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Purchase Decision / Degree of Financial Leverage

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5. You are considering the purchase of new equipment for your company and you have narrowed down the possibilities to two models which perform equally well. However, the method of paying for the two models is different. Model A requires $5,000 per year payment for the next five years. Model B requires the following payment schedule. Which model should you buy if your opportunity cost is 8 percent?
Year Payment (Model B)
1 $7,000
2 6,000
3 5,000
4 4,000
5 3,000

7.
Table 8.1
Plan 1 Plan 2
Interest Expense $25,000 $50,000
Preferred Dividend $3,000 $1,500
Common Shares Outstanding 200,000 100,000

What is the degree of financial leverage at a base level EBIT of $120,000 for both financing plans? The firm has a 40 percent tax rate. (See Table 8.1.)

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Solution Summary

The solution looks at two questions - making the purchase decison among alternatives and how to calculate the degree of financial leverage. This solution is formatted in an attached Word document.

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See Also This Related BrainMass Solution

Break-even, fixed v variable costs, degree of leverage, EPS

Please use attached format to answer questions.

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)

3. Therapeutic Systems sells its products for $8 per unit. It has the following costs:

Rent $120,000
Factory labor $1.50 per unit
Executive salaries $112,000
Raw material $.70 per unit

Separate the expenses between fixed and variable costs per unit. Using this information and the sales price per unit of $6, compute the break-even point.

8. The Harding Company manufactures skates. The company's income statement
for 2001 is as follows:

HARDING COMPANY
Income Statement
For the Year Ended December 31, 2001
Sales (10,000 skates @ $50 each) . . . . . . . . . . . $500,000
Less: Variable costs (10,000 skates at $20) . . . 200,000
Fixed costs . . . . . . . . . . . . . . . . . . . . . . . . . . 150,000
Earnings before interest and taxes (EBIT) . . . . . . 150,000
Interest expense . . . . . . . . . . . . . . . . . . . . . . . . . 60,000
Earnings before taxes (EBT) . . . . . . . . . . . . . . . . 90,000
Income tax expense (40%) . . . . . . . . . . . . . . . . . 36,000
Earnings after taxes (EAT) . . . . . . . . . . . . . . . . . . $ 54,000

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 skates).

10. Cain Auto Supplies and Able Auto Parts are competitors in the aftermarket for
auto supplies. The separate capital structures for Cain and Able are presented
below.

Cain Able
Debt @ 10% . . . . . . . . . . . . . $ 50,000 Debt @ 10% . . . . . . . . . . . . . . . . . . $100,000
Common stock, $10 par . . . . . 100,000 Common stock, $10 par . . . . . . . . . 50,000
Total . . . . . . . . . . . . . . . . . . $150,000 Total . . . . . . . . . . . . . . . . . . . . . . . $150,000
Common shares . . . . . . . . . . 10,000 Common shares . . . . . . . . . . . . . . . 5,000

a. Compute earnings per share if earnings before interest and taxes are
$10,000, $15,000, and $50,000 (assume a 30 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 the break-even level for EBIT?

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