China America Manufacturing is evaluating two different operating structures whi

Question

China America Manufacturing is evaluating two different operating structures which are described below. The firm has annual interest expense of $250, common shares outstanding of 1,000, and a tax rate of 40 percent.

(a) For each operating structure, calculate

      (a1) EBIT and EPS at 10,000, 20,000, and 30,000 units.

      (a2) the degree of operating leverage (DOL) and degree of total leverage (DTL) using 20,000 units as a base sales level.

      (a3) the operating breakeven point in units.

(b) Which operating structure has greater operating leverage and business risk?

(c) If China America projects sales of 20,000 units, which operating structure is recommended?

Explanation / Answer

a.

a1.

a2.

b.

Operating structure 2 has greater operating leverage as well as high business risk because of high investment in plant and machinery, reflecting as fixed cost.

c.

in a given circumstances and data available, Operating structure 2 has higher EBIT and EPS at 20000 sales unit. so it should be selected .

Operating Structure 1 Fixed Cost Price Per unit Variable cost per unit 500 1 0.75 EBIT = Sales Revenue - Variable cost - Fixed cost At 10000 unit sale EBIt = 10000*1 - .75*10000 - 500 = 2000 At 20000 unit sale EBIT = 20000*1 - .75*20000 - 500 = 4500 At 30000 unit sale EBIT = 30000*1 - .75*30000 - 500 = 7000 EPS = ((EBIT - Interest)*(1 - Tax Rate))/No. of shares Tax rate = 40% Interest expenses = 250 No. of shares = 1000 At 10000 unit sale EPS= 1.05 At 20000 unit sale EPS= 2.55 At 30000 unit sale EPS= 4.05

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