Expert answer:Week 5 Assignment
Expert answer:Here is the week 5 assignment. I appreciate you! If you could provide the assignment in Excel and also a Word Document. Thank you for all your help.
week_5_assignment_fin375_2017.doc
week_5_lecture_2017.doc
Unformatted Attachment Preview
Operating Leverage and Forecasting Problems
Please complete the following problems. When calculating earnings per share and
PE ratios, please show your work. This problem is similar to the examples shown in
the lecture.
1. You manufacture hunting pack systems in China for 80 dollars each, including
shipping. The manufacturing costs only include variable costs. Variable costs are
not calculated as a percentage of sales in this case. Sales are a function of the
number of packs sold and the price per pack. Likewise, variable costs are a
function of the number of packs sold and the cost to produce each pack. You sell
these packs to retailers for 200 dollars each. In the current year you will sell
100,000 packs. Your fixed costs including such items as insurance, marketing,
travel, shows, office supplies, warehouse rentals etc. totals 5 million dollars this
year and are not part of the 80 dollars per pack manufacturing cost. The federal
income tax rate for your company is 40 percent.
Your company is publicly traded on the NASDAQ with 1,000,000 shares
outstanding.
a. Please create a current income statement using the same format as found
in the lecture. (10 points)
b. Please calculate earnings per share. (5 points)
c. Please calculate the price/earnings multiple assuming that the current
stock price is 10 dollars per share. (5 points)
2. Create a two-year forecast of the income statement from the information provided
in problem number one. Please create three columns of data: current year, year 2,
and year 3. Assume that sales increase ten percent per year for year’s two and
three. Please show the earnings per share for each of the three years. (10 points)
3. Please estimate the stock price for year’s two and three, assuming that the current
PE multiple remains constant for each of the two forecasted years. (6 points)
Week Five Lecture
Operating Leverage Lecture
Introduction
This week we shall discuss fixed and variable costs, contribution, operating leverage and
forecasting the income statement using these concepts. These are important concepts to
understand as we move into making the financing decision for our company. The net
income per share becomes an important consideration in selecting the mix of debt and
equity. The operating leverage of a company directly impacts the growth of net income.
Variable and Fixed Costs
Variable costs are those expenses that fluctuate as sales or production changes. If we
were manufacturing ice cream then flavoring, packaging, milk etc. would all be examples
of variable costs. If sales went up ten percent, we would expect these expenses to rise
approximately ten percent also.
Fixed costs are those expenses that do not change as a function of sales or production.
While these expenses will rise or fall, they do so independent of the changes in sales.
Examples of fixed costs in our ice cream manufacturing business might include the CEOs
salary, other administrative salaries and benefits, rent, insurance, office supplies etc.
Contribution Margin
One way to apply the fixed and variable cost concepts to our business is the concept of
contribution margin. This concept is best shown through an example:
If I manufacture ice cream, then my accounting staff can calculate the variable cost per
unit of ice cream and compare it with the sales price per gallon. The variable cost per
unit is determined by establishing the total number of gallons to be sold next year (or
whatever time frame desired).
Next the total amount of ingredients is calculated. For example, once the total amount of
sugar required is calculated, then the purchasing staff can get price quotes based upon
order quantities and price break points. From this information, the variable cost per
gallon can be readily calculated.
Below is the contribution margin for my company:
Sale Price per gallon
Variable cost per gallon
Contribution Margin
$2.00
1.10
————$ .90
For every gallon of ice cream sold, ninety cents is thrown off to cover all the fixed costs
of the business and provide an operating profit.
Every product or service can be analyzed to determine its contribution margin. This
becomes the most secret financial information of the company. Why? If a competitor
knows this information they can use it to destroy your company.
Contribution Margin and Price Competition
Using the example in the previous section, if my competition (which sells ice cream of a
comparable quality and price as mine) decides drop price, what should I do? Answer:
match their price!
Matching
Example:
My Price
My Competitor’s
New Price
Sale Price per gallon
$2.00
$1.50
Variable cost per gallon
Contribution Margin
1.10
————$ .90
1.10
———-$ .40
By matching my competitor’s price, I retain my market share. If I did not match price
then my competitor would take away sales from me. By matching and making the sale, I
am more profitable than I otherwise would have been. (In the short run!) When I match
prices and sell a gallon of ice cream, I make forty cents contribution margin, which I
otherwise would not have made. While the forty cents may not give me profits, it does
cover some of my fixed costs. So in the short run, I am more profitable than I otherwise
would have been.
