CHAPTER 12

Determining the Financing Mix

CHAPTER ORIENTATION
This chapter focuses on useful aids to the financial manager in his or her determination of the
firm’s proper financial structure. It includes the definitions of the different kinds of risk, a
review of break-even analysis, the concepts of operating leverage, financial leverage, the
combination of both leverages, and their effect on (earnings per share) EPS. Then the chapter
concentrates on the way the firm arranges its sources of funds. The cost of capital-capital
structure argument is highlighted in a straightforward manner without dwelling excessively
on pure theory. A moderate view of the effect of financial leverage on the firm’s overall cost
of capital is highlighted and explained. Later, techniques useful to the financial officer faced
with the determination of an appropriate financing mix are described. Agency theory and the
concept of free cash flow as they relate to capital structure determination are also discussed.
An overview of actual practice is also included.

CHAPTER OUTLINE

I. Business risk and financial risk

A. Risk has been defined as the likely variability associated with expected
revenue streams.
1. Focusing on the financial decision, the variations in the income stream
can be attributed to:
a. The firm’s exposure to business risk.
b. The firm’s decision to incur financial risk.
B. Business risk can be defined as the variability of the firm’s expected earnings
before interest and taxes (EBIT).
1. Business risk is measured by the firm’s corresponding expected
coefficient of variation (i.e., the larger the ratio, the more risk a firm is
exposed to).

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 2. Dispersion in operating income does not cause business risk. It is the
result of several influences; (e.g., the company’s cost structure,
product demand characteristics, and intra-industry competition.) These
influences are a direct result of the firm’s investment decision.
C. Financial risk is a direct result of the firm’s financing decision. When the firm
is selecting different financial alternatives, financial risk refers to the
additional variability in earnings available to the firm’s common shareholders
and the additional chance of insolvency borne by the common shareholder
caused by the use of financial leverage.
1. Financial leverage is the financing of a portion of the firm’s assets with
securities bearing a fixed (limited) rate of return in hopes of increasing
the ultimate return to the common shareholders.
2. Financial risk is to a large extent, passed on to the common
shareholders who must bear almost all of the potential inconsistencies
of returns to the firm after the deduction of fixed payments.
II. Break-even analysis
A. The objective of break-even analysis is to determine the break-even quantity of
output by studying the relationships among the firm’s cost structure, volume of
output, and operating profit.
1. The break-even quantity of output is the quantity of output (in units)
that results in an EBIT level equal to zero.
B. Use of the model enables the financial officer to:
1. Determine the quantity of output that must be sold to cover all
operating costs.
2. Calculate the EBIT that will be achieved at various output levels.
C. Some actual and potential applications of break-even analysis include:
1. Capital expenditure analysis as a complementary technique to
discounted cash flow evaluation models.
2. Pricing policy.
3. Labor contract negotiations.
4. Evaluation of cost structure.
5. The making of financial decisions.

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D. Essential elements of the break-even model are:
1. Fixed costs are costs that do not vary in total amount as the sales
volume or the quantity of output changes over some relevant range of
output. For example, administrative salaries are considered fixed
because these salaries are generally the same month after month. Other
examples are:
a. Depreciation.
b. Insurance premiums.
c. Property taxes.
d. Rent.
The total fixed cost is unchanged regardless of the quantity of product
output or sales, although, over some relevant range, these costs may be
higher or lower (i.e., in the long run).
2. Variable costs are costs that tend to vary in total as output changes.
Variable costs are fixed per unit of output. For example, direct
materials are considered a variable cost because they vary with the
amount of products produced. Other variable costs are:
a. Direct labor.
b. Energy cost associated with the production area.
c. Packaging.
d. Freight-out.
e. Sales commissions.
3. To implement the behavior of the break-even model, it is necessary for
the financial manager to:
a. Identify the most relevant output range for his or her planning
purposes.
b. Approximate all costs in the semifixed-semivariable range and
allocate them to the fixed and variable cost categories.
4. Total revenue and volume of output
a. Total revenue from sales is equal to the price per unit multiplied
by the quantity sold.
b. The volume of output is the firm’s level from operations and is
expressed as sales dollars or a unit quantity.

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E. Finding the break-even point
1. The break-even model is just a simple adaptation of the firm’s income
statement expressed in the following format:
sales - (total variable costs + total fixed costs) = profit
a. Trial and error
(1) Select an arbitrary output level.
(2) Calculate the corresponding EBIT amount.
(3) When EBIT equals zero, the breakeven point has been
found.
b. Contribution margin analysis
(1) The difference between the unit selling price and the
unit variable cost equals the contribution margin.
(2) Then, the fixed cost divided by the contribution margin
equals the breakeven quantity in units.
c. Algebraic analysis
(1) QB = the break-even level of units sold,

P = the unit sales price,

F = the total fixed cost for the period,
V = unit variable cost.
(2) Then,
F
QB =
P−V
F. The break-even point in sales dollars:
1. Computing a break-even point in terms of sales dollars rather than units
of output is convenient, especially if the firm deals with more than one
product. Also, if the analyst cannot get unit cost data, he or she can
compute a general break-even point in sales dollars by using the firm’s
annual report.

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 2. Since variable cost per unit and the selling price per unit are assumed
constant, the ratio of total variable costs to sales (VC/S) is a constant
for any level of sales. So, if the break-even level of sales is denoted S*,
the corresponding equation is:
F
S* =
VC
1−
S
G. Limitations of break-even analysis:
1. The cost-volume-profit relationship is assumed to be linear.
2. The total revenue curve is presumed to increase linearly with the
volume of output.
3. A constant production and sales mix is assumed.
4. The break-even computation is a static form of analysis.
III. Operating Leverage
A. Operating leverage is the responsiveness of a firm’s EBIT to fluctuations in
sales. Operating leverage results when fixed operating costs are present in the
firm’s cost structure. It should be noted here that fixed operating costs do not
include interest charges incurred from the firm’s use of debt financing.
B. The responsiveness of a firm’s EBIT to fluctuating sales levels can be
measured as follows:

 degree of operating 
  % change in EBIT
 leverage from the  = DOLs =
 base sales level  % change in sales
 
For example, if DOLs equals five times, a 10% rise in sales over the coming
period will result in a 50% rise in EBIT. (This means of measure also holds
true for the negative direction.)
C. If unit costs are available, the DOLs can be measured by the following
formula:
Q(P − V)
DOLs =
Q(P − V) − F
D. If an analytical income statement is the only thing available, the following
formula can be used to produce the same results:
revenue before fixed costs S − VC
DOLs = =
EBIT S − VC − F

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 E. It should be noted here that the three formulas stated all produce the same
results. But, more important is the understanding that in this example a 1%
change in sales will result in a 5% change in EBIT.
F. Implications of operating leverage:
1. At each point above the break-even level, the degree of operating
leverage decreases (i.e., the greater the sales level, the lower the
DOLs).

