Question

DeSoto Tools Inc. is planning to expand production. The expansion will cost $2,900,000, which can be financed either by bonds at an interest rate of 6 percent or by selling 58,000 shares of common stock at $50 per share. The current income statement before expansion is as follows:

DESOTO TOOLS INC. Income Statement 20X1
Sales	$	3,090,000
Variable costs		927,000
Fixed costs		809,000
Earnings before interest and taxes	$	1,354,000
Interest expense		490,000
Earnings before taxes	$	864,000
Taxes @ 40%		345,600
Earnings after taxes	$	518,400
Shares		190,000
Earnings per share	$	2.73

     

After the expansion, sales are expected to increase by $1,590,000. Variable costs will remain at 40 percent of sales, and fixed costs will increase to $1,368,000. The tax rate is 40 percent.

a. Calculate the degree of operating leverage, the degree of financial leverage, and the degree of combined leverage before expansion. (For the degree of operating leverage, use the formula: DOL = (S − TVC) / (S − TVC − FC). For the degree of combined leverage, use the formula: DCL = (S − TVC) / (S − TVC − FC − I). These instructions apply throughout this problem.) (Round your answers to 2 decimal places.)
  

b. Construct the income statement for the two alternative financing plans. (Round EPS to 2 decimal places.)
  

c. Calculate the degree of operating leverage, the degree of financial leverage, and the degree of combined leverage, after expansion. (Round your answers to 2 decimal places.)
  

Answer 1

Answer a.

A	Sales	3090000
B	Variable Costs	927000
C	Contribution	2163000
D	Fixed Cost	809000
E	Earnings Before Interest and taxes	1354000
F	Interest Expesne	490000
G	Earnings before taxes	864000
H	Taxes @ 40%	345600
I	Earnings after taxes	518400
J	Shares	190000
K	EPS	2.73
L=C/E	Degree of operating leverage	1.60
M = C/G	Degree of combined leverage	2.50
N=M/L	Degree of financials leverage	1.57

Answer b and c.

Income statement when financed by bonds

Sales	4680000
Variable Costs	1872000
Contribution	2808000
Fixed Cost	1368000
Earnings Before Interest and taxes	1440000
Interest Expesne	664000
Earnings before taxes	776000
Taxes @ 40%	310400
Earnings after taxes	465600
Shares	190000
EPS	2.45
Degree of operating leverage	1.95
Degree of combined leverage	3.62
Degree of financials leverage	1.86

Income statement when financed by shares

Sales	4680000
Variable Costs	1872000
Contribution	2808000
Fixed Cost	1368000
Earnings Before Interest and taxes	1440000
Interest Expesne	490000
Earnings before taxes	950000
Taxes @ 40%	380000
Earnings after taxes	570000
Shares	248000
EPS	2.30
Degree of operating leverage	1.95
Degree of combined leverage	2.96
Degree of financials leverage	1.52