Arnold Vimka is a venture capitalist facing two alternative investment opportuni

Question

Arnold Vimka is a venture capitalist facing two alternative investment opportunities. He intends to invest $800,000 in a start-up firm. He is nervous, however, about future economic volatility. He asks you to analyze the following financial data for the past year’s operations of the two firms he is considering and give him some business advice.

Required

Use the contribution margin approach to compute the operating leverage for each firm.

If the economy expands in coming years, Larson and Benson will both enjoy a 10 percent per year increase in sales, assuming that the selling price remains unchanged. Compute the change in net income for each firm in dollar amount and in percentage. (Note: Since the number of units increases, both revenue and variable cost will increase.)

If the economy contracts in coming years, Larson and Benson will both suffer a 10 percent ­decrease in sales volume, assuming that the selling price remains unchanged. Compute the change in net income for each firm in dollar amount and in percentage. (Note: Since the ­number of units decreases, both total revenue and total variable cost will decrease.)

Company Name Larson Benson Variable cost per unit (a) $ 16.00 $ 7.00 Sales revenue (8,000 units × $25) $ 200,000 $ 200,000 Variable cost (8,000 units × a) (128,000 ) (56,000 ) Contribution margin $ 72,000 $ 144,000 Fixed cost (24,000 ) (96,000 ) Net income $ 48,000 $ 48,000

Explanation / Answer

Operating leverage:

Sales volume increases by 10%

Sales volume decreases by 10%

Company Name Ref Larson Benson Variable cost per unit (a) 16 7 Sales revenue (8,000 units × $25) 2,00,000 2,00,000 Variable cost (8,000 units × a) 1,28,000 56,000 a Contribution margin 72,000 1,44,000 Fixed cost 24,000 96,000 b Net income 48,000 48,000 c= a/b Operating leverage 1.5 3

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