Question

Integrative—Leverage and risk Firm R has sales of 101,000 units at $1.97 per unit, variable operating costs of $1.68 per unit, and fixed operating costs of $6,010. Interest is $10,080 per year. Firm W has sales of 101,000 units at $2.59 per unit, variable operating costs of $0.98 per unit, and fixed operating costs of $62,600. Interest is $17,400 per year. Assume that both firms are in the 40% tax bracket. a. Compute the degree of operating, financial, and total leverage for firm R. b. Compute the degree of operating, financial, and total leverage for firm W. c. Compare the relative risks of the two firms. d. Discuss the principles of leverage that your answers illustrate.

Answer 1

Firm R

Sales : (Q )101,000 units at (P) $ 1.97 per units

Variable Cost (V) = $ 1.68 per unit

Fixed operating cost(F)= =$ 6,010

Interest (I)= $ 10,080

Degree of Operating Leverage (DOL)= [Q(P-V)] / [Q(P-V) - F) =  1.2581

Degree of Financial Leverage (DFL)= [Q(P-V)-F ] / [ Q(P-V)-F-I ] = 1.7636

Degree of Total Leverage (DTL) = DFL * DOL = 2.22

Firm W

Sales : (Q )101,000 units at (P) $ 2.59 per units

Variable Cost (V) = $0.98 per unit

Fixed operating cost(F)= =$ 62,600

Interest (I)= $ 17,400

Degree of Operating Leverage (DOL)= [Q(P-V)] / [Q(P-V) - F) =  1.3145

Degree of Financial Leverage (DFL)= [Q(P-V)-F ] / [ Q(P-V)-F-I ] = 1.0958

Degree of Total Leverage (DTL) = DFL * DOL =1.44

Operating Risk is high for firm W (1.31>1.25) - DOL

Financial Risk is high for firm R (1.76 > 1.09) - DFL

Overall risk for Firm R > Firm W (DTL)