FINANCE FINAL PROJECTMINI CASE # 1 FROM CHAPTER 12

By: Siraj Haq

SCENARIO• I am a new hire Financial Analyst for

a highly leveraged Ski manufacturer “SKI PALACE” in Colorado’s Rocky Mountains.

• The company manufacturers only one product..

State of the Art snow ski called ‘SNOOKI’

SCENARIO• Meeting next week with CFO, Maria Sanchez

• To help her discuss the business and financial risks with the CEO, she has asked me to prepare an analysis focused on these 3 questions…

Q1. What is the firms break-even point in sales dollars?

Q2. If sales should increase by 30%(as president expects), by what percentage would the EBT(earnings before taxes) and net income increase?

Q3. Prepare another income statement using sales with new 30% increase.

COST STRUCTURE OF THE COMPANY• The following information is provided.

Output level 80,000 units

Operating assets $4,000,000

Operating asset turnover 8 times

Return on operating assets 32 %

Degree of operating leverage 6 times

Interest expense $600,000

Tax rate 35%

WORKING PLAN?

Prepare Current Income

statement

Determine the Break-Even Point

(BEP)

Analyze how EBIT, EBT and NI change if 30%

increase in sales

Prepare supporting

documents and a new Income

Statement

WHAT IS A BREAK-EVEN POINT???

• The Break-even Point is the level of output (in sales or in units) that allows the company to cover all of its variable costs.

• The Breakeven Point (in sales dollars or units) is a very important figure because it is this figure that enables the manager to make a decision as to whether or not the firm should stay in business.

WHAT IS A BREAK-EVEN POINT???

The Break Even Analysis enables the CFO:

1. Determine the quantity of output that must be sold to cover all the operating costs

2. Calculate the EBIT , that will be achieved at various output levels

At the break even quantity of output EBIT is equal to ZERO

OTHER IMPORTANT TERMS ???

Operating Leverage• The level to which a company is dependent on sales of

individual products.• A company with only a few sales has a high operating

leverage because it must use these few sales to pay its operating expenses. • On the other hand, a company with many sales has a low

operating leverage and may therefore sell more or fewer products without it affecting its profitability as much

OTHER IMPORTANT TERMS ???

Fixed CostsCosts that do no vary in total dollar amount as sales

volume or quatitiy of output changes

Ex : Administrative salariesDepreciationInsuranceProperty taxesRent

OTHER IMPORTANT TERMS ???

Variable CostsCosts that fixed amount per unit of output, but vary in

total as the output changes

Ex : Direct LaborDirect materialsEnergy costspackagingsales commisions

STEP 1 : WHAT IS THE REVENUE OF SKI PALACE?

Operating Asset turnover =

Solving for Revenue ( Sales) gives us

Revenue ( Sales) = Operating Asset turnover * Operating Assets

Revenue ( Sales) = 8 * $4,000,000.00

Revenue ( Sales) = $32,000,000.00

STEP 2 : WHAT IS THE OPERATING PROFIT MARGIN OF SKI PALACE?

Operating profit Margin =

Operating profit Margin =

Operating profit Margin = 0.04 or 4 %

STEP 3 : WHAT IS THE EARNINGS BEFORE INTEREST AND TAXES (EBIT) OF SKI PALACE?

EBIT = Revenue (sales) * Operating profit margin

EBIT = $32,000,000.00 * 0.04

EBIT = $1,280,000.00

STEP 4: WHAT IS THE REVENUE BEFORE FIXED COSTS OF SKI PALACE?

Revenue before Fixed Cost = EBIT * Degree of operating

Leverage

Revenue before Fixed Cost = $1,280,000.00 * 6

Revenue before Fixed Costs = $7,680,000.00

STEP 5: WHAT IS THE TOTAL VARIABLE COSTS

OF SKI PALACE?

