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?
Solutions
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 3 months agoRelated Solutions
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