Reference no: EM133027685

Question - Socrates Air is a low cost airline, primarily operating in Southern and Central Europe. Socrates Income Statement for this year is detailed below:

Euro (millions)

Sales: 89

(Cost of sales*: 45)

Gross profit: 44

Staffing costs**: 12

S,G & A***: 11

*Cost of sales is made up of the 20 million annual cost of leasing aircraft, through a ten year contract with no early exit option and the 25 million cost of aviation fuel, which is purchased on the open market as and when needed

** All staff are contractors, employed via "flexible" contracts and are only paid if their services are required by the airline

*** S,G & A covers Sales, General and Admin costs, including head office, insurance and IT. Socrates does not vary spending in this area as sales fluctuate, as they believe they have optimised this element of their business model for any economic situation

The corporate tax rate is 20% and this is not expected to change in the near future.

Socrates has total debt of 100 million Euros, with a fixed interest rate of 5%. This is not expected to change in the near future.

Required -

i) Determine the degree of operating leverage for Socrates

ii) Determine the degree of financial leverage for Socrates

iii) Determine the degree of total leverage for Socrates

iv) Socrates forecast a 5% decrease in sales next year. Assuming no change in unit costs, unit revenue, or tax rates, use your previous answer(s) to forecast net income next year. Comment on the relative change in net income to sales.

v) Socrates sales revenue per passenger seat sold is 89 Euro. Determine Socrates breakeven sales volume using this year's figures.

vi) Plato Airlines is Socrates major competitor. The sales figures of Plato and Socrates have been highly correlated, reflecting the similarities in both the products and clients of the two companies. However, there is a major difference in Plato's operating model, with all staff employed on long term contracts of employment. Plato believes this model encourages loyalty and commitment from staff, who are prepared to put in extra unpaid hours when the business is busy, but appreciate additional paid time off when the business is quieter. Plato has similar levels of debt to Socrates, but these pay a variable rate of interest linked to LIBOR.

Comment on how this impacts each of the following:

a) Business risk. Justify your answer in a maximum of three sentences

b) Financial risk