Question

15-10 (Lecverage analysti) You have developed the following analytical profit and loss satement fr your company. It represents the most recent year's operations, which ended yesterday. Sales Variable costs Revenue before fixed costs Fixed costs EBIT Interest expense Earnings before taxes Taxes (0.50) Net income $45750000 22800000 $22950000 9200000 13750000 1350000 $12400000 6200000 $6 200000 Your supervisor has just hand ed you a memo asking for written responses to the following questions (a) At this level of output, what is the degree of operating leverage? (b) What is the degree of financial leverage? (c) What is the degree of combined leverage? (d) What is the firm's break-even point in sales dollars? (e) If sales increase by 25%, by what percent would earnings before taxes (and net income increase?

Answer 1

Ans:

a). Degree of Operating leverage(DOL):

DOL = (Contribution/EBIT)

*Contribution = $22,950,000

EBIT = $13,750,000

DOL = $22,950,000/$13,750,000

DOL = 1.67 times

*Note: Contribution is nothing but, revenue before fixed costs.

b). Degree of financial leverage(DFL):

DFL = [EBIT/(EBIT - Interest expense)]

EBIT = $13,750,000

Interest expense = $1,350,000

DFL = [$13,750,000/($13,750,000 - 1,350,000)]

DFL = $13,750,000/$12,400,000

DFL = 1.11 times.

c). Degree of combined leverage(DCL):

DCL = DOL $\times$ DFL

DCL = 1.67 $\times$ 1.11

DCL = 1.85 times.

d). Break even point(BEP) in sales dollars:

BEP = (Fixed cost )/(Contribution margin ratio).

Fixed cost = $9,200,000

*Contribution margin ratio = 50%

BEP = $9,200,000/50%

BEP = $18,400,000.

*Working notes:

Contribution margin ratio = (Sales - Variable costs)/Sales

Contribution margin ratio = ($45,750,000 - $22,800,000)/$45,750,000

Contribution margin ratio = $22,950,000/$45,750,000

Contribution margin ratio = 0.50 times or 50%.

e). Calculation of percentage of change in Earnings before tax and Net income due to change in Sales:

Particulars	Existing capacity	If sales increase by 25%	Percentage of change
Sales	$45,750,000	$57,187,500	25%
Less: Variable costs	$22,800,000	$28,500,000	25%
Revenue before fixed costs	$22,950,000	$28,687,500
Less: Fixed costs	$9200,000	$9200,000
EBIT	$13,750,000	$19,487,500
Less: Interest expense	$1,350,000	$1,350,000
Earnings before tax	$12,400,000	$18,137,500	46.27%
Less: Taxes(0.50)	$6,200,000	$9,068,750
Net income	$6,200,000	$9,068,750	46.27%

So, If sales increase by 25%, Earnings before tax increase by 46.27% and net income also increase by 46.27%.

Note: Calculations are rounded off to two decimals.

Thank you,

Feel free to comment incase of further help.