Question

5. Computing and interpreting the degree of operating leverage (DOL) It is December 31. Last year, Praxis Corporation had sales of $16,000,000, and it forecasts that next year's sales will be $17,600,000. Its fixed costs have been and are expected to continue to be $1,200,000, and its variable cost ratio is 40.00%. Praxis's capital structure consists of a $13.5 million bank loan, on which it pays an interest rate of 6%, and 300,000 shares of common equity. The company's profits are taxed at a marginal rate of 35%. Given this data, complete the following sentences: • The percentage change in the company's sales is • The percentage change in EBIT is • The degree of operating leverage (DOL) at $17,600,000 is There are several ways to use and interpret a firm's DOL value. Consider the following statement and indicate whether it accurately reflects the meaning or an appropriate use of a firm's DOL value. At sales of $24 million, Firm X's DOL IS 1.75, and Firm C's DOL is 6.50. Firm C exhibits a lower level of business risk than Firm X True or False: This statement accurately describes a firm's DOL. False

Answer 1

Preparing the Income Statement for Last yaer and Forecasted year:-

Particular	Current Year	Next Year
Revenue	16,000,000	17,600,000
Variable Costs @40%	(6,400,000)	(7,040,000)
Gross Profit	9,600,000	10,560,000
Fixed Costs	(1,200,000)	(1,200,000)
EBIT	8,400,000	9,360,000
interest [$13,500,000*6%]	(810,000)	(810,000)
Taxable Income	7,590,000	8,550,000
Taxation (40%)	(2,656,500)	(2,992,500)
Net income (a)	4,933,500	5,557,500
No of Shares outstanding (b)	300,000	300,000
EPS [(a)/(b)]	16.445	18.525

- Current Year's Sales = $16,000,000

Next year's sales = $17600,000

% change in Sales = (Next Year Sales-Current Year Sales)/Current Year Sales

= (17600,000-16000,000)/16000,000

= 10%

- Current Year EBIT = $ 8,400,000

Next Year EBIT = $ 9,360,000

% change in EBIT = (Next Year EBIT-Current Year EBIT)/Current Year EBIT

= (9360,000-8400,000)/8400,000

= 11.43%

- Degree of Financial Leverage (DOL) at $17,600,000 = % Change in EBIT/% Change in Sales

= 11.43%/10%

= 1.143 times

- The Satement is False

DOL = % Change in EBIT/% Change in Sales

So, the greater the DOL, the higher the Operating Fixed cost. As DOL will be higher when the % Change in EBIT is greater than % Change in Sales and this can only happen due to higher Fixed Cost.

Thus, higher DOL is risky as it increases the risk of Loss rather than profit(i.e., Business Risk).

Hence, the statement is False.

If you need any clarification, you can ask in comments.

If you like my answer, then please up-vote as it will be motivating