LYCEUM OF CEBU

Midterm Exam
Finance 103
Name:
Subject:
Year:

OPERATING LEVERAGE AND BREAKEVEN ANALYSIS

Mang Asar Inc. (‘the Company’) produces stereo components that sell at P100 per unit. The Company’s
fixed costs are P200,000, variable costs are P50 per unit, 5,000 components are produced and sold each
year, EBIT is currently P50,000, and the Company’s assets (all equity-financed) are P500,000. The
Company can change its production process by adding P400,000 to assets and P50,000 to fixed operating
costs. This change would (1) reduce variable costs per unit by P10 and (2) increase output by 2000 units,
but (3) the sales price on all units would have to be lowered by P95 to permit sales of the additional output.
Mang Asar Inc. has tax loss carry-forwards that cause its tax rate to be zero, it uses no debt, and its average
cost of capital is 10%.
a. Should Mang Asar Inc. make the change? Why or why not?
b. Would Mang Asar Inc.’s breakeven point increase or decrease if it made the change?
c. Suppose Mang Asar Inc. was unable to raise additional equity financing and had to borrow the
P400,000 at an interest rate of 10% to make the investment. Use the DuPont equation to find the
expected ROA of the investment. Should Mang Asar Inc. make the change if debt financing must
be used? Explain.

FINANCING LEVERAGE

Jabi Inc., a producer of turbine generators, is in this situation: EBIT = P4 million, tax rate = T = 35%, debt
outstanding = D = P2 million, rd = 10%, rs = 15%, shares of stock outstanding = N0 = 600,000, and book
value per share = 10%. Because Jabi Inc.’s product market is stable and the company expects no growth,
all earnings are paid out as dividends. The debt consists of perpetual bonds.
a. What are Jabi Inc.’s earnings per share (EPS) and its price per share (WACC)?
b. What is Jabi Inc.’s weighted average cost of capital (WACC)?
c. Jabi Inc. can increase its debt by P8 million to a total of P10 million, using the new debt to buy back
and retire some of its share at the current price. Its interest rate on debt will be 12% (it will have to
call and refund the old debt), and it cost of equity will rise from 15% to 17%. EBIT will remain
constant. Should Jabi Inc. change its capital structure? Why or why not?
d. If Jabi Inc. did not have to refund the P2 million of old debt, how would this affect the situation?
Assume that the new and the still outstanding debt are equally risky, with rd = 12%, but that coupon
rate on the old debt is 10%.
e. What is Jabi Inc.’s TIE coverage ratio under the original situation and under the conditions in Part
c of this question?