Question

A review of the degree of total leverage

You and your colleague, Emily, are currently participating in a finance internship program at Carter Chemical Company. Your current assignment is to work together to review Carter’s current and projected income statements. You will also assess the consequences of management’s capital structure and investment decisions on the firm’s future riskiness. After much discussion, you and Emily decide to calculate Carter’s degree of operating leverage (DOL), degree of financial leverage (DFL), and degree of total leverage (DTL) based on this year’s data to gain insights into Carter’s risk levels.

The most recent income statement for Carter Chemical Company follows. Carter is funded solely with debt capital and common equity, and it has 2,000,000 shares of common stock currently outstanding.

	This Year’s Data	Next Year’s Projected Data
Sales	$80,000,000	$86,000,000
Less: Variable costs	32,000,000	34,400,000
Gross profit	48,000,000	51,600,000
Less: Fixed operating costs	28,000,000	28,000,000
Net operating income (EBIT)	20,000,000	23,600,000
Less: Interest expense	4,000,000	4,000,000
Taxable income (EBT)	16,000,000	19,600,000
Less: Tax expense (40%)	6,400,000	7,840,000
Net income	$9,600,000	$11,760,000
Earnings per share (EPS)	$4.80	$5.88

Given this information, complete the following table and then answer the questions that follow. When performing your calculations, round your EPS and percentage change values to two decimal places.

Carter Chemical Company Data
DOL (Sales = $80,000,000) ____ a. 18.00 b. 2.40 c. 1.20
DFL (EBIT = $20,000,000) ____ a. 1.20 b. 18.00 c. 1.25
DTL (Sales = $80,000,000) a. 1.20 b. 3.00 c. 18.00

Everything else remaining constant, assume Carter Chemical Company decides to convert its labor-intensive manufacturing facility into a capital-intensive facility by laying off over 75% of its labor force and replacing the workers with robotic and technologically advanced manufacturing equipment. Assume that, over the next five years, the wages saved as a result of the layoffs will pay for the changes made to Carter’s plant and equipment changes. How would this affect Carter’s DOL, DFL, and DCL?

•	The DOL would be expected to _____ . a. increase b. remain unchanged c. decrease
•	The DFL would be expected to _____ . a. increase b. remain unchanged c. decrease
•	The DTL would be expected to _____ . a. increase b. remain unchanged c. decrease

Answer 1

- Degree of Operating Leverage(DOL) = Contribution/EBIT

Contribution = Gross Profit

DOL = $48,000,000/$20,000,000

DOL = 2.4 times

Option B

- Degree of Financial Leverage(DFL) = EBIT/EBT

DFL = $20,000,000/16,000,000

DFL = 1.25 times

Option C

- Degree of Combined Leverage(DCL) = Contribution/EBT

DCL = $48,000,000/$16,000,000

DCL = 3 times

Option B

DCL can also be calculated by = DOL*DFL

ii). As the 75% of the wages will be replaced by Manufacturing equipment and for the next 5 years the reduction in wages will be used to pay for the changes in Equipment.

Thus, we can say that Wages will be reduced which will increase Contribution or Gross Profit.

But since, the amount of reduction in wages and increase in operating Expenses will be same there will be no impact on EBIT, i.e., EBIT will be same.

- DOL would be Expected to Increase

As Contribution will increase but EBIT will be same. Increase in Nominator will increase DOL.

- DFL will be expected to Remain Unchanged

As, EBIT and EBT will be thw same.

- DCL would be Expected to Increase

As Contribution will increase but EBT will be same. Increase in Nominator will increase DCL.

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