WACC Yield vs Coupon

CFA Level I
#1

Given the following information on the annual operating results for ArtFrames, a producer of quality metal picture frames:

  • Sales of $3,500,000.
  • Variable costs at 45% of sales.
  • Fixed costs of $1,050,000.
  • Debt interest payments on $750,000 issued at par with an annual 9.0% coupon; market yield is currently 7.0%.

ArtFrames’s degree of operating leverage (DOL) and degree of financial leverage (DFL) are closest to:

DOL

DFL

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QBank Custom Quiz November 21, 2019

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Question 38 of 50 DownArrow

ID: 1109108 · Intermediate

Score: 81.08%

Given the following information on the annual operating results for ArtFrames, a producer of quality metal picture frames:

  • Sales of $3,500,000.
  • Variable costs at 45% of sales.
  • Fixed costs of $1,050,000.
  • Debt interest payments on $750,000 issued at par with an annual 9.0% coupon; market yield is currently 7.0%.

ArtFrames’s degree of operating leverage (DOL) and degree of financial leverage (DFL) are closest to:

DOL DFL

A)

2.20 1.08

Achieved

B)

2.20 1.50

Failed

C)

3.00 1.50

Failed

Explanation

DOL = (sales – variable costs) / (sales – variable costs – fixed costs)

Variable costs = $3,500,000 × 45% = $1,575,000

Fixed costs = $1,050,000

DOL = ($3,500,000 – $1,575,000) / ($3,500,000 – $1,575,000 – $1,050,000) = 2.20

DFL = EBIT / (EBIT – interest)

Interest = $750,000 × 9% = $67,500

EBIT = sales – variable costs – fixed costs = $3,500,000 – $1,575,000 – $1,050,000 = $875,000

DFL = $875,000 / ($875,000 – $67,500) = 1.08

I’m having triubtr grasoing this, why is the coupon % used to calculate interest expense instead of the yield?

#2

What was the YTM on the bonds when they were originally issued?

#3

If it was issued at par, coupon and yield are equal. Since coupon > yield it is a premium so you would want to capture the higher payment of Coupon? Am I close?

#4

So the yield at issuance was . . . ?

Why are you telling me the situation now? I didn’t ask about the situation now.

Not yet, but you’ll get there.

#5

If it was issued at par then Coupon = yield. So if yield adjusted down you want to capture the higher (original) cost?

#6

Give me a number.

You seem determined to tell me about the situation now, even though I haven’t asked about it.

To be clear: the reason I haven’t asked about it is that I don’t care about it.

#7

9%?

#8

Since rates could change from when they were equal (issued at par) the original yield is equal to the current coupon rate .9%. I hope that is the right reasonkng.

#9

Say it like you mean it!

:wink:

#10

You keep fixating on how the TYM might change.

Stop it! It doesn’t matter!

Careful of the typos. Nine percent, not zero-dot-nine percent.

Nope, but you’ll get it.

The right reasoning is that the original yield was 9% because the coupon rate is 9% and the bonds were issued at par.

That’s it: finito.

#11

Now that we have the original yield, on to the next question: what was the carrying value of the bonds (on ArtFrames’ balance sheet) at the beginning of the year?

#12

$750,000 since the bond was issued at par there was no discount/premium. Since it was issued at par and yield = coupon. Interest expense would be the yield of 9% * 750,000 = 67,500

#13

Bingo! :+1:

The yield used to compute interest expense doesn’t change; it’s the YTM at issuance.

You multiply that yield by the beginning-of-period carrying value (par ± unamortized premium/discount) to get interest expense.

What the market thinks the YTM is today doesn’t matter in computing interest expense.

(Note that the best part of all of this is that now that I’ve made you go through this whole stupid thing yourself, there’s no chance that you’ll forget it before the exam.)

#14

I really appreciate it, i was thinking he usually gives the answer but I liked this much more. I hope I pass this time!!