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?