2. At the break-even level of sales, the degree of operating leverage is

undefined.
3. Operating leverage is present anytime the percentage change in EBIT
divided by the percentage change in sales is greater than one.
4. The degree of operating leverage can be attributed to the business risk
that a firm faces.
IV. Financial leverage
A. Financial leverage, as defined earlier, is the practice of financing a portion of
the firm’s assets with securities bearing a fixed rate of return in hopes of
increasing the ultimate return to the common stockholders. To see if financial
leverage has been used to benefit the common shareholders, the discussion
here will focus on the responsiveness of the company’s EPS to changes in its
EBIT. It should be noted here that not all analysts rely exclusively on this type
of relationship.
B. The firm is using financial leverage and is exposing its owners to financial risk
when:
% change in EPS
is greater than 1.00
% change in EBIT
C. A precise measure of the firm’s use of financial leverage can be expressed in
the following relationship:

 degree of financial 
  % change in EPS
 leverage from the  = DFLEBIT =
 base EBIT level  % change in EBIT
 
1. As was the case with operating leverage, the degree of financial
leverage concept can be in the negative direction as well as in the
positive direction.
2. You should also note that the greater the degree of financial leverage,
the greater the fluctuations (positive or negative) in EPS.

384
 D. An easier way of measuring the degree of financial leverage that produces the
same results without computing percentage changes in EBIT and EPS is:
EBIT
DFLEBIT =
EBIT − I
where I is the sum of all fixed financing costs.
V. Combining operating and financial leverage
A. Since changes in sales revenues cause greater changes in EBIT, and if the firm
chooses to use financial leverage, changes in EBIT turn into larger variations
in both EPS and EAC (earnings available to common shareholders). Then,
combining operating and financial leverage causes rather large variations in
EPS.
B. One way to measure the combined leverage can be expressed as:

 degree o f combined 
  % change in EPS
 leverage from the  = DCLs =
 base sales level  % change in sales
 
If the DCL is equal to 5.0 times, then it is important to understand that a 1%
change in sales will result in a 5% change in EPS.
C. The degree of combined leverage is actually the product of the two
independent leverage measures. Thus, we have:
DCLs = (DOLs ) x (DFLEBIT)

D. As you might have guessed, there is still another way to compute DCLs. It is a
more direct way in that no percentage fluctuations or separate leverage values
have to be determined. You need only substitute the appropriate values into the
following equation:
Q(P − V)
DCLs =
Q(P − V) − F − I
All variables have previously been defined.
E. Implications of combining operating and financial leverage
1. The total risk exposure that the firm assumes can be managed by
combining operating and financial leverage in different degrees.
2. Knowledge of the various leverage measures that have been examined
here aids the financial officer in his or her determination of the proper
level of overall risk that should be accepted.

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VI. Introduction to Financing Mix Determination.
A. A distinction can be made between the terms financial structure and capital
structure.
1. Financial structure is the mix of all items that appear on the right-hand
side of the firm’s balance sheet.
2. Capital structure is the mix of the long-term sources of funds used by
the firm.
3. In this chapter, we do not dwell on the question of dealing with an
appropriate maturity composition of the firm’s sources of funds. Our
main focus is on capital structure management, (i.e., determining the
proper proportions relative to the total in which the permanent forms of
financing should be used.)
B. The objective of capital structure management is to mix the permanent sources
of funds in a manner that will maximize the company’s common stock price.
This will minimize the firm’s composite cost of capital. This proper mix of
funds sources is referred to as the optimal capital structure.
VII. Capital structure theory
A. The cost of capital-capital structure argument may be characterized by this
question:
1. Can the firm affect its overall cost of funds, either favorably or
unfavorably, by varying the mixture of financing sources used?
B. The argument deals with the postulated effect of the use of financial leverage
on the overall cost of capital of the company.
C. If the firm’s cost of capital can be affected by the degree to which it uses
financial leverage, then capital structure management is an important subset of
business financial management.
VIII. Capital structure theory: A moderate position
A. The moderate position on capital structure importance admits to the facts that
(l) interest expense is tax-deductible in the world of corporate activity and (2)
the probability of the firm’s suffering bankruptcy costs is directly related to the
company’s use of financial leverage.

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B. When interest expense is tax-deductible, the sum of the cash flows that the
firm could pay to all contributors of corporate capital (debt investors and
equity investors) is affected by its financing mix. This is not the case when an
environment of no corporate taxation is presumed.
1. The amount of the tax shield on interest may be calculated as:
Tax shield = rd(M)(t)

where rd = the interest rate paid on outstanding debt,

M = the principal amount of the debt,

t = the firm’s tax rate.
2. The moderate position presents the view that the tax shield must have
value in the marketplace. After all, the government’s take is decreased,
and the investor’s take is increased because of the deductibility of
interest expense.
3. Therefore, according to this position, financial leverage affects firm
value, and it must also affect the cost of corporate capital.
C. To use too much financial leverage, however, would be imprudent. It seems
reasonable to offer that the probability that the firm will be unable to meet the
financial obligations contained in its debt contracts will increase the more the
firm uses leverage-inducing instruments (debt) in its capital structure. The
likelihood of firm failure, then, carries with it certain costs (bankruptcy costs)
that rise as leverage use increases. There will be some point at which the
expected cost of default will be large enough to outweigh the tax shield
advantage of debt financing. At that point, the firm will turn to common equity
financing.
D. Figure 12.1 that follows depicts the moderate view on capital structure
importance. This view of the cost of capital-capital structure argument
produces a saucer-shaped or U-shaped average cost of capital curve. In Figure
12.1, the firm’s optimal range of financial leverage use lies between points A
and B. It would be imprudent for the firm to use additional financial leverage
beyond point B because (l) the average cost of capital would be higher than it
has to be and (2) the firm’s common stock price would be lower than it has to
be. Therefore, we can say that the degree of financial leverage use signified by
point B represents the firm’s debt capacity.

