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Chapter 2: Q5-2DQ (page 143)

What factors would cause a difference in the use of financial leverage for a utility company and an automobile company?

Short Answer

Expert verified

A utility company would have more demand. Hence, the future profits can be calculated with more certainity. It will increase the financial leverage of the company at lower risk of incurring the cost of financial distress. On the other hand, more risk is involved in an automobile company. Its profit forecast is volatile. Hence, the automobile company would choose the lower financial leverage.

Step by step solution

01

Step-by-Step Solution:Step 1: Financial leverage

Financial leverage means the borrowing which is used to purchase the asset with the expectation that the income from the new asset will exceed the cost of borrowing.

02

factors affecting the financial leverage

Financial leverage is affected by the company’s profitability, growth opportunities, tangibility of assets etc. If the company is operating in the business with a high demand, the company would increase the financial leverage of the company and vice-versa. Hence, the utility company (providing service for basic need) have more demand than the automobile company (for luxury items). Hence, the utility company should increase the financial leverage and the automobile company should lower the financial leverage.

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Most popular questions from this chapter

In 20X2, sales increased to \(5,740,000 and the assets for that year were as follows:

Cash

\)163,000

Accounts receivable

924,000

Inventory

1,063,000

New plant and equipment

520,000

Total assets

$2,670,000

Once again compute the four ratios

b. Compute the following:

1. Accounts receivable turnover.

2. Inventory turnover.

3. Fixed asset turnover.

4. Total asset turnover.

Why is interest expense said to cost the firm substantially less than the actual expense, while dividends cost it 100 percent of the outlay?

Using the income statement for Times Mirror and Glass Co., compute the following ratios:

b. The fixed charge coverage.

Times mirror and glass company

Sales

\(126,000

Less: Cost of goods sold

93,000

Gross profit

\)33,000

Less: selling and administrative expenses

11,000

Lease Expenses

4,000

Operating profit*

\(18,000

Less: Interest expenses

3,000

Earning before taxes

\)15,000

Less: Taxes (30%)

4,500

Earning after taxes

$10,500

*equal income before interest and taxes

In January 2007, the Status Quo Company was formed. Total assets were \(544,000, of which \)306,000 consisted of depreciable fixed assets. Status

Quo uses straight-line depreciation of \(30,600 per year, and in 2007 it estimated its fixed assets to have useful lives of 10 years. Aftertax income has been \)29,000 per year each of the last 10 years. Other assets have not changed since 2007.

b. To what do you attribute the phenomenon shown in part a?

Lemon Auto Wholesalers had sales of \(1,000,000 last year, and cost of goods sold represented 78 percent of sales. Selling and administrative expenses were 12 percent of sales. Depreciation expense was \)11,000 and interest expense for the year was \(8,000. The firm’s tax rate is 30 percent.

a. Compute earnings after taxes.

b. Assume the firm hires Ms. Carr, an efficiency expert, as a consultant. She suggests that by increasing selling and administrative expenses to 14 percent of sales, sales can be increased to \)1,050,900. The extra sales effort will also reduce cost of goods sold to 74 percent of sales. (There will be a larger markup in prices as a result of more aggressive selling.) Depreciation expense will remain at \(11,000. However, more automobiles will have to be carried in inventory to satisfy customers, and interest expense will go up to \)15,800. The firm’s tax rate will remain at 30 percent. Compute revised earnings after taxes based on Ms. Carr’s suggestions for Lemon Auto Wholesalers. Will her ideas increase or decrease profitability?
See all solutions

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