1. Such analysis allows the firm to determine at what level of operations it will break even and to explore the relationship between volume, costs, and profits.
2. A utility is in a stable, predictable industry and therefore can afford to use more financial leverage than an automobile company, which is generally subject to the influences of the business cycle. An automobile manufacturer may not be able to service a large amount of debt when there is a downturn in the economy.
3. A labour-intensive company will have low fixed costs and a correspondingly low break-even point. However, the impact of operating leverage on the firm is small and there will be little magnification of profits as volume increases. A capital-intensive firm, on the other hand, will have a higher break-even point and enjoy the positive influences of operating leverage as volume increases.
4. For break-even analysis based on accounting flows, amortization is considered part of fixed costs. For cash flow purposes, it is eliminated from fixed costs.
The accounting flows perspective is longer-term in nature because we must consider the problems of equipment replacement.
5. Both operating and financial leverage imply that the firm will employ a heavy component of fixed cost resources. This is inherently risky because the obligation to make payments remains regardless of the condition of the company or the economy.
6. Debt can only be used up to a point. Beyond that, financial leverage tends to increase the overall costs of financing to the firm as well as encourage creditors to place restrictions on the firm. The limitations of using financial leverage tend to be greatest in industries that are highly cyclical in nature.
7. The higher the interest rate on new debt, the less attractive financial leverage is to the firm.
8. Operating leverage primarily affects the operating income of the firm. At this point, financial leverage takes over and determines the overall impact on earnings per share. A delineation of the combined effect of operating and financial leverage is presented in Table 5-6 and Figure 5-5.
9. At progressively higher levels of operation than the break-even point, the percentage change in operating income as a result of a percentage change in unit volume diminishes. The reason is primarily mathematical — as we move to increasingly higher levels of operating income, the percentage change from the higher base is likely to be less.
10. The starting level of sales is significant because we measure what can happen at that point. Note that in formula 5-3, we must specify the quantity or beginning point at which degree of operating leverage is being computed.
11. Financial leverage, or the use of debt, not only determines how much interest we must pay but also the number of shares of common stock that we must issue to support the nondebt portion of our capital structure. Only by examining “earnings per share” can we pick up the effect of outstanding shares on the operation of the firm.
12. The indifference point only measures indifference based on earnings per share. Since our ultimate goal is market value maximization, we must also be concerned with how these earnings are valued. Two plans that have the same earnings per share may call for different price-earnings ratios, particularly when there is a differential risk component involved because of debt.
13. Television broadcasters commit to production schedules, program purchases, etc., in the spring, create the fall/winter program schedule, and then send the salespeople out to sell advertising air time for the coming season. Thus, the costs are virtually 100% locked in before any revenues are generated. A minor fluctuation in advertising revenue, therefore, has a major effect on operating earnings.
14. Students may come up with many points worth discussing. Emphasis should be directed to the tremendous debt load that required servicing. Consumer demand slowed down affecting cash flows, and increased interest rates at the end of an economic cycle had the same effect. Coupled with the excessive prices paid (particularly for Federated Stores) this caused problems. There was only a small margin for error. Discussion may also include Robert Campeau’s ego, failure to follow advice, and failure to achieve asset sales at projected prices. Campeau’s gamble was risky but it was close.
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