Exam 1-chapter 5
Discuss the various uses for break even analysis.
This analysis allows the firm to determine the level of operations it will take to break even (earn zero profit) and to explore the relationship between volume, costs, and profits.
Explain how the break-even point and operating leverage are affected by the choice of manufacturing facilities (labor intensive versus capital intensive).
A labor intensive company will have low fixed costs and a correspondingly low break-even point. However, the impact of operating leverage on the firm is small and there will be little magnification of profits as volume increases. A capital-intensive firm, on the other hand, will have a higher break-even point and enjoy the positive influences of operating leverage as volume increases.
What factors would cause a difference in the use of financial leverage for a utility company and an automobile company?
A utility is in a stable, predictable industry and therefore can afford to use more financial leverage than an automobile company, which is generally subject to the influences of the business cycle. An automobile manufacturer may not be able to service a large amount of debt when there is a downturn in the economy.
Explain why operating leverage decreases as a company increases sales and shifts away from the break-even point.
At progressivley higher levels of operations than the break-even point, the percentage change in the operating income as a result of a percentage change in unit volume diminishes. The reason is primarily mathematical- as we move to increasingly higher levels of operating income, the percentage change from the higher base is likely to be less.
What does risk taking have to do with the use of operating and financial leverage?
Both operating and financial leverage imply that the firm will employ a heavy component of fixed cost resources. This is inherently risky because the obligation to make payments remains regardless of the condition of the company or the economy.
Discuss the limitations of financial leverage
Debt can only be used up to a point. Beyond that, financial leverage tends to increase the overall costs of financing to the firm as well as encourage creditors to place restrictions on the firm. The limitations of using financial leverage tend to be greatest in industries that are highly cyclical in nature.
What role does depreciation play in break-even analysis based on accounting flows? Based on cash flows? Which perspective is longer term in nature?
For break-even analysis based on accounting flows, depreciation is considered part of fixed costs. For cash flow purposes, it is eliminated from fixed costs. The accounting flows perspective is longer term in nature because we must consider the problems of equipment replacement.
Explain how combined leverage brings together operating income and earnings per share.
Operating leverage primarily affects the operating income of the firm. At this point, financial leverage takes over and determines the overall impact on earnings per share. A delineation, of the combined effect of operating and financial leverage is presented in Table 5-6 and Figure 5-5.
How does the interest rate on new debt influence the use of financial leverage?
The higher the interest rate on new debt, the less attractive financial leverage is to the firm.
When you are considering two different financing plans, does being at the level where earnings per share are equal between the two plans always mean you are indifferent as to which plan is selected?
The point of equality only measures indifference based on earnings per share. Since our ultimate goal is market value maximization, we must also be concerned with how these earnings are valued. Two plans that have the same earnings per share may call for different price-earnings ratios, particularly when there is a differential risk component involved because of debt.