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 Kc

Capital costs
Ko
Kd

A B
Financial leverage
Figure 12.1
Capital Costs and Financial Leverage: The Moderate View Which Considers Taxes
and Financial Distress

E. We conclude that the determination of the firm’s financing mix is centrally

important to both the financial manager and the firm’s owners.
IX. Firm value and Agency Costs
A. Agency problem results in costs to the firm’s owners to monitor management
actions.
B. Capital structure management given risk to agency costs associated with
conflict between firms stockholders and bondholders.
1. Covenants in bond contracts may reduce potential conflicts.
2. Costs associated with protective covenants are borne by shareholders.
3. Monitoring costs rise as firm’s use of financial leverage increases.
4. With higher degrees of financial leverage, costs associate with financial
distress increases.
C. Market value of levered firm is the sum of the market value of the unlevered
firm plus the present value of tax shields less the present value of the financial
distress costs and of agency costs.

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 D. Agency costs, free cash flow, and capital structure
1. Free cash flow’s cash flow in excess of that required to fund all
positive NPV projects.
2. Professor Jensen suggests substantial free cash flow can lead to
managerial misbehavior and poor discounts associated with
expenditures of the cash.
3. Jensen’s control hypothesis suggests that by increasing the level of firm
debt, shareholders will have more control over management.
a. Management working under threat of financial failure will work
more efficiently.
X. Basic tools of capital structure management
A. Recall that the use of financial leverage has two effects on the earnings stream
flowing to the firm’s common stockholders: (l) the added variability in the
earnings per share (EPS) stream that accompanies the use of fixed-charge
securities and (2) the level of EPS at a given earnings before interest and taxes
level (EBIT) associated with a specific capital structure. The first effect is
quantified by the degree of financial leverage measure. The second effect is
analyzed by means of what is generally referred to as EBIT-EPS analysis.
B. The objective of EBIT-EPS analysis is to find the EBIT level that will equate
EPS regardless of the financing plan chosen (from among two plans) by the
financial manager.
1. A graphic analysis or an algebraic analysis can be used.
2. Study problems at the end of this chapter illustrate the nature of EBIT-
EPS analysis.
3. EBIT-EPS analysis considers only the level of the earnings stream and
ignores the variability (riskiness) in it. In other words, this tool of
capital structure management disregards the implicit costs of debt
financing. Therefore, it must be used with caution and in conjunction
with other basic tools of capital structure management.
C. Comparative leverage ratios provide another tool of capital structure
management. This involves the computation of various balance-sheet leverage
ratios and coverage ratios. Information for the latter comes essentially from the
income statement. The ratios that would exist under alternative financing plans
can then be computed and examined for their suitability to management.

389
 D. The use of industry norms in conjunction with comparative leverage ratios can
aid the financial manager in arriving at an appropriate financing mix. Industry
norms can be thought of as standards for comparison. We recognize that
industry groupings contain firms whose basic business risk may differ widely.
Nevertheless, corporate financial analysts, investment bankers, commercial
loan officers, and bond-rating agencies rely on industry classes in order to
compute such "normal" ratios. Since so many observers are interested in
industry standards, the financial officer must be too.
XI. A glance at actual capital structure management
A. The opinions and practices of financial executives reinforce the major topics
covered in this chapter. Most senior financial officers, for example, do believe
there is an optimum capital structure for the corporation.
B. Target debt ratios are widely used by financial officers. Surveys indicate that
the firm’s actual target debt ratio is affected by several factors including (l) the
firm’s ability to meet its financing charges adequately, (2) maintaining a
desired bond rating, (3) providing an adequate borrowing reserve, and (4)
exploiting the perceived advantages of financial leverage. In practice, the
firm’s own management group and staff of analysts seem to be the most
important influence on actually setting the target debt ratio.
C. In this chapter, we defined debt capacity as the maximum proportion of debt
that the firm can include in its capital structure and still maintain its lowest
composite cost of capital. Executives operationalize this concept in different
ways. The most popular approach is to define the firm’s debt capacity as a
target percent of total capitalization (i.e., total long-term debt divided by the
sum of all long-term debt, preferred equity, and common equity).
D. In the opinion of your authors, the single most important factor that should affect
the firm’s financing mix is the underlying nature of the business in which it
operates. This means the firm’s business risk must be carefully assessed. This
means the firm’s capital structure cannot be properly designed without a thorough
understanding of its commercial (business) strategy.
XII. Multinational firm: Business Risk and Global Sales
A. Business risk for multinational firm is directly affected by
1. sensitively of firm’s product demand to general economic conditions.
2. degree of competition
3. product diversification
4. growth prospects
5. global sales volume and production output.
B. Multinational firm expansion into foreign markets increases the firm’s business risk.

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 ANSWERS TO
END-OF-CHAPTER QUESTIONS

12-1. Business risk is the uncertainty that envelops the firm’s stream of earnings before
interest and taxes (EBIT). One possible measure of business risk is the coefficient of
variation in the firm’s expected level of EBIT. Business risk is the residual effect of
the (1) company’s cost structure, (2) product demand characteristics, (3) intra-
industry competitive position. The firm’s asset structure is the primary determinant of
its business risk. Financial risk can be identified by its two key attributes: (1) the
added risk of insolvency assumed by the common stockholder when the firm chooses
to use financial leverage; (2) the increased variability in the stream of earnings
available to the firm’s common stockholders.
12-2. Financial leverage is financing a portion of the firm’s assets with securities bearing a
fixed (limited) rate of return. Anytime the firm makes its preferred dividend payment,
financial leverage is provided by the use of preferred stock.
12-3. Operating leverage is the use of operating fixed costs in the firm’s cost structure.
When operating leverage is present, any percentage fluctuation in sales will result in a
greater percentage fluctuation in EBIT.
12-4. The most important shortcomings of break-even analysis are:
a. The cost-volume-profit relationship is assumed to be linear over the entire
range of output.
b. All of the firm’s production is assumed to be salable at the fixed selling price.
c. The sales mix and production mix are assumed constant.
d. The level of total fixed costs and the variable-cost-to-sales ratio are held
constant over all output and sales ranges.
12-5. As the sales of a firm increase, two things occur that bias the cost and revenue
functions toward a curvilinear shape. First, sales will increase at a decreasing rate. As
the market approaches saturation, the firm must cut its price to generate sales revenue.
Second, as production approaches capacity, inefficiencies occur that result in higher
labor and material costs. Furthermore, the firm’s operating system may have to bear
higher administrative and fixed costs. The result is higher per unit costs as production
output increases.
12-6. a. Financial structure: the mix of all items that appear on the right-hand side of
the company’s balance sheet.
b. Capital structure: the mix of long-term funds used by the firm.
c. Optimal capital structure: the mix of long-term funds that will minimize the
composite cost of capital for raising a given amount of funds.
d. Debt capacity: the maximum proportion of debt that the firm can include in its
capital structure and still maintain its lowest composite cost of capital.

