Question

The computation and interpretation of the degree of financial leverage (DFL)

It is December 31. Last year, Torres Industries had sales of $160,000,000, and it forecasts that next year’s sales will be $152,000,000. Its fixed costs have been—and are expected to continue to be—$64,000,000, and its variable cost ratio is 1.00%. Torres’s capital structure consists of a $15 million bank loan, on which it pays an interest rate of 8%, and 750,000 shares of common equity. The company’s profits are taxed at a marginal rate of 40%. Given this data, complete the following sentences:

Note: For these computations, round each EPS to two decimal places.

•	The company’s percentage change in EBIT is .
•	The percentage change in Torres’s earnings per share (EPS) is .
•	The degree of financial leverage (DFL) at $152,000,000 is .

The following are the two principal equations that can be used to calculate a firm’s DFL value:

DFL (at EBIT = $X)=Percentage Change in EPSPercentage Change in EBITDFL (at EBIT = $X)=Percentage Change in EPSPercentage Change in EBIT

DFL (at EBIT = $X)=EBITEBIT−Interest−Preferred Dividends(1 – Tax Rate)DFL (at EBIT = $X)=EBITEBIT−Interest−Preferred Dividends(1 – Tax Rate)

Consider the following statement about DFL, and indicate whether or not it is correct.

All other factors remaining constant, the larger the proportion of common equity used by the firm in its capital structure, the smaller the firm’s DFL.

False

True

Answer 1

Ans-Given Data-

	Last Year	Next Year
Sales	$160,000,000	$152,000,000
Fixed Cost	$64,000,000	$64,000,000
Variable Cost Ratio	1%	1%
Amount of Loan in Capital Structure	$15,000,000
Rate of Interest	8%
Interest for the period	$1,200,000
Number of Shares	750,000
Tax rate	40%

Calculation of EBIT and EPS

Sales	$160,000,000	$152,000,000
Variable Cost (1% of Sales)	1,600,000	1,520,000
Contribution	158,400,000	150,480,000
Fixed Cost	64,000,000	64,000,000
Earnings before interest and Tax (EBIT)	94,400,000	86,480,000
Interest	1,200,000	1,200,000
Earnings before tax (EBT)	93,200,000	85,280,000
Tax @40%	37,280,000	34,112,000
Earning After Tax	55,920,000	51,168,000
Number of Shares	750,000	750,000
Earning per share (EPS)	74.56	68.224

The percentage change in EBIT is- (86,480,000-94,400,000) / 94,400,000

= -7,920,000/ 94,400,000

= - 8.39%

The percentage change in EPS- (68.224-74.56) / 74.56

= -6.336/ 74.56

= -8.50%

The Degree of financial leverage at $ 152,000,000

DFL= % change in EPS / % change in EBIT

=-8.50% / -8.39%

=1.01

If the firms fixed capital cost remain constant across a range of EBIT values, The firm's DFL will vary across the range of EBIT values.

Based on the calculations, the statement is TRUE.

In the above case the fixed cost is same, DFL vary across the range of EBIT is 1.01.