Question

If a firm has a Degree of Total Leverage (DTL) of 3.5, then a forecast of a 7% drop in Sales would mean a _____________.

Group of answer choices

3.5% decrease in Earnings Per Share (EPS)

24.5% decrease in Earnings Per Share (EPS)

7% decrease in Earnings Per Share (EPS)

24.5% decrease in Earnings Before Interest and Taxes (EBIT).

Answer 1

In order to calculate the above solution, we need to understand the meaning of Degree of Total leverage.

Degree of Total leverage is the measure of percentage change in Net income due to percentage change in the sales.

This means that higher the percentage change in the net income as compared to sales, higher will be the DTL

Also the percentage change in sales is directly related to DTL

Net Income is the income that is calculated after deducting all the interests and taxes applicable to be deducted from the income, which in other words will be the earnings left for the common stock holders.

As given in the above scenerio :

DTL = 3.5%

Drop in sales = 7%

As there is drop in sales, percentage change in sales will be - 7% .

By using the formula, the correct solution will be

DTL = Percentage change in the Net income / Percentage change in Sales

3.5 = Percentage change in net income / - 7 %

Percentage change in net income = 3.5 * -7% = 24.5% fall in net income

So, as the net income is amount available to be distributed to shareholders, it will denote EPS.

Hence there will be 24.5% fall in EPS. So the correct answer is option 2 that is "24.5% decrease in Earnings Per Share (EPS)" .

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