Question

The Sterling Tire Company's income statement for 20X1 is as follows 

STERLING TIRE COMPANY For the Year Ended Decenber 31, 28x1 

Sales (21,800 tires at $62 each)  $1,302,000

Variable costs (21,038 tires at S31) 651,000

Fixed costs                               410,000

Earnings before interest and taxes (EBIT)  241,000

Interest expense                       50,500

Earnings before taxes (EBT)      $190,500

Income tax expense (20%)         38,100

Earnings after taxes (EAT)       $152,400 

a. Compute the degree of operating leverage. 

b. Compute the degree of financial leverage.

c. Compute the degree of combined leverage

d. Compute the breek-even point in units.

Answer 1

SOLUTION :

a.

Degree of operating leverage (DOL)

= (Sales - Variable costs) / EBIT

= (1302000 - 651000) / 241000

= 651000 / 241000

= 2.70124

= 2.70 (ANSWER)

b.

Degree of financial leverage (DFL)

= EBIT / EBT 

= 241000 / 190500

= 1.2651

= 1.27 (ANSWER).

c.

Degree of combined leverage 

= Contribution margin / EBT  

= (1302000 - 651000)  / 190500

= 3.4173

= 3.42  (ANSWER).

d.

Break-even Point  in units = Fixed costs / Unit contribution margin

= 410000 / (62 - 31)

= 13225.81

= 13226 tires (ANSWER).

Answer 2

Quantity = 21,000

Price = $62

Variable Cost = $30

Fixed Cost = $400,000

Interest expense= $50,000

a

Degree of operating leverage = (sales − variable costs) / (sales − variable costs − fixed costs)

Degree of operating leverage=((62-30)*21000)/((62-30)*21000-400000)

Degree of operating leverage=2.47

b

Degree of Financial Leverage =EBIT/(EBIT-Interest Expense)

=241000/(241000-50000)

Degree of Financial Leverage=1.26

C

Degree of Combined Leverage

Degree of Combined Leverage = (sales − variable costs) / (sales − variable costs − fixed costs-Interest Expense)

=((62-30)*21000)/((62-30)*21000-400000-50000)

Degree of Combined Leverage=3.03

          d

Break even Point

Degree of operating leverage =fixed costs/ (sales − variable costs)

=400000/(62-30)

Break even Point=12500 Units