Your business plan for your proposed start-up firm envisions first-year revenues

Question

Your business plan for your proposed start-up firm envisions first-year revenues of $720,000, fixed costs of $360,000, and variable costs equal to one-third of revenue.

a. What are expected profits based on these expectations?

b. What is the degree of operating leverage based on the estimate of fixed costs and expected profits? (Round your answer to 2 decimal places.)

Degree of operating leverage?

c. If sales are 10% below expectation, what will be the decrease in profits? (Round your answer to 2 decimal places. Omit the "%" sign in your response.)

Decrease in profits %

e. Based on the DOL, what is the largest percentage shortfall in sales relative to original expectations that the firm can sustain before profits turn negative?

What are break-even sales at this point? (Round "Shortfall" answer to 2 decimal places. Omit the "$ & %" signs in your response.)

Shortfall % = ?

Break-even sales $ = ?

Explanation / Answer

a)

expected profits = 720000 -360000 - (720000/3) = 120000

b)

degree of operating leverage = (Fixed costs/Expected pretax income) + 1 = (360000/120000)+1 = 4.00

c)

new profit = 720000*0.9 -360000 - (720000*0.9/3) = 72000

decrease in profits = (120000 - 72000)/120000 = 40%

d)

let expeted revenue is decreased by x percent

then

720000 * (1-x) - 360000 - (72000*(1-x)/3) = 0

x = 0/25 = 25%

hence shortfall = 25%

for break even sales, profit is zero

x - 360000 - x/3 = 0

x = 540000

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