External Funding Requirement and Degree of Leverage
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. ;
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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:
- What are retained earnings for last year?
- How much debt will be needed for the new project?
- How much external equity must Martin use at the beginning of this year ; in order to finance the new expansion?
- If Martin decides to retain all earnings for the coming year, how much ; external equity will be 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:
- Calculate the contribution ; margins for the two companies.
- Calculate the ; break-even point for each firm, in dollars and in units.
- Compare the two ; companies. What conclusions could you ; make regarding the use of operating leverage employed by the two firms?
- Assume that ; both companies experience an increase in sales by 15% next year. ; What would be the operating income for each ; firm net year? Explain the difference in ; the change in operating income between the two companies.
- Based on the ; information from the above questions, what recommendations would you make to ; the two companies and why?