In the long run, I either must cut fixed costs or figure out a way to make ice cream at a
lower variable cost per unit. If my competitor has done either of these things, then they
can maintain their lower prices. If I cannot improve my operation, then I will eventually
run out of cash on the balance sheet and have to quit this market.
Classic market share fights revolve around the contribution margin. A competitor with a
strong balance sheet (lots of cash) drops prices in an attempt to drive people out of the
market. If the competitor has not figured out a way to become more efficient, then the
fight revolves around who has the strongest balance sheet. Once the war is over, the
winner would normally raise prices back to profitable levels.
Now lets take the concept of fixed and variable costs on to another closely related idea:
operating leverage.
Operating Leverage
Operating leverage is defined as the relationship of fixed and variable costs associated
with sales. Companies with high operating leverage will have relatively small variable
costs as a percentage of sales. Firms with low operating leverage have fairly large
percentages of variable costs as a percentage of sales.
A firm typically raises its operating leverage (reduces its variable costs as a percentage of
sales) with the goal of increasing capacity to produce products. Usually reductions in
variable costs are done by shifting some of these costs to fixed costs (e.g. automating a
process). Of course the goal of increased production is to sell more goods and thus
become more profitable. Because increasing fixed costs also raises the breakeven point
of a company, this strategy carries significant risks. If sales fall off or do not materialize,
then the company may find itself in serious financial trouble.
Example of High Operating Leverage
Software firms normally have high operating leverage. They have large fixed costs
associated with the expensive software programmers, analysts and engineers needed to
create new products and debug current programs. Variable costs for these companies
might include product packaging, disks, and customer support services which are a small
percentage of sales. It would not be surprising to see a software house with only ten
percent of its sales dollars going to variable costs. This would give it a ninety percent
contribution margin.
Here is an example of a high operating leverage firm:
Sales
Variable costs @ 10% of sales
Contribution Margin
Fixed costs
Operating Income
Taxes @ 40%
Net Income
# Shares Outstanding
1,000,000
100.000
————–900,000
800,000
————–100,000
40,000
————-60,000
30,000
Earnings Per Share (EPS)
$2.00
Current Price of Stock
$20.00
Price/Earnings Multiple
10X
(current stock price / earnings per share)
Calculating the price earnings ratio or multiple is straightforward. You divide the current
(market driven) stock price by the current earnings per share. The result is usually
expressed (as is shown in the example above) as 10X or ten times. It can also be
interpreted as 10 dollars of share price for each dollar of net income (on a per share
basis).
You cannot calculate a PE ratio for the future. It depends upon the current stock price
and relates the current stock price to the profits earned from the company. We will use
the PE ratio as part of a methodology to forecast stock price.
If sales increase ten percent see the impact on earnings per share and the projected impact
on stock price (assuming the current PE ratio is applied to the new EPS). Will the stock
price move right to thirty-eight dollars? If investors were willing to pay ten dollars for
each dollar of net income (the current relationship of stock price to EPS) then you would
expect the price to be around thirty-eight dollars. It would not be surprising to see the
price move above the projected level. Why? Investors would become euphoric over the
future potential of the company and bid the price higher today in anticipation of future
growth that would exceed that being projected now.
Sales
Variable costs @ 10% of sales
Contribution Margin
Fixed costs
Operating Income
Taxes @ 40%
Net Income
Current
Sales
10% Sales
Increase
1,000,000
1,100,000
100.000
————–900,000
110,000
————-990,000
800,000
————–100,000
800,000
————-190,000
40,000
————-60,000
76,000
———–114,000
# Shares Outstanding
30,000
30,000
Earnings Per Share (EPS)
$2.00
$3.80
Current Price of Stock
$20.00
Price/Earnings Multiple
10X
(Current stock price / earnings per share)
Note that the fixed costs remained the same with sales increasing. These costs do not go
up automatically with an increase in sales.
