China America Manufacturing is evaluating two different operating structures which are described below. The firm has annual interest expense of $250, common shares outstanding of 1,000, and a tax rate of 40 percent.
(a) For each operating structure, calculate
(a1) EBIT and EPS at 10,000, 20,000, and 30,000 units.
(a2) the degree of operating leverage (DOL) and degree of total leverage (DTL) using 20,000 units as a base sales level.
(a3) the operating breakeven point in units.
(b) Which operating structure has greater operating leverage and business risk?
(c) If China America projects sales of 20,000 units, which operating structure is recommended?
(a1)
(a2) and (a3)
b) Operating structure 2 has greater fixed costs, greater operating leverage, and greater business risk than operating structure 1.
(c) If sales are projected at 20,000 units, China America Manufacturing should choose operating structure 2 because it results in a higher EBIT and EPS for the firm. Operating structure 2 has a higher operating breakeven point, but with sales estimated at 20,000 units versus a breakeven point of 4,000 units, the firm should take advantage of the added leverage.
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