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12-7. The decision to use financial leverage by the firm affects both the level and variability
of the EPS flowing to the common stockholders. EBIT-EPS analysis deals only with
the level (amount) of EPS available under a given financing plan. The variability in
the earnings stream associated with the plan is ignored. EBIT-EPS analysis, then,
disregards the riskiness inherent to a particular financing alternative.
12-8. The objective of capital structure management is to mix the permanent sources of
funds used by the firm in a manner that will maximize the company’s common stock
price.
12-9. Balance-sheet leverage ratios compare the firm’s use of funds supplied by creditors to
those supplied by owners. The inputs to these metrics come from the company’s
balance sheet. Coverage ratios relate earnings or cash flow amounts that are available
for servicing financing costs to such financing costs. The inputs to computing
coverage ratios generally come from the company’s income statement. At times,
footnotes to the financial statements might have to be consulted to calculate some
coverage ratios properly. Balance sheet ratios include debt ratios include debt ratio
(Total debt divided by Total assets) and current ratio (current assets divided by current
liabilities). Coverage ratios include times-interest-earned (EBIT divided by interest
expense) and fixed charge coverage (EBIT plus fixed changes divided by interest
expense plus fixed charges).
12-10. If revenues from sales are highly volatile, then other things being equal, cash flows
will be volatile. This would make it difficult to meet, on a timely basis, a large
amount of fixed financing costs. Because of this, a high degree of financial risk will
be avoided by firms that operate in industries which experience large sales
fluctuations.
12-11. Within the realm of capital structure theory, the independence hypothesis offers that
both common stock price and the composite cost of capital are not affected by the
firm’s use of financial leverage. This presumes that interest expense is not tax-
deductible.
12-12. This means that the shape of the firm’s composite cost of capital curve is saucer-
shaped or U-shaped with respect to the use of financial leverage. Over moderate
degrees of leverage use, the overall cost of capital decreases. Throughout the optimal
range of leverage use, the cost of capital curve is relatively flat. At excessive degrees
of leverage use, the overall cost of capital rises. The result is a saucer shape.
12-13. The level of EBIT that will result in the same EPS regardless of the financing plan
ultimately chosen from a set of two alternatives.
12-14. Industry norms for the various balance-sheet leverage ratios and coverage ratios
provide only rough guidelines for the design of the firm’s financing mix. Norms are
usually averages or some other measure of central tendency. Few firms, in reality,
will have the same operating characteristics as a hypothetical "normal" firm. Thus,
norms are best used on an "exception" basis. That is, if the firm’s capital structure
ratios differ widely from the norms, then a defensible explanation for that condition
should be available.

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12-15. Free cash flow is that cash flow in excess of that required to fund all projects that have
positive net present values when discounted at the relevant cost of capital.
12-16. Financial managers clearly favor the use of internally generated equity (such as the
change in retentions during a given year) in the financing of capital budgets.

SOLUTIONS TO
END-OF-CHAPTER PROBLEMS

12-1 a. Breakeven Point in Sales Dollars = Fixed Costs

1 − Variable Costs
Sales
$10,143,000 = $10,143,000

1 - $25,137,000 1 - .498
$50,439,375

$10,143,000 = $20,205,179.28
.502

b. Percentage increase in EBT and NI = (%∆ sales) x (DCL)

(+30%) x (1.85) = 55.50% increase

12-2 a.
(EBIT − 0)(1 − 0.35) =
(EBIT − $420,000)(1 − 0.35)
160,000 64,000

0.65 EBIT 0.65 EBIT − $273,000

=
160,000 64,000

EBIT = $700,000

b. Plan A Plan B
EBIT $700,000 $700,000
Interest 0 420,000
EBT $700,000 $280,000
T(0.35) 245,000 98,000
EAC $455,000 $182,000
÷ No. of common shares 160,000 64,000
EPS $ 2.84 $ 2.84

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 (EBIT − I) x (1 − T)
12-3 a. EBIT indifference level =
# shares outstanding

where EBIT = Earnings before interest and taxes

I = Interest Expense
T = Taxes
(EBIT − 0) x (1 − .3) (EBIT − 80,000) x (1 − .3)
=
100,000 50,000
0.7 EBIT 0.7 EBIT − $56,000
=
100 50
EBIT = $160,000

b. Analytical Income Statement

Plan A Plan B
EBIT $160,000 $160,000
(Interest) (0) (80,000)
EBT $160,000 $80,000
(Taxes @ 30%) (48,000) (24,000)
EAC $112,000 $56,000
÷ # of common shares 100,000 50,000
EPS $1.12 $1.12

F $9,200,000 $9,200,000
12-4 a. S* = = =
VC $22,800,000 1 − .498
1− 1−
S $45,750,000
$9,200,000
= = $18,326,693.23
.502
b. (25%) (1.85) = 46.25%

394
 F $170,000 $170,000
12-5 a. QB = = = = 6,296 pairs of shoes
P−V $85 − $58 $27
F $170,000 $170,000 $170,000
b. SB = = = = = $534,591.19
VC $58 1 − .682 .318
1− 1−
S $85

c. 7,000 9,000 15,000

Pairs of Shoes Pairs of Shoes Pairs of Shoes
Sales $595,000 $765,000 $1,275,000
Variable Costs 406,000 522,000 870,000
Sales before fixed costs $189,000 $243,000 $405,000
Fixed costs 170,000 170,000 170,000
EBIT $ 19,000 $ 73,000 $ 235,000
Notice that the degree of operating leverage decreases as the firm’s sales level rises
above the break-even point.

F $8,000,000 $8,000,000
12-6 a S* = = =
VC $13.5 m 1 − 0.45
1− 1−
S $30.0 m

$8,000,000
= = $14,545,455
0.55
b (25%) (2.19) = 54.75%

12-7 a. S (1 - .6) - $300,000 = $250,000

.4S = $550,000

S = $1,375,000 = (P . Q)

Solve the above relationship for P.

