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.
      
3. 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.

(Please show working out)

Answer 1

1) Operating break even point

Contribution per unit = selling price per unit - variable cost per unit

Contribution per unit = $ 6 - $ 3.50 = $ 2.50

PV ratio = [Contribution / sales ] X 100 %

Sales = 30,000 X $ 6 = $ 180,000

Contribution = 30,000 X $ 2.50 = $ 75,000

PV ratio = [ $ 75,000 / $ 180,000] X 100 % = 41.6667%

Break even point ( units) = fixed cost / contribution per unit = $ 50,000 / $ 2.50 = 20,000 units

Break even point ( sales dollars) = fixed cost / PV ratio = $ 50,000 / 41.67% = $ 50,000 X 100 / 41.6667 = $ 120,000

2) Calculation for Earning available to ordinary share holders

	$
Sales revenue [ 40,000 X 6 ]	240,000
Less: Variable operating cost [ 40,000 X 3.5]	140,000
Contribution margin	100,000
Less: Fixed operating cost	50,000
EBIT ( Earning before interest and tax)	50,000
Less: Interest	13,000
Earning before tax	37,000
Less: Tax ( 30%)	11,100
Earning after tax	25,900
Less: Preferential dividend	7,000
Profit available to ordinary shareholders	18,900

DOL = Contribution / EBIT = $ 100,000 / $ 50,000 = 2

DFL = EBIT / EBT = $ 50,000 / $ 37,000 = 1.35

DTL = DOL X DFL = 2 X 1.35 = 2.70

3) Additional sales of 15,000 latch

Calculation for net profit available to ordinary shareholders

	$
Sales [ 55,000 X 6]	330,000
Less: Variable operating costs [ 55,000 X 3.50]	192,500
Contribution margin	137,500
Less: Fixed operating costs	50,000
EBIT ( Earning before interest and tax)	87,500
Less: Interest expenses	13,000
Earning before tax	74,500
Less: Tax ( 30%)	22,350
Earning after tax	52,150
Less: Preferential dividend	7,000
Profit available to ordinary shareholders	45,150

DOL = % Change in EBIT / % Change in sales

Absolute Change in EBIT = $ 87,500 - $ 50,000 = $ 37,500

Percentage change in EBIT =[ $ 37,500/ $ 50,000]X 100% = 75%

absolute change in sales = $ 330,000 - $ 240,000 = $ 90,000

Percentage change in sales =[ $ 90,000/ $ 240,000] X 100% = 37.50%

DOL = 75/37.50 = 2.00

DFL = % Change in earning before tax / % Change in EBIT

absolute change in Earning before tax = $ 74,500 - $ 37,000 = $ 37,500

Percentage change in EBT = [$ 37,500/ $ 37,000] X100 % = 101.35

Absolute change in EBIT = $ 87,500 - $ 50,000 = $ 37,500

percentage change in EBIT = [ $ 37,500 / $ 50,000] X100% = 75%

DFL = 101.35/75 = 1.35

DTL = 2 X 1.35 = 2.70