Chapter 9, Problem 5PSA

To determine

Times Interest Earned:

Times interest earned measures whether the company is in position to pay its debt obligations or not. It is also known as interest coverage ratio.

1.

To compute: Times interest earned of M Company.

Explanation of Solution

Given,

For M company

Income before interest is $200,000.

Interest expense is $60,000.

Times interest earned

Formula to calculate times interest earned,

  $\text{Times}\text{interest}\text{earned}=\frac{\text{Income}\text{before}\text{interest}\text{and}\text{tax}}{\text{Interest}\text{expense}}$

Substitute $200,000 for income before interest and tax and $60,000 for interest expense.

  $\begin{array}{c}\text{Times}\text{interest}\text{earned}=\frac{\$200,000}{\$60,000}\\ =3.33\text{times}\end{array}$

Thus, times interest earned of M Company is 3.33 times.

2.

To determine

To compute: Times interest earned of W Company.

Explanation of Solution

Given,

For W company

Income before interest is $400,000.

Interest expense is $260,000.

Times interest earned

Formula to calculate times interest earned,

  $\text{Times}\text{interest}\text{earned}=\frac{\text{Income}\text{before}\text{interest}\text{and}\text{tax}}{\text{Interest}\text{expense}}$

Substitute $400,000 for income before interest and tax and $260,000 for interest expense.

  $\begin{array}{c}\text{Times}\text{interest}\text{earned}=\frac{\$400,000}{\$260,000}\\ =1.54\text{times}\end{array}$

Thus, times interest earned of W company is 1.54 times.

3.

To determine

To compute: Net income if sales increase by 30%.

Explanation of Solution

Net income if sales increase by 30%.

Particulars	M Company ($)(given)	M Company ($)(30% increased sales)	W Company ($)(given)	W Company ($)(30% increased sales)
Sales	1000,000	1,300,000	1,000,000	1,300,000
Variable expenses	800,000	1,040,000	600,000	780,000
Income before interest	200,000	260,000	400,000	520,000
Interest expense	60,000	60,000	260,000	260,000
Net income	140,000	200,000	140,000	260,000
Increase in net income		43%		86%

Table (1)

Working note:

Formula to calculate percentage increase in net income,

  $\text{Percentage}\text{increase}\text{in}\text{net}\text{income}=\frac{\text{Increase}\text{in}\text{net}\text{Income}}{\text{Prior}\text{net}\text{income}}$

For Company M

  $\begin{array}{c}\text{Percentage}\text{increase}\text{in}\text{net}\text{income}=\frac{\$60,000}{\text{\$140,000}}\\ =43\%\end{array}$

For Company W

  $\begin{array}{c}\text{Percentage}\text{increase}\text{in}\text{net}\text{income}=\frac{\text{\$120,000}}{\text{\$140,000}}\\ =86\%\end{array}$

Thus, net income of Company M gets increased by 43% and Company W by 86%.

4.

To determine

To compute: Net income if sales increase by 50%.

Explanation of Solution

Net income if sales increase by 50%.

Particulars	M Company ($)(given)	M Company ($)(50% increased sales)	W Company ($)(given)	W Company ($)(50% increased sales)
Sales	1000,000	1,500,000	1,000,000	1,500,000
Variable expenses	800,000	1,200,000	600,000	900,000
Income before interest	200,000	300,000	400,000	600,000
Interest expense	60,000	60,000	260,000	260,000
Net Income	140,000	240,000	140,000	340,000
Increase in net income		71%		143%

Table (1)

Working Note:

Formula to calculate percentage increase in net income,

  $\text{Percentage}\text{increase}\text{in}\text{net}\text{income}=\frac{\text{Increase}\text{in}\text{net}\text{Income}}{\text{Prior}\text{net}\text{income}}$

For Company M

  $\begin{array}{c}\text{Percentage}\text{increase}\text{in}\text{net}\text{income}=\frac{\$100,000}{\text{\$140,000}}\\ =71\%\end{array}$

For Company W

  $\begin{array}{c}\text{Percentage}\text{increase}\text{in}\text{net}\text{income}=\frac{\text{\$200,000}}{\text{\$140,000}}\\ =143\%\end{array}$

Thus, net income of Company M gets increased by 71% and Company W by 143%.

5.

To determine

To compute: Net income if sales increase by 80%.

Explanation of Solution

Net income if sales increase by 80%.

Particulars	M Company ($)(given)	M Company ($)(80% increased sales)	W Company ($)(given)	W Company ($)(80% increased sales)
Sales	1000,000	1,800,000	1,000,000	1,800,000
Variable expenses	800,000	1,440,000	600,000	1,080,000
Income before interest	200,000	360,000	400,000	720,000
Interest expense	60,000	60,000	260,000	260,000
Net Income	140,000	300,000	140,000	460,000
Increase in net income		114%		229%

Table (1)

Working Note:

Formula to calculate percentage increase in net income,

  $\text{Percentage}\text{increase}\text{in}\text{net}\text{income}=\frac{\text{Increase}\text{in}\text{net}\text{Income}}{\text{Prior}\text{net}\text{income}}$

For Company M

  $\begin{array}{c}\text{Percentage}\text{increase}\text{in}\text{net}\text{income}=\frac{\$160,000}{\text{\$140,000}}\\ =114\%\end{array}$

For Company W

  $\begin{array}{c}\text{Percentage}\text{increase}\text{in}\text{net}\text{income}=\frac{\text{\$320,000}}{\text{\$140,000}}\\ =229\%\end{array}$

Thus, net income of Company M gets increased by 114% and Company W by 229%.