One way to project the impact of increased earnings per share on stock price is shown
below:
Current PE multiple X projected EPS = New Stock Price expected from EPS increase
10X
x
$3.80
=
$38.00 per share new stock price
Sales Drop and High Operating Leverage
If sales fall, perhaps ten percent, then the benefits of high operating leverage suddenly
become major liabilities. An example with a ten percent sales drop is shown below:
Current
10% Sales
Sales
Decrease
Sales
Variable costs @ 10% of sales
Contribution Margin
Fixed costs
Operating Income
Taxes @ 40%
Net Income
1,000,000
900,000
100.000
————–900,000
90,000
————-810,000
800,000
————–100,000
800,000
————-10,000
40,000
————-60,000
4,000
———–6,000
# Shares Outstanding
30,000
30,000
Earnings Per Share (EPS)
$2.00
$ .20
Current Price of Stock
$20.00
Price/Earnings Multiple
10X
(current stock price / earnings per share)
Note again that the fixed costs remained the same with sales decreasing. These costs do
not go up or down automatically with a decrease in sales.
Projecting the impact of the sales drop using the PE ratio and new EPS is shown below:
Current PE multiple X projected EPS = New Stock Price expected from EPS decrease
10X
x
$ .20
=
$ 2.00 per share new stock price
If sales fell only ten percent in our highly leveraged company, then the stock price might
very well fall from twenty dollars a share to only two dollars. Why? Because currently
investors are willing to pay ten dollars for each dollar of net income. Therefore the new
net income figure only supports a stock value of two dollars per share.
Financial Leverage vs. Operating Leverage
The text refers often to the levered firm. This is in reference to financial leverage.
Financial leverage is defined as increasing the debt on the balance sheet in an effort to
ultimately increase return on equity. Funding new capital projects with debt rather than
equity, will (if profitable) allow a firm to increase its net income and its total assets
without increasing equity. This will ultimately result in a higher ROE. ROE is defined
as net income/equity).
Operating leverage focuses on fixed and variable cost relationships to the sales dollar.
Changing the relationship of variable and fixed costs (which are all a part of the income
statement only) will change the impact sales increases or decreases have on a company’s
earnings per share.
Normally a well-run company would not want to have both high operating leverage and
high financial leverage. Such a company would be at extreme financial risk. While it is
true they would see phenomenal jumps in their stock prices in the good times, the
opposite would be true in recessions.
Companies with high operating leverage normally should avoid large amounts of debt.
However, firms with relatively modest operating leverage can take advantage of financial
leverage without creating extreme risk to the organization.
Forecasting with Operating Leverage Concepts
Forecasting a company’s income statement is relatively straightforward once its operating
expenses are broken into fixed and variable components. The steps to do a forecast are
listed below:
1. Complete a sales forecast. This is the heart of the forecast, since variable costs
are a percentage of sales.
2. Forecast variable costs as a percentage of current sales. If variable costs are 25
percent of sales today, then assume that future variable costs will be 25 percent of
future sales.
3. Forecast fixed costs at no change, unless you have specific knowledge of cost
changes (such as rent increases).
4. Inflation may be applied to the future variable and fixed costs using standard
index methods. Inflation should be applied to variable costs only after the
variable costs have been projected as a percentage of sales. Sales forecasts do not
get adjusted for inflation. Sales only increase if prices are deliberately increased
by management.
The examples of changes in sales shown above also illustrate a forecast using an increase
or a decrease in sales.
Conclusion
Although academics have long held that markets are random, such assumptions are now
being challenged. If one thinks about it, truly random markets would make it impossible
for anyone to be profitable over the long run. The stock market plays a critical role in the
creation of wealth in society. But it is not a bank!
Companies can be analyzed using the concepts of fixed and variable costs. Operating
leverage and contribution margin concepts are very useful for effective financial
management of a company.
…
Purchase answer to see full
attachment
How it works
- Paste your instructions in the instructions box. You can also attach an instructions file
- Select the writer category, deadline, education level and review the instructions
- Make a payment for the order to be assignment to a writer
- Download the paper after the writer uploads it
Will the writer plagiarize my essay?
You will get a plagiarism-free paper and you can get an originality report upon request.
Is this service safe?
All the personal information is confidential and we have 100% safe payment methods. We also guarantee good grades