Question

New England Fastener Ltd makes a patented marine bulkhead latch that wholesales for $6.00. Each latch has variable operating costs of $3.50. Fixed operating costs are $50 000 per year. The firm pays $13 000 interest and preference dividends of $7000 per year. At this point, the firm is selling 30 000 latches a year and is taxed at 30%.

1. Calculate New England Fastener’s operating break-even point.
   
2. Based on the firm’s current sales of 40 000 units per year and its interest and preference dividend costs, calculate its EBIT and net profit available for ordinary shareholders.
   
   1. Calculate the firm’s DOL.
   2. Calculate the firm’s DFL.
   3. Calculate the firm’s DTL.
      

New England Fastener has entered into a contract to produce and sell an additional 15, 000 latches in the coming year. Use the DOL, DFL and DTL to predict and calculate the changes in EBIT and net profit available for ordinary shareholders. Check your work by a simple calculation of New England Fastener’s EBIT and net profit available for ordinary shareholders using the basic information given

Answer 1

break even poin(in units)=fixed cost/contribution per unit=$50000/$6-$3.5=20000 units

calculation of EBIT and earnings available to ordinary shareholders:

particulars		amount($)
sales	40000 units x   $6	240000
less: variable costs	40000 x $3.5	140000
contribution		100000
less: fixed costs		50000
EBIT		50000
Less:interest		13000
EBT		37000
Less:Tax	30% x 37000	11100
EAT		25900
less:preference dividend		7000
earnings available to ordinary shareholders		18900

a) DOL=contribution/EBIT=100000/50000=2

b) DFL=EBIT/EBT-PREFERENCE DIVIDEND=50000/37000-7000=1.67

c)DTL=DOL X DFL=2 x 1.66=3.34

if produced and sold additional 15000 units,then

% change in output=15000 units/40000 units=37.5%=.375

here operating leverage=2, so we can write 2=% change in EBIT/%change in output

so % change in EBIT=2 X .375=75%

so increase in EBIT=$50000 X 75%=$37500 AND new EBIT=$50000+$37500=$87500

earnings available to ordinary shareholders=EBIT-Interest-preference dividend=87500-13000-7000=$67500.