Question

Remember to explain all your steps and to show all formulas you use before you put numbers into the equations.
-Write the formula, substitute the numbers into the formula, say what is left to compute, compute

Use the following information to answer questions 4 and 5 (including their appropriate subsections) D. Newcombe & Associates, Inc., is considering the introduction of a new product. Production of the new product requires an investment of $140,000 in equipment that has a five-year life. The equipment has no salvage value at the end of five years and will be depreciated on a straight-line basis. Newcombe's required return is 15%, and the tax rate is 34%. The firm has made the following forecasts: Base Case 2,000 Lower Bound 1,800 Upper Bound 2,200 Unit Sales Price per unit $55 $55 $55 Variable cost per unit $22 $22 $22 Fixed cost per year $10,000 $10,000 $10,000 Question 5 Suppose that sales for the project under consideration by Newcombe increases from 2,000 units to 2,200 units per year. Compute the DOL for project at sales of 2,000 units. Use both the definition of the DOL and its algebraic equivalent. Assume Newcombe pays no taxes on this project.

Answer 1

Solution:

DOL is the Degree of operating Leverage. DOL is defined as the percentage change in the operating income (EBIT) from a given percentage change in sales.

DOL = (Percentage change in EBIT) / (Percentage change in Sales) = (Change in EBIT/EBIT) / (Change in Sales/Sales)

DOL = {Q (P -V) } / {Q(P-V) - F}

Q -> Quantity of the units sold

P -> Price per unit

V -> Variable cost per unit

F -> Fixed costs

In our question the respective quantities are:-

Q = 2000 , P = 55 , V =22 , F =10000

Putting the values in the formula we get,

DOL = {2000(55-22)} / { 2000(55 -22) - 10000}

= { 2000 * 33 } / { (2000 * 33) -10000}

= 66000 / {66000 - 10000}

=66000 / 56000

= 1.1785

The Degree of Operating Leverage for the project at sales of 2000 units is 1.1785