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fm16 13 - Q BE = $200($15 – $10 = 40 c Now to develop an...

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Mini Case: 16 - 13 b. (2) What is operating leverage, and how does it affect a firm's business risk? Show the operating break even point if a company has fixed costs of $200, a sales price of $15, and variables costs of $10. Answer: Operating leverage is the change in EBIT caused by a change in quantity sold. The higher the proportion of fixed costs within a firm’s overall cost structure, the greater the operating leverage. Higher operating leverage leads to more business risk, because a small sales decline causes a larger EBIT decline. Q is quantity sold, F is fixed cost, V is variable cost, TC is total cost, and P is price per unit. Operating Breakeven = Q BE Q BE = F / (P – V) Example: F=$200, P=$15, AND V=$10:
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Unformatted text preview: Q BE = $200 / ($15 – $10) = 40. c. Now, to develop an example which can be presented to PizzaPalace’s management to illustrate the effects of financial leverage, consider two hypothetical firms: Firm U, which uses no debt financing, and Firm L, which uses $10,000 of 12 percent debt. Both firms have $20,000 in assets, a 40 percent tax rate, and an expected EBIT of $3,000. 1. Construct partial income statements, which start with EBIT, for the two firms. Answer: Here are the fully completed statements: Firm U Firm L Assets $20,000 $20,000 Equity $20,000 $10,000 EBIT $ 3,000 $ 3,000 INT (12%) 1,200 EBT $ 3,000 $ 1,800 Taxes (40%) 1,200 720 NI $ 1,800 $ 1,080...
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