Question

Based on the following information on Levered Company, answer these questions:

a) If sales increase by 10%, what should happen to operating income?

b) If operating income increases by 10%, what should happen to EPS?

c) If sales increase by 10%, what should be the effect on EPS?

Sales (100,000 units)                             $1,400,000

Variable Costs                                      $800,000

Fixed Costs                                            $250,000

Interest paid                                            $125,000

Tax rate                                                          34%

Common stocks issued/outstanding 100,000 shares

Answer 1

a) In considering the above data operating income = sales- variable cost - Fixed cost.

Thus Operating income = 1400000 - 800000 - 250000 = $ 350000

Now if sales increase by 10%, then sales = 1400000 + 140000 = $ 1540000

Operating income = 1540000 - 800000 - 250000 = $ 490000

Thus change in operating income = (490000 - 350000) / 350000 = 0.4 & 100 = 40%

Operating income will increase by 40% Ans

b) Now Net income  = operating income - Interest expense - tax = 350000 - 125000 = $225000 - 34% of 225000 = $ 148500

EPS = 148500/100000 = 1.48

If operating income increase by 10%, then new operating income = 350000 + 10% of 350000 = $ 385000

Thus new Net income = 385000 - 125000 = $ 260000 - 34% 260000 = 260000 - 88400 = $171600

EPS = 171600/ 100000 = 1.71

Thus EPS would increase by 0.23* 100 = 23% Ans

c) if sales increase by 10%, then Net income = 490000 - 125000 = 365000 -34% 365000 = $ 240900

EPS = 240900/100000 = 2.41

Original net income = 350000 - 125000 =225000 - 34% 225000 = $ 148500

EPS = 148500/100000 = 1.48

Thus there would be increase in EPS of 0.93* 100 = 93% Ans