Study Problems: Return and Break-even
Problem 1 (Expect rate of return and risk): Summerville Inc. is considering an investment in one of two common stocks. Given the information that follows, which investment is better, based on the risk (as measured by the standard deviation) and return of each? (Colorado State University-Global Campus, 2014).
COMMON STOCK A COMMON STOCK B
PROBABILITY RETURN PROBABILITY RETURN
0.30 11% 0.20 -5%
0.40 15% 0.30 6%
0.30 19% 0.30 14%
Expected return and risk (standard deviation) for each stock (Keown, Martin, & Petty, 2014, pp. 186, 191):
Common stock A is the better investment: the expected return of 15 percent and risk (standard deviation) of 10.16 percent for common stock A is better (higher return, lower risk) than for common stock B (9.4 percent and 9.96 percent, respectively); the expected return/risk ratio is higher for common stock A (147.6 percent) than for common stock B (94.4 percent) (Keown, Martin, & Petty, 2014, pp. 186, 191).
Problem 2 (Capital asset pricing model): The expected return for the general market is 12.8 percent, and the risk premium in the market is 9.3 percent. Tasco, LBM, and Exxos have betas of 0.864, 0.693, and 0.575, respectively. What are the corresponding required rates of return for the three securities? (Colorado State University-Global Campus, 2014).
Required rates of return for the three securities:
(Keown, Martin, & Petty, 2014, p. 208).
Problem 3 (Break-even analysis): You have developed the following income statement for the Hugo Boss Corporation. It represents the most recent year’s operations, which ended yesterday.
Sales $ 50,439,375
Variable costs (25,137,000)
Revenue before fixed costs $ 25,302,375
Fixed costs (10,143,000)
EBIT $ 15,159,375
Interest expense (1,488,375)
Earnings before taxes $ 13,671,000
Taxes at 50% (6,835,500)
Net income $ 6,835,500
Your supervisor in the controller’s office has just handed you a memorandum asking for written responses to the following questions (Colorado State University-Global Campus, 2014):
a. What is the firm’s break-even point in sales dollars?
The firm’s break-even point in sales is $20,219,705.88 ($10,143,000 / (1 – [$25,137,000 / $50,439,375]); break-even point in sales = fixed costs / (1-[variable costs / revenues])) (Keown, Martin, & Petty, 2014, p. 387).
b. If sales should increase by 30 percent, by what percent would earnings before taxes (and net income) increase?
If sales increase by 30 percent, earnings before taxes and net income would each increase 54.7 percent (Keown, Martin, & Petty, 2014, p. 263).
Capital Structure Management: More Art than Science
A firm’s capital structure is that portion of the balance sheet which remains after you subtract non-interest-bearing liabilities (accounts payable and accrued expenses) from the financial structure of the balance sheet (Keown, Martin, & Petty, 2014, p. 394). Capital structure thus refers...