New England Fastener Ltd Makes A Patented Marine Bulkhead
New England Fastener Ltd Makes A Patented Marine Bulkhead Latch That W
New England Fastener Ltd manufactures a patented marine bulkhead latch that wholesales for $6.00 each. The company incurs variable operating costs of $3.50 per latch, with fixed operating costs amounting to $50,000 annually. The firm also pays interest expenses of $13,000 and preference dividends of $7,000 annually. Currently, the company sells 30,000 latches per year, with its operations taxed at a rate of 30%. The assignment involves calculating the operating break-even point, analyzing financial performance based on current sales, and predicting the impact of increased sales using financial leverage concepts (DOL, DFL, DTL).
Paper For Above instruction
Introduction
Understanding the financial dynamics of a manufacturing firm like New England Fastener Ltd requires a comprehensive analysis of its break-even point, operating leverage, financial leverage, and combined leverage. These metrics are essential for decision-making, especially when considering increased production and sales forecasts. This paper aims to analyze these aspects based on the provided data, offering insights into the company's operational breakeven, profitability under current sales levels, and the anticipated impact of increased sales on its financial performance.
Calculation of the Operating Break-Even Point
The operating break-even point is the level of sales where total revenues equal total operating costs, resulting in zero operating profit. It is calculated as:
\[
\text{Break-even units} = \frac{\text{Fixed Operating Costs}}{\text{Price per unit} - \text{Variable Operating Costs per unit}}
\]
Using the provided data:
- Fixed operating costs = \$50,000
- Price per latch = \$6.00
- Variable operating costs per latch = \$3.50
Calculating the contribution margin per unit:
\[
\text{Contribution Margin} = \$6.00 - \$3.50 = \$2.50
\]
Therefore, the break-even point in units:
\[
\text{Break-even units} = \frac{\$50,000}{\$2.50} = 20,000 \text{ latches}
\]
This indicates that New England Fastener Ltd needs to sell at least 20,000 latches annually to cover its fixed operating costs.
Financial Performance at Current Sales Level
With current sales of 40,000 latches:
Total Revenue:
\[
40,000 \times \$6.00 = \$240,000
\]
Total Variable Operating Costs:
\[
40,000 \times \$3.50 = \$140,000
\]
Contribution Margin:
\[
40,000 \times \$2.50 = \$100,000
\]
Earnings Before Interest and Taxes (EBIT):
\[
\text{EBIT} = \text{Contribution Margin} - \text{Fixed Operating Costs} = \$100,000 - \$50,000 = \$50,000
\]
Incorporate interest expenses:
\[
\text{Earnings Before Tax (EBT)} = \text{EBIT} - \text{Interest} = \$50,000 - \$13,000 = \$37,000
\]
Net profit after taxes:
\[
\text{Net Profit} = \text{EBT} \times (1 - \text{Tax rate}) = \$37,000 \times 0.70 = \$25,900
\]
Preference dividends are paid out before profits available to ordinary shareholders; hence, profit available to shareholders:
\[
\text{Net profit for ordinary shareholders} = \$25,900 - \$7,000 = \$18,900
\]
Note: Preference dividends are deducted before calculating funds for ordinary shareholders only if considering residual dividends; otherwise, they are typically paid before profit distribution.
Leverage Measures Analysis
Degree of Operating Leverage (DOL):
\[
\text{DOL} = \frac{\text{Contribution Margin}}{\EBIT} = \frac{\$100,000}{\$50,000} = 2
\]
This indicates that a 1% change in sales volume results in a 2% change in EBIT.
Degree of Financial Leverage (DFL):
\[
\text{DFL} = \frac{\EBIT}{\EBIT - \text{Interest}} = \frac{\$50,000}{\$50,000 - \$13,000} = \frac{\$50,000}{\$37,000} \approx 1.351
\]
A DFL of approximately 1.35 implies that EBIT amplifies the effect of operating income with respect to fixed financial costs.
Degree of Total Leverage (DTL):
\[
\text{DTL} = \text{DOL} \times \text{DFL} = 2 \times 1.351 \approx 2.702
\]
This indicates the combined effect of operating and financial leverage on net income.
Impact of Additional Sales
New sales forecast: 15,000 latches additional to the current 40,000, totaling 55,000 units.
Using DOL, DFL, and DTL to forecast changes:
Change in EBIT:
\[
\text{Percentage change in sales} = \frac{15,000}{40,000} = 0.375 \text{ or } 37.5\%
\]
\[
\Delta \EBIT = \text{DOL} \times \text{Percentage change in sales} \times \EBIT = 2 \times 0.375 \times \$50,000 = \$37,500
\]
New EBIT:
\[
\$50,000 + \$37,500 = \$87,500
\]
Change in Net Profit:
Applying DTL:
\[
\text{Percentage change in net profit} = \text{DTL} \times \text{Percentage change in sales} = 2.702 \times 0.375 \approx 1.013
\]
Forecasted net profit:
\[
\$25,900 \times (1 + 1.013) = \$25,900 \times 2.013 \approx \$52,181
\]
Alternatively, a straightforward recalculation supports these estimates: the increased sales will significantly boost EBIT and net profit, as indicated by the leverage ratios.
Cross-verified EBIT:
\[
\text{New EBIT} = (\text{Contribution Margin} \times \text{Total Units} ) - \text{Fixed Operating Costs}
\]
\[
= ( \$2.50 \times 55,000) - \$50,000 = \$137,500 - \$50,000 = \$87,500
\]
Net profit after taxes:
\[
\text{EBIT} - \text{Interest} = \$87,500 - \$13,000 = \$74,500
\]
\[
\text{Net profit} = \$74,500 \times 0.70 = \$52,150
\]
Thus, the projections aligned with leverage calculations demonstrate the significant impact increased sales have on profitability, emphasizing the importance of leverage analysis in strategic planning.
Conclusion
The analysis underscores that New England Fastener Ltd's break-even point is at 20,000 units, comfortably below current sales levels, indicating operational profitability. With current operations, the firm’s EBIT and net profit are positive, benefiting from fixed operating costs and financial expenses manageable within its profit levels. Leveraging the concepts of DOL, DFL, and DTL reveals that increased sales substantially amplify profits, highlighting the firm's operational and financial leverage risks and opportunities. The forecasted rise in sales by 15,000 units could nearly double the net profit, illustrating the leverage effect’s magnitude. Strategic management must evaluate such leverage effects to optimize profitability while managing associated risks.
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