Question

In: Finance

A project generates $7,000 in revenue each year. It has the following costs: fixed cost:$1,200/year variable...

A project generates $7,000 in revenue each year. It has the following costs:

fixed cost:$1,200/year

variable cost: 65%of revenue

depreciation: $400/year

A) If sales increases by 20%, what will be the increase in pretax profits? (Hint: Calculate the base case pretax first then apply the sales growth)

B) What is the degree of operating leverage (DOL) for this project?

Expert Solution

Question A). Solution :- Calculation of increase in Pre tax profit level :-

Increased (new) sales revenue = 7000 + 20 % of 7000

= 7000 + 1400

= $ 8400.

Particulars

Amount in $ (When sales revenue = 7000)

Amount in $ (When sales revenue = 8400)

Sales

(-) VC

7000

4550 (65 % of 7000)

8400

5460 (8400 * 65 %)

Contribution

(-) FC

2450

1200

2940

1200

EBD

(-) Dep.

1250

400

1740

400

Profit

850

1340

Accordingly, Pre tax profit increases by $ 490 (1340 - 850).

Conclusion :- Increase in pre tax profit by $ 490.

(VC means Variable costs, FC means Fixed costs and EBD means Earnings before depreciation).

Question B). Solution :- Degree of operating leverage (DOL) = % Change in pre tax profit / % Change in sales.

% Change in profit = (New profit - Old profit) / Old profit.

= (1340 - 850) / 850.

= 490 / 850 = 0.5765 i.e., 57.65 %

% Change in sales = 20 % (Given in question)

Accordingly, Degree of operating leverage (DOL) = 57.65 / 20

= 2.8825 Times. (Rounded off to 2.88 Times)

Conclusion :- Degree of operating leverage (DOL) = 2.88 Times (approx).

jeff jeffy answered 9 months ago

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