200,000 (P) = $1,375,000

P = $6.875

b. Sales $1,375,000
Less: Total variable costs 825,000
Revenue before fixed costs $550,000
Less: Total fixed costs 300,000
EBIT $ 250,000

395
 F $180,000
12-8 a. QB = = = 1,200 units
P−V $150

F $180,000
b. SB = = = $600,000
VC 1 − 0.70
1−
S

c. (20%) x (1.316) = 26.32%

(EBIT − I)(1 − t) − P (EBIT − I)(1 − t) − P

12-9 a. =
Ss Sb

(EBIT − $0)(1 − 0.5) − 0 (EBIT − $600,000)(1 − 0.5) − 0

=
1,000,000 700,000
0.5 EBIT 0.5 EBIT − $300,000
=
10 7
EBIT = $2,000,000

b. Plan A Plan B
EBIT $2,000,000 $2,000,000
Interest 0 600,000
EBT $2,000,000 $1,400,000
Taxes 1,000,000 700,000
NI $1,000,000 $ 700,000
Preferred Dividend 0 0
EAC $1,000,000 $ 700,000
EPS $ 1.00 $ 1.00
c. See Analysis Chart.
d. Since, $2,400,000 exceeds $2,000,000, the levered plan (Plan B) will provide
for higher EPS.

396
 2.0

Plan B
1.5
Plan A
EPS

1.0 $1.00 indiff. level

0.5

$600,000

$1 Mil. $2 Mil. $3 Mil.

EBIT

(EBIT − 0)(1 − 0.4) (EBIT − $120,000)(1 − 0.4)

12-10 a. =
80,000 40,000

0.6 EBIT 0.6 EBIT − $72,000

=
80 40
EBIT = $240,000

b. Plan A Plan B
EBIT $240,000 $240,000
Interest 0 120,000
EBT $240,000 $120,000
T (.40) 96,000 48,000
EAC $144,000 $72,000
÷ No. of common shares 80,000 40,000
EPS $1.80 $1.80

397
12-11 a. Firm C appears to be excessively levered. Both its debt ratio and burden
coverage ratio are unfavorable relative to the industry norm. The firm’s
price/earnings ratio is significantly (6 vs. 10) lower than the industry norm.

b. Firm B.

c. The investing market place seems to place more weight on coverage ratios than
balance-sheet leverage measures. Thus, Firm B’s price/earnings ratio exceeds
that of Firm A

398
 SOLUTION TO COMPREHENSIVE PROBLEM

1. In solving for the break-even point in units, the following step-by-step approach
seems to be the most logical to students and the easiest for them to understand.

COMPUTE BREAK-EVEN POINT:

STEP 1: Compute the operating profit margin:

Operating profit Margin [M] x Operating Asset Turnover =
Return on Operating Assets.
M x 8 = 32%
M=4%
STEP 2: Compute the sales level associated with the given output level:
Operating Assets x Operating Asset Turnover = Sales
$4,000,000 x 8 = Sales
Sales = $32,000,000
STEP 3: Compute EBIT:
Sales [STEP 2] x Operating Profit Margin [STEP 1] = EBIT
$32,000,000 x 4% = EBIT
EBIT = $1,280,000
STEP 4: Compute revenue before fixed costs:
EBIT [STEP 3] x Degree of Operating Leverage = Revenue before Fixed
Costs
$1,280,000 x 6 = Revenue before Fixed Costs
Revenue before Fixed Costs = $7,680,000
STEP 5: Compute total variable costs:
Sales [STEP 2] - Revenue before Fixed Costs [STEP 4] = Total Variable
Costs
$32,000,000 - $7,680,000 = Total Variable Costs
Total Variable Costs = $24,320,000
STEP 6: Compute total fixed costs:
Revenue before Fixed Costs [STEP 4] - EBIT [STEP 3] = Fixed Costs
$7,680,000 - $1,280,000 = Fixed Costs
Fixed Costs = $6,400,00

399
STEP 7: Find selling price per unit (P) and variable cost per unit (V):
P = Sales [STEP 2] / Output in Units
P = $32,000,000 / 80,000 units
P = $400
V = Total Variable Costs [STEP 5] / Output in units
V = $24,320,000 / 80,000 units
V = $304
STEP 8: Compute break-even point (in units):
QB = Fixed Costs [STEP 6] / (P - V) [STEP 7]
QB = $6,400,000 / ($400 - $304)
QB = 66,667
After determining the break-even point using the preceding approach described, the students
have the information necessary to prepare an analytical income statement as follows:

Sales [STEP 2] $32,000,000

(Variable Costs) [STEP 5] (24,320,000)
Revenue before Fixed Costs [STEP 4] $7,680,000
(Fixed Costs) [STEP 6] (6,400,000)
EBIT [STEP 3] $1,280,000
(Interest Expense) (600,000)
Earnings before Taxes $680,000
(Taxes @ 35%) (238,000)
Net Income $442,000

Thereafter, the students have the data they need to answer questions a - e as follows:
a. Degree of Financial Leverage:
DFLEBIT = EBIT / (EBIT - Interest)
DFLEBIT = $1,280,000 / (1,280,000 - 600,000)
DFLEBIT = 1.88
b. Degree of Combined Leverage:
DCLs = DOLs x DFLEBIT
DCLs = 6 x 1.88
DCLs = 11.28

400
 c. Break-even point in sales dollars:
S* = F / [1 - (C / S)]
S* = $6,400,000 / [1 - ($24,320,000 / $32,000,000)]
S* = $26,666,667
d. If sales increase 30%, by what percent would EBT increase?
% increase in EBT = % increase in Sales x DCLS
% increase in EBT = 30% x 11.28
% increase in EBT = 338%
e. Analytical Income Statement to verify

Sales $41,600,000
(Variable Costs) (31,616,000)
Revenue before Fixed Costs $9,984,000
(Fixed Costs) (6,400,000)
EBIT $3,584,000
(Interest Expense) (600,000)
Earnings before Taxes $2,984,000
(Taxes @ 35%) (1,044,400)
Net Income $1,939,600)

It may be useful to develop the following proof to assist in explaining the interrelationships of
the various values:
% change in EBT = (EBTafter - EBTbefore) / EBTbefore
% change in EBT = ($2,984,000 - $680,000) / $680,000
% change in EBT = 338%

