Corporate Finance【Reading 38】Sample 2012, percentage, business, higher

kim226

All else equal, a firm's business risk is higher when:

A) the firm has low operating leverage.

B) variable costs are the highest portion of its expense.

C) fixed costs are the highest portion of its expense.

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The higher the percentage of a firm's costs that are fixed, the higher the operating leverage, and the greater the firm's business risk and the more susceptible it is to business cycle fluctuations.

terpsichorefan

thanks for sharing

kim226

Yangtze Delta High Technology produces multimedia-enabled wireless phones. The factory incurs rent, depreciation, salary, and other fixed costs totaling RMB 10 million per year. Also, the company incurs annual interest of RMB 3 million on debt. Each phone sold by Yangtze Delta sells for RMB 200. The variable cost per phone is RMB 150. Yangtze Delta’s operating breakeven quantity of sales is closest to:

A) 200,000.

B) 260,000.

C) 65,000.

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The operating breakeven point is the quantity of product sold at which operating income is zero (revenue equals operating cost).
F = Fixed operating cost = RMB 10,000,000
P = Price per unit = RMB 200
V = Variable cost per unit = RMB 150
Operating breakeven quantity = F / (P − V) = 10,000,000 / (200 − 150) = 200,000.

kim226

Jayco, Inc., sells blue ink for $4.00 a bottle. The ink's variable cost per bottle is $2.00. Ink has fixed cost of $10,000. What is Jayco's breakeven point in units?

A) 2,500.

B) 6,000.

C) 5,000.

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QBE = [FC] / (P - V)
QBE = [10,000] / (4.00 - 2.00) = 5,000

kim226

Annual fixed costs at King Mattress amount to $325,000. The variable cost of raw materials and labor is $120 for the typical mattress. Sales prices for mattresses average $160. How many units must King Mattress sell to break even?

A) 40.

B) 8,125.

C) 2,708.

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QBreakeven = Fixed Cost / (Price – Variable Cost)
QBreakeven = $325,000 / (160 – 120) = 8,125

kim226

Jayco, Inc. has a division that makes red ink for the accounting industry. The unit has fixed costs of $10,000 per month, and is expected to sell 40,000 bottles of ink per month. If the variable cost per bottle is $2.00 what price must the division charge in order to breakeven?

A) $2.50.

B) $2.25.

C) $2.75.

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40,000 = $10,000/(P - $2)
40,000P – $80,000 = $10,000
P = $90,000/40,000 = $2.25.

kim226

Wanton’s San Y’isidro Co. manufactures custom door knobs for international clients. Average Revenue is $35 per unit, variable costs are $15 per unit, and total costs are $200,000. If sales are 10,000 units, what is the firm's breakeven sales quantity?

A) 2,500 units.

B) 1,750 units.

C) 3,000 units.

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For this problem you need 2 equations. Break-even quantity = Fixed Costs / (Price - Variable cost) Q = FC / (P - V) Fixed Costs = Total Costs - Variable Costs FC = TC - VC = 200,000 - 150,000 = 50,000
Q = 50,000 / (35 - 15) = 2,500

kim226

Which of the following firms is likely to have a higher debt ratio?

A) Bath & Books, which produces toiletries and other consumer staples that are in demand regardless of economic conditions.

B) Critter Care, which has a low debt rating due to the prior financial mismanagement by the chief executive officer.

C) Egg Harbor Furs, which serves as a wholesaler of fine furs and garments.

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Bath & Books appears to have relatively little business risk, especially in relation to Egg Harbor Furs, which is likely to be a much more cyclical business. Creditors will be less willing to lend funds to Critter Care whose managers have shown poor money management skills in the past.

kim226

Munn Industrial Components currently finances its operations with 100% equity, but is considering changing its target capital structure to 70% equity and 30% debt. Munn has a large asset base, a 20% operating profit margin, and the average interest rate on debt is expected to be 6.0%. If Munn makes the change to its capital structure and EBIT is unchanged, what is most likely the impact on Munn’s net income and return on equity (ROE) respectively?

Impact on Net Income

Impact on Return on Equity

A) No Change Increase

B) Decrease Increase

C) Decrease Decrease

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You should be able to figure out this question with logic (without having to use calculations). The interest expense associated with using debt represents a fixed cost that reduces net income. However, the lower net income value is spread over a smaller base of equity capital, serving to increase the ROE.

kim226

Which of the following statements regarding the impact of financial leverage on a company’s net income and return on equity (ROE) is most accurate?

A) Using financial leverage increases the volatility of ROE for a level of volatility in operating income.

B) If a firm has a positive operating profit margin, using financial leverage will always increase ROE.

C) Increasing financial leverage increases both risk and potential return of existing bondholders.

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If a firm is financed with 100% equity, there is a direct relationship between changes in the firm’s ROE and changes in operating income. Adding financial leverage (debt) to the firm’s capital structure will cause ROE to become much more volatile and ROE will change more rapidly for a given change in operating income. The increased volatility in ROE reflects an increase in both risk and potential return for equity holders. Note that financial leverage results in increased default risk, but since existing bond holders are compensated by coupon interest and return of principal, their potential return is unchanged. Although financial leverage will generally increase ROE if a firm has a positive operating margin (EBIT/Sales), if the operating margin were small, the added interest expense could turn the firm’s net profit margin negative, which would in turn make ROE negative.