External Funding Requirement and Degree of Leverage

Part One: External Funding Requirement

Your company, Martin Industries, Inc., has  experienced a higher than expected demand for its new product line. The company  plans to expand its operation by 25% by spending $5,000,000 for an additional  building. 

The firm would like to maintain its 40% debt to  total asset ratio in its capital structure and its dividend payout ratio of 50%  of net income. Last year, net income  was $2,500,000. 

Required:

  1. What are retained earnings for last year?
  2. How much debt will be needed for the new project?
  3. How much external equity must Martin use at the beginning of this year  in order to finance the new expansion?
  4. If Martin decides to retain all earnings for the coming year, how much  external equity will be required?

Part  Two:  The Degree of Leverage

Assume  that two companies, Brake, Inc. and Carbo, Inc., have the following operating  results:

Brake,    Inc.

Carbo,    Inc.

Sales

$300,000

$300,000

Variable    Costs

60,000

180,000

Fixed    Costs

210,000

90,000

Operating Income

$30,000

$30,000

 
Required:

  1. Calculate the contribution  margins for the two companies.
  2. Calculate the  break-even point for each firm, in dollars and in units.
  3. Compare the two  companies. What conclusions could you  make regarding the use of operating leverage employed by the two firms?
  4. Assume that  both companies experience an increase in sales by 15% next year.  What would be the operating income for each  firm net year? Explain the difference in  the change in operating income between the two companies.
  5. Based on the  information from the above questions, what recommendations would you make to  the two companies and why?

 
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