Chapter 8 1. Certain liability and net worth items generally increase spontaneou

Question

Chapter 8

1. Certain liability and net worth items generally increase spontaneously with increases in sales. Put an ( x ) by those items that typically increase spontaneously:

Accounts payable ________

Notes payable to banks ________

Accrued wages ________

Accrued taxes ________

Mortgage bonds ________

Common stock ________

Retained earnings ________

2. What benefits can be derived from breakeven analysis?

3. Explain how profits or losses will be magnified for a firm with high operating leverage as opposed to a firm with lower operating leverage. 4. Discuss the relationship between a firm’s degree of total leverage and its perceived risk.

Explanation / Answer

(1) Out of the options listed, Accounts Payable, Accrued Wages and Accrued Taxes increase spontaneously with rise in sales because all of them have a roughly direct linear relationship with the sales revenue. Increase in sales require increased raw material purchase which in turn would lead to greater accounts payable (as compared to before rise in sales and assuming the firm has the same % of credit raw material purchase as before). Similarly, higher sales revenue would need higher production production volume, thereby requiring higher number of workers and greater accrual of wages. The same line of reasoning can be used for accrued taxes as well. Greater Revenue, greater income and hence greater taxes (as well as accrued taxes).

Retained Earnings increase as a result of increased sales owing to a corresponding increase in net income. However, if the company pays out its entire net income as dividends then there would be no rise in retained earnings even if sales rise. Hence, retained earnings is not one of the correct options.

Mortgage Bonds, Notes Payable and Common Stock are all sources of financing and hence do not get impacted by a spontaneous rise in sales value. A company might definitely require more financing sources to support higher sales levels but that is not necessary. A company can sustain higher sales level if it has existing spare capacity which would not need any extra financing per se.

Hence, the final answer table would be as given below:

Accounts Payable - (x)

Notes Payable -

Accrued Wages - (x)

Accrued Taxes - (x)

Mortgage Bonds -

Common Stock -

Retained Earnings -

NOTE: Please raise separate queries for solutions to the remaining unrelated questions as one query can be used to post just a single complete question (which can have multiple parts).

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