Question

Given the following information, which of the following is most correct?

Historical Year Projected Year

Sales. 350,000. 420,000

EBIT 200,000 250,000

EBT 180,000 236,000

Net Income 117,000 153,400

EPS   1.19 1.56

A.Fixed cost and interest expense increasing proportionately with sales.

B. The degree of financial leverage is 1.325

C. The degree of operating leverage is 0.669

D. None of these choices are correct

E.The degree of operating leverage is 1.555

Answer 1

In order to check which of the options are correct, We need to calculate the Financial Leverage, Operating Leverage, change in interest rates and change in sales.

Let's start with Sales. Change in sales = [(New Sales - Old Sales)/ Old Sales] * 100

New Sales = $420,000 Old Sales = $350,000

Percentage change in sales = [($420,000 - $350,000) / $350,000 ] *100

Percentage change in sales =( 70,000 / 350,000) * 100 = 20%

In the same way, we can calculate the percentage change in EBIT = [New EBIT - Old EBIT)/ Old EBIT]*100

Percentage change in EBIT = [ ($250,000 - $200,000)/ $200,000] * 100

Percentage change in EBIT = (50,000/ 200,000)*100 = 25%

Percentage change in Net Income = [(New Income - Old income)/ Old Income] * 100

Percentage change in Net Income = [(153,400 - 117,000)/ 117,000] * 100

Percentage change in Net Income = (36400/ 117,000) * 100 = 31.11%

Also, lets calculate the interest income for the Historical & Projected Year.

Interest for Historical Year = EBIT - EBT = 200,000 - 180,000 = 20,000

Interest for Projected Year = EBIT - EBT = 250,000 - 236,000 = 14,000

Change in interest rate = 14,000 - 20,000)/20,000]* 100 = -42.86%

Now, lets discuss the options one by one.

A. The change in interest rate is -42.86% while the change in sales is 25% .

Hence, this option is not correct.

B. Degree of Financial Leverage = Change in Net Income / Change in EBIT = 31.11 / 25 = 1.244

But, in the option it is 1.325. Hence, not correct.

C. Degree of Operating Leverage = Change in EBIT / Change in Sales = 25 / 20 = 1.25

But, in the option it is 0.669. Hence, not correct.

E. As already calculated above, Degree of Operating Leverage = 1.25. Hence this option is not correct.

D. This is the answer (since all other options are incorrect).