2. COMPUTE BREAK-EVEN POINT:

STEP 1: Compute the operating profit margin:

Operating profit Margin [M] x Operating Asset Turnover =
Return on Operating Assets.
M x 12 = 48%
M = 4%

401
STEP 2: Compute the sales level associated with the given output level:
Operating Assets x Operating Asset Turnover = Sales
$6,000,000 x 12 = Sales
Sales = $72,000,000
STEP 3: Compute EBIT:
Sales [STEP 2] x Operating Profit Margin [STEP 1] = EBIT
$72,000,000 x 4% = EBIT
EBIT = $2,880,000
STEP 4: Compute revenue before fixed costs:
EBIT [STEP 3] x Degree of Operating Leverage = Revenue before Fixed
Costs
$2,880,000 x 10 = Revenue before Fixed Costs
Revenue before Fixed Costs = $28,800,000
STEP 5: Compute total variable costs:
Sales [STEP 2] - Revenue before Fixed Costs [STEP 4] = Total Variable
Costs
$72,000,000 - $28,800,000 = Total Variable Costs
Total Variable Costs = $43,200,000
STEP 6: Compute total fixed costs:
Revenue before Fixed Costs [STEP 4] - EBIT [STEP 3] = Fixed Costs
$28,800,000 - $2,880,000 = Fixed Costs
Fixed Costs = $25,920,00
STEP 7: Find selling price per unit (P) and variable cost per unit (V):
P = Sales [STEP 2] / Output in Units
P = $72,000,000 / 120,000 units
P = $600
V = Total Variable Costs [STEP 5] / Output in units
V = $43,200,000 / 120,000 units
V = $360

402
STEP 8: Compute break-even point (in units):
QB = Fixed Costs [STEP 6] / (P - V) [STEP 7]
QB = $25,920,000 / ($600 - $360)
QB = 108,000
After determining the break-even point using the preceding approach described, the students
have the information necessary to prepare an analytical income statement as follows:

Sales [STEP 2] $72,000,000

(Variable Costs) [STEP 5] (43,200,000)
Revenue before Fixed Costs [STEP 4] $28,800,000
(Fixed Costs) [STEP 6] (25,920,000)
EBIT [STEP 3] $2,880,000
(Interest Expense) (720,000)
Earnings before Taxes $2,160,000
(Taxes @ 42%) (907,200)
Net Income $1,252,800

Thereafter, the students have the data they need to answer questions a - e as follows:
a. Degree of Financial Leverage:
DFLEBIT = EBIT / (EBIT - Interest)
DFLEBIT = $2,880,000 / (2,880,000 - 720,000)
DFLEBIT = 1.333
b. Degree of Combined Leverage:
DCLs = DOLs x DFLEBIT
DCLs = 10 x 1.333
DCLs = 13.33
c. Break-even point in sales dollars:
S* = F / [1 - (VC / S)]
S* = $25,920,000 / [1 - ($43,200,000 / $72,000,000)]
S* = $64,800,000
d. If sales increase 40%, by what percent would EBT increase?
% increase in EBT = % increase in Sales x DCLS
% increase in EBT = 40% x 11.28
% increase in EBT = 533%

403
 e. Analytical Income Statement to verify

Sales $100,800,000
(Variable Costs) (60,480,000)
Revenue before Fixed Costs $40,320,000
(Fixed Costs) (25,920,000)
EBIT $14,400,000
(Interest Expense) (720,000)
Earnings before Taxes $13,680,000
(Taxes @ 42%) (5,745,600)
Net Income $7,934,400)

It may be useful to develop the following proof to assist in explaining the interrelationships of
the various values:
% change in EBT = (EBTafter - EBTbefore) / EBTbefore
% change in EBT = ($7,934,400 - $1,252,800) / $1,252,800
% change in EBT = 533%

ALTERNATIVE PROBLEMS AND SOLUTIONS

ALTERNATIVE PROBLEMS

12-1A. (Leverage Analysis) You have developed the following analytical income statement
for your corporation. It represents the most recent year’s operations, which ended
yesterday.
Sales $40,000,000
Variable costs 16,000,000
Revenue before fixed costs $24,000,000
Fixed costs 10,000,000
EBIT $14,000,000
Interest expense 1,150,000
Earnings before taxes $12,850,000
Taxes 3,750,000
Net income $9,100,000
Your supervisor in the controller’s office has just handed you a memorandum asking
for written responses to the following questions:
a. At this level of output, what is the degree of operating leverage?
b. What is the degree of financial leverage?
c. What is the degree of combined leverage?
d. What is the firm’s break-even point in sales dollars?

404
 e. If sales should increase by 20%, by what percent would earnings before taxes
(and net income) increase?
12-2A. (Break-even Point and Operating Leverage) Matthew Electronics manufactures a
complete line of radio and communication equipment for law enforcement agencies.
The average selling price of its finished product is $175 per unit. The variable cost for
these same units is $140. Matthew’s incurs fixed costs of $550,000 per year.
a. What is the break-even point in units for the company?
b. What is the dollar sales volume the firm must achieve to reach the break-even
point?
c. What would be the firm’s profit or loss at the following units of production
sold: 12,000 units? 15,000 units? 20,000 units?
d. Find the degree of operating leverage for the production and sales levels given
in part c above.
12-3A. (Break-even Point and Profit Margin) A recent business graduate of Dewey
University is planning to open a new wholesaling operation. His target operating
profit margin is 25%. His unit contribution margin will be 40% of sales. Average
annual sales are forecast to be $4,250,000.
a. How large can fixed costs be for the wholesaling operation and still allow the
25% operating profit margin to be achieved?
b. What is the break-even point in dollars for the firm?
12-4A. (Leverage Analysis) You are supplied with the following analytical income statement
for your firm. It reflects last year’s operations.
Sales $18,000,000
Variable costs 7,000,000
Revenue before fixed costs $11,000,000
Fixed costs 6,000,000
EBIT $5,000,000
Interest expense 1,750,000
Earnings before taxes $3,250,000
Taxes 1,250,000
Net income $2,000,000
a. At this level of output, what is the degree of operating leverage?
b. What is the degree of financial leverage?
c. What is the degree of combined leverage?
d. If sales should increase by 15%, by what percent would earnings before taxes
(and net income) increase?
e. What is your firm’s break-even point in sales dollars?

