question archive Omar Hana Enterprise is considering the needs of restructuring their capital structure
Omar Hana Enterprise is considering the needs of restructuring their capital structure
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Omar Hana Enterprise is considering the needs of restructuring their capital structure. For the first phase, they are evaluating two different operating structures that are described below. The firm has annual interest expense of $250, common shares outstanding of 1,000 unit, and a tax rate of 40 percent. Fixed Costs Operating structure 1 $1000 Operating structure 2 $1500 Price per unit $1 $1 Variable cost per unit $0.80 $0.70 For each operating structure, calculate: a) EBIT and EPS at 20,000 units. (7 marks) b) The degree of operating leverage (DOL) and degree of total leverage (DTL) using 20,000 units as a base sales level. (8 marks) c) The operating breakeven point in units. (3 marks) d) If Omar Hana projects sales of 20,000 units, which operating structure is recommended?
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a) Statement showing the calculation of EBIT and EPS at 20000 units under operating structure 1 & 2:
| Particulars | operating structure 1 | operating structure 2 | |
| Units | 20000 | 20000 | |
| Sales | = 20000 x 1 = $ 20000 | = 20000 x 1 = $ 20000 | |
| Less | Variable cost | = 20000 x 0.80 = $ 16000 | = 20000 x 0.70 = $ 14000 |
| Contribution | $ 4000 | $ 6000 | |
| Less | Fixed cost | $ 1000 | $ 1500 |
| EBIT | $ 3000 | $ 4500 | |
| Less | Interest | $ 250 | $ 250 |
| EBT | $ 2750 | $ 4250 | |
| Less | Tax @ 40% | $ 1100 | $ 1700 |
| EAT | $ 1650 | $ 2550 | |
| ÷ | common shares outstanding | 1000 | 1000 |
| EPS | $ 1.65 | $ 2.55 |
b) Calculation of Degree of operating leverage (DOL) and Degree of total leverage (DTL) using 20000 units as base sale units:
Degree of operating leverage = EBIT ÷ EBT
| Operating structure 1 | Operating structure 2 | |
| Contribution | $ 4000 | $ 6000 |
| EBIT | $ 3000 | $ 4500 |
| EBT | $ 2750 | $ 4250 |
| DOL = contribution ÷ EBIT | = 4000 ÷ 3000 = 1.33 | = 6000 ÷ 4500 = 1.33 |
| DFL = EBIT ÷ EBT | = 3000 ÷ 2750 = 1.09 | = 4500 ÷ 4250 = 1.06 |
| DTL = contribution ÷ EBT | = 4000 ÷ 2750 = 1.45 | = 6000 ÷ 4250 = 1.41 |
c) Calculation of Break-even point in units:
Break-even point = Fixed cost ÷ contribution per unit
Contribution per unit = Total contribution ÷ number of units
| Operating structure 1 | Operating structure 2 | |
| Contribution | $ 4000 | $ 6000 |
| Fixed cost | $ 1000 | $ 1500 |
| Contribution per unit | =4000 ÷ 20000 = $ 0.20 | = 6000 ÷ 20000 = $ 0.30 |
| Break-even point in units | = 1000 ÷ 0.20 = 5000 units | = 1500 ÷ 0.30 = 5000 units |
d) Determining the operating structure at 20000 units project sale:
The analysis will be done on the basis of total leverage: Total leverage measures total risk. It depends on the combination of operating and financial risk.
| DOL | DFL | Comments |
| Low | Low | Lower total risk. cannot take advantage of trading on equity. |
| High | High | Higher total risk. very risky combination. |
| High | Low | Moderate total risk. Not a good combination. Lower EBIT due to higher DOL and lower advantage of trading on equity due to low DFL. |
| Low | High | Moderate total risk. Best combination. Higher financial risk is balanced by lower total business risk. |
Since operating structure 1 has the same DOL i.e., 1.33 but has high DFL i.e., 1.09 as compared to operating structure 2 i.e., 1.06. Hence, the best-operating structure is 1.
