Chapter 5
Operating and Financial Leverage
Discussion Questions
|5-1. |Discuss the various uses for break-even analysis. |
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| |Such analysis allows the firm to determine at what level of operations it will break even (earn zero profit) |
| |and to explore the relationship between volume, costs, and profits. |
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|5-2.
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This is inherently risky because the obligation to make payments remains regardless of the condition|
| |of the company or the economy. |
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|5-6. |Discuss the limitations of financial leverage. |
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| |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. |
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|5-7. |How does the
managers must be careful how they use the money of the firm. Debt creates a
Although the financial goal is to create profit, we need to calculate the breakeven point to get started.
5. Determine the necessary sales in unit and dollars to break-even or attain desired profit using the break-even formula.
b. Other indications of financial difficulties (default on loan or similar agreements, arrearages in dividends, denial of usual trade credit from suppliers, restructuring of debt, noncompliance with statutory capital requirements, the need to seek new sources or methods of financing, or the need to dispose of substantial assets).
It helps managers a lot in evaluating future courses of action regarding pricing and the introduction of new services. CVP analysis or Breakeven is used to compute the volume level at which total revenues are equal to the total costs. When total costs and total revenues are equal, the organization is said to be “breaking even”. Managers can utilize P&L statements which are used to project profit or net income. P&L statements can be developed to serve decision making purposes. These can be created for any subunit within an organization, whereas income statements are created only for the overall accounting entity. Break even analysis contains important assumptions and is very essential to the managers to determine whether assumed values can be realistically achieved. Managers can perform CVP analysis to plan future levels of operating activity and provide information about:
The purpose of break-even analysis is to determine the number of units of a product to sell that will
This question gives students an opportunity to exercise their ability to interpret break-even analyses. Key teaching points should include explaining the preparation of a break-even chart, the interpretation of the break-even volume (938,799 hectoliters [HL]), and the comparison of the break-even volume to the current volume (1,173,000 HL). Another key point is that the chart in case Exhibit 5 is relevant only for the current cost structure of the company—if variable costs increase or the plant expansion is approved, the break-even volume will rise. Finally, students should be aided in understanding that “break-even” refers to operating profit, not free cash flow. The typical use of the break-even chart ignores taxes, investments, and the depreciation tax shield.
Break-even point analysis is a measurement system that calculates the margin of safety by comparing the amount of revenues or units that must be sold to cover fixed and variable costs associated with making the sales. In other words, it’s a way to calculate when a project will be profitable by equating its total revenues with its total expenses. There are several different uses for the equation, but all of them deal with managerial accounting and cost management (Break-Even Point, n.d.)
* A broader capital base gives the company more access to credit which gives the company an option to venture into new business opportunities
firm’s financing, for example, issuing or repurchasing stock and borrowing or repaying loans. It also
A company's break-even point is the amount of sales or revenues that it must generate in order to equal its expenses. In other words, it is the point at which the company neither makes a profit nor suffers a loss. Calculating the break-even point (through break-even analysis) can provide a simple, yet powerful quantitative tool for managers. In its simplest form, break-even analysis provides insight into whether or not revenue from a product or service has the ability to cover the relevant costs of production of that product or service. Managers can use this information in making a wide range of business decisions, including setting prices, preparing competitive bids, and applying for loans.
It seems then that companies should fully leverage the company or a least come close to doing so but there is a probability that the company enters financial distress as its leverage (D/E) increases. Financial distress can be very costly for companies, and the cost for this scenario is shown in the current market value of the levered firm's securities. Investors factor the potential for future distress into their assessment of the present value (this is where PV of distress costs is subtracted from un-levered company value and the PV of the tax-shield.) The value for the costs
Table IV (Appendix 2) from the research paper is to test the possibility that a firm fits in one of the five categories. It shows that firms with greater debt to total capital, Q, and restriction of dividend, have high tendency to be categorised as financially constrained, whereas firms that owns greater cash flow, cash, dividends paid, retained earnings, and unused line of credit, have high tendency to be categorised as not financially constrained.
the manager may use a simple analysis of past operating data to obtain a percentage of sales
Harris and Reviv (1990) gave one more reason of using debt in capital structure. They say that management will hide information from shareholders about the liquidation of the firm even if the liquidation will be in the best interest of shareholders because managers want the perpetuation of their service. Similarly, Amihud and Lev (1981) suggest that mangers have incentives to pursue strategies that reduce their employment risk. This conflict can be solved by increasing the use of debt financing since bondholders will take control of the firm in case of default as they are powered to do so by the debt indentures. Stulz (1990) said when shareholders cannot observe either the investing decisions of management or the cash flow position in the firm, they will use debt financing. Managers, to maintain credibility, will over-invest if it has extra cash and under-invest if it has limited cash. Stulz (1990) argued that to reduce the cost of underinvestment and overinvestment, the amount of free cash flow should be reduced to