Welker Products sells small kitchen gadgets for $15 each. The gadgets have a variable cost of $4 per unit, and Welker Products' fixed operating costs are $220,000 per year. Welker Products' capital structure includes 55% debt and 45% equity. Annual interest expense is $25,000, and the corporate tax rate is 35%.

a.   Calculate the break-even point in units.

b.   If Welker Products sells 25,000 units, calculate the firm's EBIT and net income.

c.    If sales increase ten percent from 25,000 units to 30,000 units, estimate the firm's expected EBIT and net income.

d.   Does Welker Products use operating leverage and/or financial leverage? Explain.

answer:

a) Calculation of break-even point in units:

Selling price=$15

Variable cost =$4

Fixed operating cost=$220,000

Annual interest expense =$25,000

Rate of tax =35%

Break even point in units =Fixed operating costs / (Selling price per unit - Variable cost per unit)

=$220,000 / $15-$4

=20,000 units

b) Calculation of firm's EBIT and net income (25,000 units):

Sales (25,000*$15) =$375,000

Variable costs (25,000*$4) =$100,000

Fixed operating cost =$220,000

EBIT =$375,000 - $100,000 - $220,000 =$55,000

Interest expenses =$25,000

EBT=$55,000 - $25,000 =$30,000

Tax @35% =$10,500

Profit after tax /Net income =$19,500 ($30,000 -$10,500)

c)Firm's expected EBIT and net income (30,000 units):

Sales (30,000*$15) =$450,000

Variable costs (30,000*$4) =$120,000

Fixed operating cost =$220,000

EBIT =$450,000 - $120,000 - $220,000 =$110,000

Interest expenses =$25,000

EBT=$110,000 - $25,000 =$85,000

Tax @35% =$29,750

Profit after tax /Net income =$55,250 ($85,000 -$29,750)

d) Usage of operating leverage and/or financial leverage:

The firm can use operating as well as financial leverage for making analsyis and decision. As the firm has fixed operating expenses, operating leverage will tend to arise. Increase in sales will lead to more change in EBIT. On the other hand where the firm has fixed interest expenses, financial leverage will arise where a percentage increase of EBIT results in change in profit before tax.