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# Financial Management

Problem 1

The XYZ Company manufactures clocks. The company's income statement for 2004 is as follows:

XYZ Company
Income Statement
For the Year Ended December 31, 2004

Sales (10,000 clocks @ \$40 each) \$400,000
Less: Variable costs (10,000 clocks at \$20) 200,000
Fixed costs 150,000

Earnings before interest and taxes (EBIT) 50,000
Interest expense 10,000

Earnings before taxes (EBT) 40,000
Income tax expense (40%) 16,000
Earnings after taxes (EAT)
\$ 24,000
Given this income statement, compute the following:

a. Degree of operating leverage.
b. Degree of financial leverage.
c. Degree of combined leverage.
d. Break-even point in units (number of clocks).

Problem 2.

Blue Corp and Red Corp are competitors in the widget supplies business. The separate capital structures for Blue and Red are presented below.

Blue Red
Debt @ 10%..................\$ 100,000 Debt @ 10% \$200,000
Common stock, \$10 par 200,000 Common stock, \$10 par 100,000
Total.........................\$300,000 Total \$300,000
Common shares 20,000
Common shares 10,000
a. Compute earnings per share if earnings before interest and taxes (EBIT) are \$20,000, \$30,000, and \$60,000 (assume a 25 percent tax rate).
b. Explain the relationship between earnings per share and the level of EBIT.
c. If the cost of debt went up to 12 percent and all other factors remained equal, what would be point of indifference for EBIT for the two capital structures?

#### Solution Summary

The solution has two questions. One dealing with operating and financial leverage and the second one relating to EBIT-EPS analysis

\$2.19