating leverage decreases as the firm's sales level rises above
the break-even point.
QB =
F
= $135,000 = 19,286 units
$13 $6
PV
Compute the new level of fixed costs at the break-even output:

SVF=0
($13) (19,286) - ($5) (19,286) - F = 0
$250,718 - $96,430 - F = 0
$154,288 = F
$154,288 - $135,000 = $19,288 addition
131
15-19B.
DOL$520,000
40,000($13 $6)
40,000($13 $6) $135,000
$280,000
145,000
= 1.93 times
Any percentage change in sales will magnify EBIT by a factor of 1.93.

15-20B.
(a)
DOL$650,000
50,000($13 $6)
50,000($13 $6) 135,000
$350,000
= 1.63 times
$215,000
(b)
DFL$215,000 =
$215,000
= 1.39 times
$215,000 $60,000
(c)
DCL$650,000 =
50,000 ($13 $6)

50,000 ($13 $6) $135,000 $60,000
$350,000
= 2.26 times
$155,000
Alternatively:
DOLS x DFLEBIT = DCLS
1.63 x 1.39 = 2.26 times
15-21B.
The task is to find the break-even point in units for the firm. Several
approaches are possible, but the one presented below makes intuitive sense to
students.
Step (1)

(Operating Profit Margin) x (Operating Asset Turnover) = Return on
Operating Assets
(M) x (6) = 0.16
M = 0.0267
Step (2)
Sales
= 6
$3,250,000
Sales = $19,500,000
Step (3)
Compute EBIT:
(0.0267) ($19,500,000) = EBIT = $520,000
132
Step (4)
Compute revenue before fixed costs. Since the degree of operating

leverage is 9 times, revenue before fixed costs (RBF) is 9 times EBIT
as follows:
RBF = (9) ($520,000) = $4,680,000
Step (5)

Sales - Total variable costs = $4,680,000
$19,500,000 - Total variable costs = $4,680,000
Step (6)

RBF - Fixed costs = $520,000
$4,680,000 - Fixed costs = $520,000
Step (7)
Step (8)
P =
$19,500,000
1,700,000
V =
$14,820,000
= $8.718
1,700,000
= $11.471

QB =
$4,160,000
$4,160,000
F
= ($11.471) ($8.718) =
=
$2.753
PV
1,511,079 units
15-22B.

F = $375,000 = 31,250 units
QB =
PV
$25 $13
Compute the new level of fixed costs at the break-even output.

SVF=0
($25) (31,250) - ($11) (31,250) - F = 0
$437,500 = F
$437,500 - $375,000 = $62,500 addition
15-23B.
(a)
$4,250,000
=
= 3.4 times
$1,250,000
EBIT
(b)
EBIT
=
EBIT I
(c)
DCL$13,750,000 = (3.4) (1.25) = 4.25 times
$1,250,000
= 1.25 times
$1,000,000
133
(d)
S*
F
3,000,000
VC =
$9.5m
1
1
S
$13.75m
$3,000,000
$3,000,000
=
= $9,705,597
1 0.6909
0.3091
15-24B.
(a)
$11,000,000
=
= 2.2 times
$5,000,000
EBIT
(b)
EBIT
=
EBIT I
(c)
DCL$18,000,000 = (2.2) (1.54) = 3.39 times
(d)
(15%) (3.39) = 50.9%
(e)
S*
$5,000,000
= 1.54 times
$3,250,000
F
$6,000,000
VC =
$7m
1
1
S
$18m
$6,000,000
1 0.389
15-25B.a.
Sales
Variable costs*
Contribution margin
= $9,819,967
A
$38,505
23,103
$15,402
40%
B
$61,995
42,157
$19,838
32%
C
$29,505
23,604
$ 5,901
20%
*Variable costs = (Sales) (1 - contribution margin ratio)

b.
35.43%
c.

F
S* = 1 VC
S
= 1
$96,862
$150,000
134
$98,800
D
Total
$19,995 $150,000
7,998
96,862
$ 11,997 $ 53,138
60% 35.43%
15-26B.a.
Sales
Variable costs*
Contribution margin
A
$49,995
29,997
$19,998
40%
B
$62,505
42,503
$20,002
32%
C
$25,005
20,004
$ 5,001
20%
D
12,495
4,998
$ 7,497
60%
Total
$150,000
97,502
$ 52,498
35%
*Variable costs = (sales) (1- contribution margin ratio).

b.
35%
c.

F
$35,000
S* = 1 VC =
= $100,000
0.35
S
Wayne's management would prefer the sales mix identified in problem 15-25B. That
first sales mix provides a higher EBIT ($18,138 vs. $17,498) and a lower break-even
point ($98,800 vs. $100,000).
135

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CHAPTER15

Business risk and financial risk

Risk is defined as the likely variability associated with expected revenue

The variations in the income stream can be attributed to

The firm's exposure to business risk

The firm's decision to incur financial risk

Business risk is measured by the firm's corresponding expected

Dispersion in operating income does not cause business risk. It is the

Financial leverage is the financing of a portion of the firm's assets with

Financial risk is passed on to the common shareholders who must bear

The objective of break-even analysis is to determine the break-even quantity

The break-even quantity of output results in an EBIT level equal to

Use of the model enables the financial officer to

Determine the quantity of output that must be sold to cover all

Calculate the EBIT achieved at various output levels.

Some potential applications include

Capital expenditure analysis as a complementary technique to

Labor contract negotiations

Evaluation of cost structure

Financial decision making

Essential elements of the break-even model

Energy cost associated with production

In order to implement the break-even model, it is necessary for the

Identify the most relevant output range for planning purposes.

Approximate all costs in the semifixed and semivariable range

Total revenue and volume of output

Total revenue (sales dollars) is equal to the selling price per

Volume of output refers to the firms level of operations and is

Finding the break-even point

The break-even model is just an adaptation of the firm's income

Three ways to find the break-even point are explained.

Trial and error

Select an arbitrary output level.

Calculate the corresponding EBIT amount.

When EBIT equals zero, the break-even point has been

Contribution margin analysis

Unit selling price - unit variable cost = contribution

Fixed cost divided by the contribution margin per unit

= the break-even level of units sold,

= the unit sales price,

= the total fixed cost for the period,

= unit variable cost.

The break-even point in sales dollars

It is convenient to calculate the break-even point in terms of sales

Limitations of break-even analysis

Assumes linear cost-volume-profit relationship.

The total revenue curve is presumed to increase linearly with the

Assumes constant production and sales mix.

This is a static form of analysis.

Operating leverage is the responsiveness of a firm's EBIT to fluctuations in

This responsiveness can be measured as follows:

If unit costs are available, the DOL can be measured by

If an analytical income statement is the only information available, the

revenue before fixed costs

Note: All three formulas provide the same results.

Implications of operating leverage

At each point above the break-even level, the degree of operating

At the break-even level of sales, the degree of operating leverage is

Operating leverage is present when the percentage change in EBIT

The degree of operating leverage is attributed to the business risk that

is greater than 1.00

A measure of the firm's use of financial leverage is as follows:

The degree of financial leverage concept can be either in the positive