Question

?You have developed the following pro forma income statement for your? corporation:

Sales	$	45,750,000
Variable costs		(22,800,000)
Revenue before fixed costs	$	22,950,000
Fixed costs		(9,200,000)
EBIT	$	13,750,000
Interest expense		(1,350,000)
Earnings before taxes	$	12,400,000
Taxes (50%)		(6,200,000)
Net income	$	6,200,000

It represents the most recent? year's operations, which ended yesterday. Your supervisor in the? controller's office has just handed you a memorandum asking for written responses to the following?questions:

a.??If sales should increase by 25 percent, by what percent would earnings before interest and taxes and net income? increase?

b. If sales should decrease by 25 percent, by what percent would earnings before interest and taxes and net income? decrease?

c.   ?If the firm were to reduce its reliance on debt financing such that interest expense were cut in? half, how would this affect your answers to parts a and b??

Answer 1

a. To calculate the relation between Sales and EBIT and Net Income, let us capture the relation between these amounts.

EBIT to Sales ratio = 12400000 / 45750000 = 27.10%

Net Income to Sales ratio = 6200000 / 45750000 = 13.55%

Therefore, 25% increase in sales would lead to increase in EBIT = 25% * 27.10% = 6.775%

Calculating new net income = EBIT = 13750 - Interest - Tax = (13750 - 675)/2 = 6537.5 in 1000's = 6537500.

Net Income to Sales new ratio = 6537500 / 45750000 *100 = 14.29%.

Hence, increase or decrease with sales = 14.29% * 25% = 3.57%.

b. If sales decrease by 25%, then the decrease will also be in the same proportion. The proportion does not change with the direction of change in sales.

c. If interest expense would reduce by 50%, then the increase or decrease would not have had any impact on EBIT, but the net income would have increased by double = 25% * 13.55% * 2 =