6.

To determine

To compute: Net income if sales decrease by 10%.

Explanation of Solution

Net income if sales decrease by 10%.

Particulars	M Company ($)(given)	M Company ($)(10% decreased sales)	W Company ($)(given)	W Company ($)(10% decreased sales)
Sales	1000,000	900,000	1,000,000	900,000
Variable expenses	800,000	720,000	600,000	540,000
Income before interest	200,000	180,000	400,000	360,000
Interest expense	60,000	60,000	260,000	260,000
Net Income	140,000	120,000	140,000	100,000
Increase in net income		-14%		-29%

Table (1)

Working note:

Formula to calculate percentage increase in net income,

  $\text{Percentage}\text{decrease}\text{in}\text{net}\text{income}=\frac{\text{Increase}\text{in}\text{net}\text{Income}}{\text{Prior}\text{net}\text{income}}$

For Company M

  $\begin{array}{c}\text{Percentage}\text{decrease}\text{in}\text{net}\text{income}=\frac{\$20,000}{\text{\$140,000}}\\ =-14\%\end{array}$

For Company W

  $\begin{array}{c}\text{Percentage}\text{decrease}\text{in}\text{net}\text{income}=\frac{\text{\$40,000}}{\text{\$140,000}}\\ =-29\%\end{array}$

Thus, net income of Company M gets decreased 14% and Company W by 29%.

7.

To determine

To compute: Net income if sales decrease by 20%.

Explanation of Solution

Net income if sales decrease by 20%.

Particulars	M Company ($)(given)	M Company ($)(20% decreased sales)	W Company ($)(given)	W Company ($)(20% decreased sales)
Sales	1000,000	800,000	1,000,000	800,000
Variable expenses	800,000	640,000	600,000	480,000
Income before interest	200,000	160,000	400,000	320,000
Interest expense	60,000	60,000	260,000	260,000
Net Income	140,000	100,000	140,000	60,000
Increase in net income		-29%		-57%

Table (1)

Working Note:

Formula to calculate percentage increase in net income,

  $\text{Percentage}\text{decrease}\text{in}\text{net}\text{income}=\frac{\text{Increase}\text{in}\text{net}\text{Income}}{\text{Prior}\text{net}\text{income}}$

For Company M

  $\begin{array}{c}\text{Percentage}\text{decrease}\text{in}\text{net}\text{income}=\frac{\$40,000}{\text{\$140,000}}\\ =-29\%\end{array}$

For Company W

  $\begin{array}{c}\text{Percentage}\text{decrease}\text{in}\text{net}\text{income}=\frac{\text{\$80,000}}{\text{\$140,000}}\\ =-57\%\end{array}$

Thus, net income of Company M gets decreased 29% and Company W by 57%.

8.

To determine

To compute: Net income if sales decrease by 40%.

Explanation of Solution

Net income if sales decrease by 40%.

Particulars	M Company ($)(given)	M Company ($)(40% decreased sales)	W Company ($)(given)	W Company ($)(40% decreased sales)
Sales	1000,000	600,000	1,000,000	600,000
Variable expenses	800,000	480,000	600,000	360,000
Income before interest	200,000	120,000	400,000	240,000
Interest expense	60,000	60,000	260,000	260,000
Net Income	140,000	60,000	140,000	(20,000)
Increase in net income		-57%		-114%

Table (1)

Working note:

Formula to calculate percentage increase in net income,

  $\text{Percentage}\text{decrease}\text{in}\text{net}\text{income}=\frac{\text{Increase}\text{in}\text{net}\text{Income}}{\text{Prior}\text{net}\text{income}}$

For Company M

  $\begin{array}{c}\text{Percentage}\text{decrease}\text{in}\text{net}\text{income}=\frac{\$80,000}{\text{\$140,000}}\\ =-57\%\end{array}$

For Company W

  $\begin{array}{c}\text{Percentage}\text{decrease}\text{in}\text{net}\text{income}=\frac{\text{\$160,000}}{\text{\$140,000}}\\ =-114\%\end{array}$

Thus, net income of Company M gets decreased 57% and Company W by 114%.

9.

To determine

Relation to fixed cost strategies of the two companies.

Explanation of Solution

Relation to fixed cost strategies of the two companies,

• Here in this case fixed cost refers to interest expenses.
• Interest expenses in Company M are $ 60,000 and in Company W are $260,000. Interest expenses are higher in company W than in Company M.
• Due to higher interest expenses, change in net income gets more effected due to change in sales.
• Higher fixed cost is inversely related to times interest earned method.
• So if sales get increased, W Company enjoys higher percent increase in income in comparison to Company M.
• If sales get decreased, M Company experiences smaller percent change in net income in comparison to Company W.