Total variable cost = Revenue (sales) - Revenue before Fixed Cost

Total variable cost = $32,000,000 - $7,680,000

Total Variable cost = $24,320,000.00

STEP 6: WHAT IS THE TOTAL FIXED COSTS OF SKI PALACE?

Total Fixed cost = Revenue before - EBITFixed Cost

Total Fixed cost = $7,680,000 - $1,280,000

Total Fixed cost = $6,400,000.00

STEP 7: WHAT IS THE PRICE PER UNIT OF A A ‘SNOOKI’ BY THE SKI

PALACE?

Price per unit =

Price per unit =

Price per Snooki = $400.00

STEP 8: WHAT IS THE VARIABLE COST PER UNIT OF A ‘SNOOKI’ BY THE SKI PALACE?

Variable Cost per unit =

Variable Cost per unit =

Variable Cost per Snooki = $304.00

STEP 9: WHAT IS THE BREAK-EVEN POINT IN UNITS OF THE SKI PALACE?

Break-Even Point =

Break-Even Point =

Break-Even Point = 66,666 units

STEP10: WHAT IS THE BREAK-EVEN POINT IN SALES OF THE SKI PALACE?

Break-Even Point =

Break-Even Point =

Break-Even Point is sales = $ 26,666,666.67

Prepare Current Income statement

INCOME STATEMENT 2012 SEASON

Revenue (sales) $32,000,000.00

Variable Costs ($24,320,000.00)

Revenue before fixed Costs $7,680,000.00

Fixed Costs ($6,400,000.00)

EBIT $1,280,000.00

Interest Expense ($600,000)

Earnings before taxes $680,000.00

Taxes Expense (35%) (238,000)

Net Income $442,000.00

Analyze how EBIT, EBT and NI change if 30%

increase in sales

Q2. IF SALES AT THE SKI PALACE WERE TO INCREASE BY 30 % ?

Degree of Operating Leverage =

% change in EBIT = Degree of Operating Leverage * % change in Revenue(sales)

% change in EBIT = 6 * 30%

% change in EBIT = 180 %

Q2. IF SALES AT THE SKI PALACE WERE TO INCREASE BY 30 % ?

The New Revenue(sales) = Old sales = 30 %

The New EBIT = The previous EBIT + 180 %

Revenue before fixed cost remains the same

The New EBT = The EBIT – the interest expense

The New Net Income = The new EBT – (.35 of the new EBT)

Preparing the New Income Statement

INCOME STATEMENT WITH 30% SALES INCREASE

Revenue (sales) $41,600,000.00 30%

Variable Costs ($31,616,000.00)

Revenue before fixed Costs $9,984,000.00

Fixed Costs ($6,400,000.00)

EBIT $3,584,000.00 180%

Interest Expense ($600,000)

Earnings before taxes $2,984,000.00 339%

Taxes Expense (35%) ($1,044,400)

Net Income $1,939,600.00 339%

IMPORTANCE OF OPERATING LEVERAGE

• Because of the Operating leverage, any percentage change in change in sales results in a much greater percentage fluctuation in the EBIT and even greater in the EBT (earnings before tax).

• Operating leverage therefore should be handled with care, a good financial manager should be very careful when introducing fixed costs into the capital structure.

DEGREE OF FINANCIAL LEVERAGE

Degree of Financial Leverage = EBIT / (EBIT-Interest)

Degree of Financial Leverage =

Degree of Financial Leverage = 1.882

DEGREE OF COMBINED LEVERAGE

Degree of Combined Leverage = Degree of Financial Leverage * Degree of Operating Leverage

Degree of Combined Leverage = 1.882 * 6

Degree of Combined Leverage = 11.292

DEGREE OF COMBINED LEVERAGE USED AS PROOF

% Change in EBT = % change in sales * Degree of Combined Leverage

% Change in EBT = 30% * 11.292 = 338.76 or 339%

As shown in the new income statement, the % change in the New EBT is also 339%Thus we can conclude our calculations are done correctly

THANK YOU

ANY QUESTIONS ??