question archive company sells its finished product for an average of RM35 per unit with a variable cost per unit of RM21
company sells its finished product for an average of RM35 per unit with a variable cost per unit of RM21
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company sells its finished product for an average of RM35 per unit with a variable cost per unit of RM21. The company has fixed operating costs of RM1,050,000. The company plans to build a new mini plant to support its expansion strategy. The construction would be financed by the sale of common stock or a bond issue. the company requires RM4.5 million for the construction of the new mini plant. The current capital structure of GE consists of RM20,000,000 of 12% bonds and 600,000 common shares outstanding. The company has two financing options to finance the construction of the new plant: Option 1: 14% bond issue of RM4.5 million Option 2: Sale of 95,600 new common shares the company has a 25% tax rate. The CEO wanted to know the effect of each financing option on its earnings potential and instructed you to evaluate each financing option. (a) Calculate the company’s operating breakeven point in units. (b) Using 100,000 units as a base, calculate the company's degree of operating leverage. (c) Determine the degree of financial leverage for each option at RM7,000,000 of EBIT. (d) Compute the financial breakeven point for each option. (e) Compute the earnings per share (EPS) under each option. (f) Which option should the company choose? Explain. (g) Based on the chosen option in part (f) calculate the company’s degree of total leverage.
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| Answer a: |
| Operating break even order = Fixed operating cost/ Contribution per unit |
| Where, Contribution per unit = sales price per unit- variable cost per unit |
| So, |
| Fixed operating cost = RM1,050,000 |
| Contribution per unit = RM35-RM21 = RM14 |
| Operating break even order = RM1,050,000/RM14 |
| Operating break even order = 75,000 unit |
| Answer b: |
| Operating leverage = Contribution/EBIT |
| Where, |
| Contribution = Total sales - Total variable cost |
| EBIT = Contribution - Total Fixed operating cost |
| So, |
| Total sales = 100,000*RM35 = RM3,500,000 |
| Total Variable cost = 100,000*RM21 = RM2,100,000 |
| Contribution = RM3,500,000-RM2,100,000 = RM1,400,000 |
| EBIT= RM1,400,000-1,050,000 = RM350,000 |
| Operating leverage = RM2,100,000/RM350,000 |
| Operating leverage = 6 |
| Answer C |
| Financing Leverage = EBIT/EBT |
| Where, |
| EBIT = Contribution - Total Fixed operating cost |
| EBT = EBIT-Interst Expenses |
| Option 1 where 14% bond issued |
| Interest expenses = (RM 20,000,000*12%) + (RM 4,500,000*14%) |
| Interest expenses =2,400,000+630,000 |
| Interest expenses =RM3,030,000 |
| EBT = 7,000,000-3,030,000 |
| EBT =RM39,70,000 |
| Financing Leverage = RM7,000,000/RM3,970,000 |
| Financing Leverage = 1.76 |
| Option 2 where 14% bond Not issued |
| Interest expenses = (RM 20,000,000*12%) |
| Interest expenses =RM2,400,000 |
| EBT = 7,000,000-2,400,000 |
| EBT =RM46,00,000 |
| Financing Leverage = RM7,000,000/RM4,600,000 |
| Financing Leverage = 1.52 |
| Answer D |
| Financial break even point is the point where your EBIT is equal to your interest expenses |
| So in option 1 the Financial break even point is RM3,030,000 |
| And in option 2 the Financial break even point is RM2,400,000 |
