Imagen Arquitectonica of Tijuana, Mexico is contemplating a major change in its cost structure

E6-15 Imagen Arquitectonica of Tijuana, Mexico is contemplating a major change in its cost structure. Currently, all of its drafting work is performed by skilled draftsmen. Alfredo Ayala, Imagen's owner, is considering replacing the draftsmen with a computerized drafting system.

However, before making the change Alfredo would like to know the consequences of the change, since the volume of business varies significantly from year to year. Shown below are CVP income statements for each alternative.

Manual System Computerized System
Sales $1,500,000 $1,500,000
Variable costs 1,200,000 600,000
Contribution margin 300,000 900,000
Fixed costs 60,000 660,000
Net income $240,000 $240,000

Instructions
a. Determine the degree of operating leverage for each alternative
b. Which alternative would produce the higher net income if sales increase by $100,000.
c. Using the margin of safety ratio, determine which alternative could sustain the greater decline in sales before operating at a loss.

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(Evaluating McGraw Industries Capital Structure) McGraw Industries, an established producer of printing equipment, expects its sales to remain flat

McGraw Industries, an established producer of printing equipment, expects its sales to remain flat for the next 3 to 5 years because of both a weak economic outlook and an expectation of little new printing technology development over that period. On the basis of this scenario, the firm’s management has been instructed by its board to institute programs that will allow it to operate more efficiently, earn higher profits, and, most important, maximize share value.

In this regard, the firm’s chief financial officer (CFO), Ron Lewis, has been charged with evaluating the firm’s capital structure. Lewis believes that the current capital structure, which contains 10% debt and 90% equity, may lack adequate financial leverage. To evaluate the firm’s capital structure, Lewis has gathered the data summarized in the following table on the current capital structure (10% debt ratio) and two alternative capital structures—A (30% debt ratio) and B (50% debt ratio)—that he would like to consider.
Capital structure*

Source of capital Current (10% debt) A (30% debt) B (50% debt)
Long-term debt $1,000,000 $3,000,000 $5,000,000
Coupon interest rate** 9% 10% 12%
Common stock 100,000 shares 70,000 shares 40,000 shares
Required return on equity*** 12% 13% 18%

*These structures are based on maintaining the firm’s current level of $10,000,000 of total financing.
**Interest rate applicable to all debt.
***Market-based return for the given level of risk.

Lewis expects the firm’s earnings before interest and taxes (EBIT) to remain at its current level of $1,200,000. The firm has a 40% tax rate.

Use the current level of EBIT to calculate the times interest earned ratio for each capital structure. Evaluate the current and two alternative capital structures using the times interest earned and debt ratios.


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Sanderson Manufacturing Company would like to achieve a capital structure consistent with a Baa2/BBB senior debt rating

B2. (Choosing financial targets) Sanderson Manufacturing Company would like to achieve a capital structure consistent with a Baa2/BBB senior debt rating. Sanderson has identified six comparable firms and calculated the credit statistics shown here.

a. Sanderson’s return on assets is 5.3%. It has a total capitalization of $600 million. What are reasonable targets for long-term debt/cap, funds from operations/LT debt, and fixed charge coverage?

b. Are there any firms among the six who are particularly good or bad comparable? Explain.
c. Suppose Sanderson’s current ratio of long-term debt to total cap is 60% but its fixed charge coverage is 3.00. What would you recommend?

FIRM A B C D E F
Senior debt rating Baa2/BBB Baa3/BBB− Baa2/BBB Baa1/A− Baa1/BBB− Baa2/BBB+
Return on assets 5.2% 5.0% 5.4% 5.7% 5.2% 5.3%
Long-term debt/cap 38% 41% 45% 40% 25% 43%
Total cap ($MM) 425 575 525 650 210 375
Funds from operations/LT debt 39% 43% 28% 46% 57% 43%
Fixed charge cov 2.57 2.83 2.75 2.38 3.59 2.15


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20 Questions: A simple structure is characterized by

1. A simple structure is characterized by (Points : 5)

2. Complete the following sentence: "Virtual organizations __________ whereas modular organizations __________." (Points : 5)

3. The phrase that best defines a virtual organization is (Points : 5)

4. Effective ambidextrous organizations have alignment, which means that (Points : 5)

5. Important advantages of a holding company structure include (Points : 5)

6. An organization such as ConAgra that has dozens of different divisions with similar products will probably have the greatest success with which form of organization structure? (Points : 5)

7. What is the name of the practice that many modular organizations use to grow? (Points : 5)

8. Which of the following statements would least likely be found in a corporate credo? (Points : 5)

9. Leaders play a key role in developing and sustaining an organization's (Points : 5)

10. The "bottom-up" perspective of empowerment (Points : 5)

11. Which of the following is not a characteristic of a successful learning organization? (Points : 5)

12. Coercive power is (Points : 5)

13. Refusal to share information, conflicts over resources, conflicts between departments and divisions, and petty interpersonal differences are symptoms of which type of barrier to change? (Points : 5)

14. Expert power (Points : 5)

15. Strategic reasons for undertaking a corporate venture include which of the following? (Points : 5)

16. Product champions (Points : 5)

17. The innovation dilemma known as seeds versus weeds refers to (Points : 5)

18. __________ produce fundamental changes that can transform a company or even revolutionize an industry, while __________ enhance existing practices and often represent evolutionary applications of fundamental breakthroughs. (Points : 5)

19. Which kind of risk taking requires that a company borrow heavily or commit a large portion of its resources in order to grow? (Points : 5)

20. Real options analysis is most appropriate when (Points : 5)

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