405
12-5A. (Break-even Point and Selling Price) Heritage Chain Company will produce 175,000
units next year. All of this production will be sold as finished goods. Fixed costs will
total $335,000. Variable costs for this firm are relatively predictable at 80% of sales.
a. If Heritage Chain wants to achieve an earnings before interest and taxes level of
$270,000 next year, at what price per unit must it sell its product?
b. Based on your answer to part a, set up an analytical income statement that will
verify your solution.
12-6A. (Break-even Point and Operating Leverage) Avitar Corporation manufactures a line
of computer memory expansion boards used in microcomputers. The average selling
price of its finished product is $175 per unit. The variable cost for these same units is
$115. Avitar incurs fixed costs of $650,000 per year.
a. What is the break-even point in units for the company?
b. What is the dollar sales volume the firm must achieve to reach the break-even
point?
c. What would be the firm’s profit or loss at the following units of production
sold: 10,000 units? 16,000 units? 20,000 units?
d. Find the degree of operating leverage for the production and sales levels given
in part c above.

12-7A. (Sales Mix and the Break-even Point) Wayne Automotive produces four lines of auto
accessories for the major Detroit automobile manufacturers. The lines are known by the
code letters A, B, C, and D. The current sales mix for Wayne and the contribution margin
ratio (unit contribution margin divided by unit sales price) for these product lines are as
follows:
Percent of Contribution
Product Line Total Sales Margin Ratio
A 25 2/3% 40%
B 41 1/3 32
C 19 2/3 20
D 13 1/3 60
Total sales for next year are forecast to be $150,000. Total fixed costs will be $35,000.
a. Prepare a table showing (1) sales, (2) total variable costs, and (3) the total
contribution margin associated with each product line.
b. What is the aggregate contribution margin ratio indicative of this sales mix?
c. At this sales mix, what is the break-even point in dollars?

406
12-8A. (Sales Mix and the Break-even Point) Because of production constraints, Wayne
Automotive (see problem 12-7A) may have to adhere to a different sales mix for next
year. The alternative plan is outlined below:
Percent of
Product Line Total Sales
A 33 1/3%
B 41 2/3
C 16 2/3
D 8 1/3
a. Assuming all other facts in problem 12-7A remain the same, what effect will
this different sales mix have on Wayne’s break-even point in dollars?
b. Which sales mix will Wayne’s management prefer?
12-9A. (EBIT-EPS Analysis) Three recent graduates of the computer program at Midstate University
are forming a company to write and distribute software for various personal computers.
Initially, the corporation will operate in the southern region of Michigan, Illinois, Indiana, and
Ohio. Twelve serious prospects for retail outlets have already been identified and committed
to the firm. The firm’s software products have been tested and displayed at several trade
shows and computer fairs in the perceived operating region. All that is lacking is adequate
financing to continue with the project. A small group of private investors in the Chicago area
is interested in financing the new company. Two financing proposals are being evaluated. The
first (plan A) is an all common equity capital structure. Three million dollars would be raised
by selling common stock at $20 per common share. Plan B would involve the use of financial
leverage. Two million dollars would be raised selling bonds with an effective interest rate of
11 percent (per annum). Under this second plan, the remaining $1 million would be raised by
selling common stock at the $20 price per share. The use of financial leverage is considered to
be a permanent part of the firm’s capitalization, so no fixed maturity date is needed for the
analysis. A 34% tax rate is appropriate for the analysis.
a. Find the EBIT indifference level associated with the two financing plans.
b. A detailed financial analysis of the firm’s prospects suggests that the long-term
EBIT will be above $450,000 annually. Taking this into consideration, which
plan will generate the higher EPS?
c. Suppose long-term EBIT is forecast to be $450,000 per year. Under plan A, a
price/earnings ratio of 19 would apply. Under plan B, a price/earnings ratio of
12.39 would apply. If this set of financial relationships does hold, which
financing plan would you recommend?
12-10A. (EBIT-EPS Analysis) Three recent liberal arts graduates have interested a group of
venture capitalists in backing a new business enterprise. The proposed operation
would consist of a series of retail outlets to distribute and service a full line of
personal computer equipment. These stores would be located in Texas, Arizona, and
New Mexico. Two financing plans have been proposed by the graduates. Plan A is an
all common equity structure. Four million dollars would be raised by selling 80,000
shares of common stock. Plan B would involve the use of long-term debt financing.
Two million dollars would be raised by marketing bonds with an effective interest

407
 rate of 16%. Under this alternative, another $2 million would be raised by selling
50,000 shares of common stock. With both plans, $4 million is needed to launch the
new firm’s operations. The debt funds raised under Plan B are considered to have no
fixed maturity date, in that this proportion of financial leverage is thought to be a
permanent part of the company’s capital structure. The fledgling executives have
decided to use a 34% tax rate in their analysis, and they have hired you on a
consulting basis to do the following:
a. Find the EBIT indifference level associated with the two financing proposals.
b. Prepare an analytical income statement that proves EPS will be the same
regardless of the plan chosen at the EBIT level found in part a above.
12-11A. (Assessing Leverage Use) Some financial data for three corporations are displayed
below:
Industry
Measure Firm A Firm B Firm C Norm
Debt ratio 15% 20% 35% 25%
Times burden covered 9 times 11 times 6 times 9 times
Price/earnings ratio 10 times 12 times 5 times 10 times
a. Which firm appears to be excessively levered?
b. Which firm appears to be employing financial leverage to the most appropriate
degree?
c. What explanation can you provide for the higher price/earnings ratio enjoyed by
firm B as compared with firm A?

