Part One: External Funding Requirement Your company, Martin Industries, Inc., ha
ID: 2701225 • Letter: P
Question
Part One: External Funding Requirement
Your company, Martin Industries, Inc., has experienced a higher than expected demand for its new product line. The company plans to expand its operation by 25% by spending $5,000,000 for an additional building.
The firm would like to maintain its 40% debt to total asset ratio in its capital structure and its dividend payout ratio of 50% of net income. Last year, net income was $2,500,000.
Required:
Part Two: The Degree of Leverage
Assume that two companies, Brake, Inc. and Carbo, Inc., have the following operating results:
Brake, Inc.
Carbo, Inc.
Sales
$300,000
$300,000
Variable Costs
60,000
180,000
Fixed Costs
210,000
90,000
Operating Income
$30,000
$30,000
Required:
Deliverables:
Brake, Inc.
Carbo, Inc.
Sales
$300,000
$300,000
Variable Costs
60,000
180,000
Fixed Costs
210,000
90,000
Operating Income
$30,000
$30,000
Explanation / Answer
Net income = $2,500,000
Dividend payout is 50%, retained earnings = 2,500,000*(1-50%)=$1,250,000
As debt to total asset ratio is 40%, new debt needed is 40%*5,000,000=2,000,000
Total equity needed is 5mn total - 2mn debt = $3,000,000 equity
If retained earnins is used, then external equity used is $3,000,000-1,250,000 = 1,750,000
If retained earnings are all retained for coming year, then external equity needed is entire $3,000,000
Part 2
Contribution margin = sales - variable costs
This is 300,000-60,000=240,000 for Brake and 300,000-180,000=120,000 for Carbo
As a % of revenues, this is 240,000/300,000=80% for Brake and 120,000/300,000=40% for Carbo
At breakeven, contribution will be = to fixed costs.
So contribution will be 210,000 for Brake and 90,000 for Carbo
As contribution % is 80% for Brake, revenues = 210,000/80%=$262,500 for Brake - this is the breakeven revenue in dollars
As contribution % is 40% for Carbo, revenues = 90,000/40%=$225,000 for Carbo - this is the breakeven revenue in dollars
While both companies have same revenues and operating margins, Brake has higher fixed costs while Carbo has lower fixed costs. So operating leverage is higher in Brake.
Operating leverage = contribution/operating income
This is = 240,000/30,000=8 for Brake and =120,000/30,000=4 for Carbo
If both have 15% increase in sales, change in operating income = change in sales % * operating leverage
So change in operating income for Brake = 15%*8 = 120%, i.e. operating income will be 30,000+120%*30,000 = 66,000
Change in operating income for Carbo = 15%*4 = 60%, i.e. operating income will be 30,000+60%*30,000 = 48,000
The difference is because of high operating leverage in Brake, i.e. higher fixed costs and lower variable costs, so at higher sales figures, the additional costs in terms of variable costs are much lower so the increase in operating income is higher.
Recommendations for Carbo would be to ensure they always have high level of sales perhaps by increasing sales commissions so that their fixed costs are always covered.
Recommendations for Brake would be to explore how they can reduce the high variable costs and perhaps move a bit more costs towards fixed, assuming they have good visibility on the sales front.
This was long but hope this helped. :) Let me know in case of queries.