San Diego State University
ADVANCED F 101 Advanced Financial Accounting
Chapter 5
Discussion Questions
5-1.
Discuss the various uses for break-even analysis.
Such analysis allows the firm to determine at what level of operations it will
break even and to explore the relationship between volume, costs, and profits.
What factors would cause a
...[Show More]
Chapter 5
Discussion Questions
5-1. |
Discuss the various uses for break-even analysis.
Such analysis allows the firm to determine at what level of operations it will
break even and to explore the relationship between volume, costs, and profits.
What factors would cause a difference in the use of financial leverage for a |
5-2. |
utility company and an automobile company?
A utility is in a stable, predictable industry and therefore can afford to use more
financial leverage than an automobile company, which is generally subject to
the influences of the business cycle. An automobile manufacturer may not be
able to service a large amount of debt when there is a downturn in the economy.
5-3. |
Explain how the break-even point and operating leverage are affected by the
choice of manufacturing facilities (labor intensive versus capital intensive). |
A labor-intensive company will have low fixed costs and a correspondingly low
break-even point. However, the impact of operating leverage on the firm is
small and there will be little magnification of profits as volume increases. A
capital-intensive firm, on the other hand, will have a higher break-even point
and enjoy the positive influences of operating leverage as volume increases.
5-4. |
What role does depreciation play in break-even analysis based on accounting
flows? Based on cash flows? Which perspective is longer term in nature? |
For break-even analysis based on accounting flows, depreciation is considered
part of fixed costs. For cash flow purposes, it is eliminated from fixed costs.
The accounting flows perspective is longer-term in nature because we must
consider the problems of equipment replacement.
5-5. |
What does risk taking have to do with the use of operating and financial
leverage? |
Both operating and financial leverage imply that the firm will employ a heavy
component of fixed cost resources. This is inherently risky because the
obligation to make payments remains regardless of the condition of the
company or the economy.
S-140
5-6. Discuss the limitations of financial leverage.
Debt can only be used up to a point. Beyond that, financial leverage tends to
increase the overall costs of financing to the firm as well as encourage creditors
to place restrictions on the firm. The limitations of using financial leverage tend
to be greatest in industries that are highly cyclical in nature.
5-7. How does the interest rate on new debt influence the use of financial leverage?
The higher the interest rate on new debt, the less attractive financial leverage is
to the firm.
5-8. Explain how combined leverage brings together operating income and earnings
per share.
Operating leverage primarily affects the operating income of the firm. At this
point, financial leverage takes over and determines the overall impact on
earnings per share. A delineation of the combined effect of operating and
financial leverage is presented in Table 5-6 and Figure 5-5.
5-9. Explain why operating leverage decreases as a company increases sales and
shifts away from the break-even point.
At progressively higher levels of operation than the break-even point, the
percentage change in operating income as a result of a percentage change in
unit volume diminishes. The reason is primarily mathematical — as we move to
increasingly higher levels of operating income, the percentage change from the
higher base is likely to be less.
5-10. When you are considering two different financing plans, does being at the level
where earnings per share are equal between the two plans always mean you are
indifferent as to which plan is selected?
The point of equality only measures indifference based on earnings per share.
Since our ultimate goal is market value maximization, we must also be
concerned with how these earnings are valued. Two plans that have the same
earnings per share may call for different price-earnings ratios, particularly when
there is a differential risk component involved because of debt.
S-141
Problems
5-1. Shock Electronics sells portable heaters for $25 per unit and the variable cost to
produce them is $17. Mr. Amps estimates that the fixed costs are $96,000.
a. Compute the break-even point in units.
b. Fill in the table below (in dollars) to illustrate that the break-even point has
been achieved.
Sales
–Fixed costs |
_______________
_______________ |
–total variable costs _______________ |
Net profit (loss) |
_______________ |
Solution:
Shock Electronics
12,000 units
$8
$96,000
$25 $17
$96,000
Price - variable cost per unit
Fixed costs
a. BE
b.
Sales
–Fixed costs |
$300,000 (12,000 units * $25)
96,000 |
–Total variable costs 204,000 (12,000 units * $17) |
Net profit (loss) |
$ 0 |
S-142
5-2. The Hartnett Corporation manufactures baseball bats with Sammy Sosa's
autograph stamped on. Each bat sells for $13 and has a variable cost of $8.
There is $20,000 in fixed costs involved in the production process.
a. Compute the break-even point in units.
b. Find the sales (in units) needed to earn a profit of $15,000.
Solution:
Hartnett Corporation
a. 4,000 units
$13 $8
$20,000
BE
7,000 units
$5
$35,000
$13 $8
$15,000 $20,000
P VC
Profit FC
b. Q
S-143
5-3. Therapeutic Systems sells its products for $8 per unit. It has the following
costs:
Rent
Factory labor
Executive salaries
Raw material |
$120,000
$1.50 per unit
$112,000
$ .70 per unit |
Separate the expenses between fixed and variable cost per unit. Using this
information and the sales price per unit of $6, compute the break-even point.
Solution:
Therapeutic Systems
Fixed Costs
Variable Costs
(per unit)
Rent $120,000
Factory labor $1.50
Executive salaries $112,000
Raw materials _______ .70
$232,000 $2.20
40,000 units
$5.80
$232,000
$8.00 $2.20
$232,000
P VC
FC
BE
S-144
5-4. Draw two break-even graphs—one for a conservative firm using labor-intensive
production and another for a capital-intensive firm. Assuming these companies
compete within the same industry and have identical sales, explain the impact of
changes in sales volume on both firms' profits.
Solution:
Labor-Intensive and capital-intensive break-even graphs
[Show Less]