SOLUTIONS FOR ALTERNATIVE PROBLEMS

Revenue Before Fixed Costs $24,000,000
12-1A.a. = = 1.71 times
EBIT $14,000,000

EBIT $14,000,000
b. = = 1.09 times
EBIT − I $12,850,000

c. DCL$40,000,000 = (1.71) (1.09) = 1.86 times

408
 F $10,000,000
d. S* = =
VC $16m
1− 1−
S $40m
$10,000,000 $10,000,000
= = = $16,666,667
1 − 0.4 0.6
e. (20%) (1.86) = 37.2%

F $550,000 $550,000
12-2A.a. Q = = = 15,715 units
B = P−V $175 − $140 $35

F $550,000 $550,000 $550,000

b. S = = = = = $2,750,000
B VC $140 1 − 0.8 .2
1− 1−
S $175

c. 12,000 15,000 20,000

Units Units Units
Sales $2,100,000 $2,625,000 $3,500,000
Variable costs 1,680,000 2,100,000 2,800,000
Sales before fixed costs $ 420,000 $ 525,000 $700,000
Fixed costs 550,000 550,000 550,000
EBIT $ -130,000 $ -25,000 $ 150,000

d. 12,000 units 15,000 units 20,000 units

$420,000 $525,000 $700,000
= -3.2 times = -21 times = 4.67 times
$ − 130,000 − $25,000 $150,000

12-3A.a. First, find the EBIT level at the forecast sales volume:
EBIT
= 0.25
S
So:
EBIT = (0.25) $4,250,000 = $1,062,500
Next, find total variable costs:
VC
= 0.6
S

409
 So:
VC = (0.60) $4,250,000 = $2,550,000
Then, solve for total fixed costs:
S - (VC + F) = $1,062,500
$4,250,000 - ($2,550,000 + F) = $1,062,500
F = $637,500

$637,500
b. SB = = $1,593,750
1 − 0.6

Revenue before fixed costs $11,000,000

12-4A. a. = = 2.2 times
EBIT $5,000,000

EBIT $5,000,000
b. = = 1.54 times
EBIT − I $3,250,000

c. DCL$18,000,000 = (2.2) (1.54) = 3.39 times

d. (15%) (3.39) = 50.8%

F $6,000,000 $6,000,000
e. S* = = = = $9,818,182
VC $7m 1 − 0.389
1− 1−
S $18m
12-5A. a. S (1 - 0.8) - $335,000 = $270,000
0.2S = $605,000
S = $3,025,000 = (P x Q)
Now, solve the above relationship for P:
175,000 (P) = $3,025,000
P = $17.29

b. Sales $3,025,000
Less: Total variable costs 2,420,000
Revenue before fixed costs $605,000
Less: Total fixed costs 335,000
EBIT $ 270,000

410
 F $650,000 $650,000
12-6A.a. QB = = = = 10,833 Units
P − V $175 − $115 $60
b. SB = (10,833 units) ($175) = $1,895,775

Alternatively,
F $650,000 $650,000 $650,000
SB = = = = = $1,895,596
VC $115 1 − 0.6571 .3429
1− 1−
S $175
Note: $1,895,775 differs from $1,895,596 only due to rounding.

c. 10,000 16,000 20,000

units units units
Sales $1,750,000 $2,800,000 $3,500,000
Variable costs 1,150,000 1,840,000 2,300,000
Revenue before fixed costs 600,000 960,000 1,200,000
Fixed costs 650,000 650,000 650,000
EBIT $ -50,000 $ 310,000 $ 550,000

d. 10,000 units 16,000 units 20,000 units

$600,000 $960,000 $1,200,000
− $50,000 $310,000 $550,000
= -12 times = 3.1 times = 2.2 times
Notice that the degree of operating leverage decreases as the firm’s sales level
rises above the break-even point.

12-7A. A B C D Total
Sales $38,500 $62,000 $29,500 $20,000 $150,000
Variable costs* 23,100 42,160 23,600 8,000 96,860
Contribution margin $15,400 $19,840 $ 5,900 $ 12,000 $ 53,140
Contribution margin ratio 40% 32% 20% 60% 35.43%
*Variable costs = (Sales) (1 - contribution margin ratio)

Break-even point in sales dollars:

F $35,000 $35,000
S* = = = = $98,786
VC 1 − 0.6457 0.3543
1−
S

411
12-8A. A B C D Total
Sales $50,000 $62,500 $25,000 12,500 $150,000
Variable costs* 30,000 42,500 20,000 5,000 97,500
Contribution margin $20,000 $20,000 $ 5,000 $ 7,500 $ 52,500
Contribution margin ratio 40% 32% 20% 60% 35%
*Variable costs = (sales) (1- contribution margin ratio).
Break-even point in sales dollars:
F $35,000
S* = = = $100,000
VC 0.35
1−
S
Wayne’s management would prefer the sales mix identified in problem 12-7A. That
first sales mix provides a higher contribution margin ($53,140 vs. $52,500) and a
lower break-even point ($98,796 vs. $100,000).

(EBIT − 0)(1 − 0.34) (EBIT − $220,000)( 1 − 0.34)

12-9A. a. =
150,000 50,000
0.66EBIT 0.66EBIT − $145,200
=
15 5
EBIT = $330,000

b. Since $450,000 exceeds the indifference level of $330,000 from part a, the
levered alternative (Plan B) will generate the higher EPS.

c. Here we compute EPS for each financing plan, apply the relevant
price/earnings ratios, and, thereby, forecast a common stock price for each
plan. Thus, we have:
Plan A Plan B
EBIT $450,000 $450,000
Interest 0 220,000
EBT $450,000 $230,000
Tax (0.34) 153,000 78,200
NI $297,000 $151,800
Preferred dividend 0 0
EAC $297,000 $151,800
÷ No. of common shares 150,000 50,000
EPS $ 1.98 $ 3.036
x P-E ratio 19 12.39
= Projected Stock Price $37.62 $37.62

412
 The added riskiness of Plan B, owing to the use of financial leverage, is reflected in
the lower P-E ratio associated with Plan B (i.e., 12.39x versus 19x for Plan A). The
rational investor will prefer Plan A (unlevered) since the same projected stock price
($37.62) can be obtained with a lower level of risk exposure.

(EBIT − 0)(1 − 0.34) (EBIT − $320,000)(1 − 0.34)

12-10A. a. =
80,000 50,000(shares)
.66 EBIT .66 EBIT − $211,200
=
80 50
EBIT = $853,333

b. Plan A Plan B
EBIT $853,333 $853,333
Interest 0 320,000
EBT $853,333 $533,333
Tax (.34) 290,133 181,333
EAC $563,200 $352,000
÷ No. of common shares 80,000 50,000
EPS $7.04 $7.04

12-11A.a. Firm C appears to be excessively levered. Both its debt ratio and burden
coverage ratio are unfavorable relative to the industry norm. The firm’s
price/earnings ratio is significantly (5 vs. 10) lower than the industry norm.
b. Firm B.
c. The investing market place seems to place more weight on coverage ratios than
balance sheet leverage measures. Thus, firm B’s price/earnings ratio exceeds
that of firm A

413