Question

In: Finance

?Firm R has sales of 99,000 units at $1.95 per? unit, variable operating costs of $1.71...

?Firm R has sales of 99,000 units at $1.95 per? unit, variable operating costs of $1.71 per? unit, and fixed operating costs of $6,080. Interest is $10,180 per year. Firm W has sales of 99,000 units at$2.59 per? unit, variable operating costs of $0.99 per? unit, and fixed operating costs of $62,800. Interest is $17,100 per year. Assume that both firms are in the 40%

tax bracket.??

a. Compute the degree of? operating, financial, and total leverage for firm R.

b. Compute the degree of? operating, financial, and total leverage for firm W.

c. Compare the relative risks of the two firms.

d. Discuss the principles of leverage that your answers illustrate.

Expert Solution

FIRM R

SALES = 99000*1.95 = 193050

VC = 99000*1.71 = 169290

CONTIBUTION = S- VC = 193050-169290 = 23760

F.O.C = 6080

EBIT = SALES - V.C - F.O.C = 193050-169290-6080 = 17680

I = 10180

EBIT-I = 17680-10180 = 7500

DEGREE OF OPERATING LEVERAGE = CONTRIBUTION/ EBIT = 23760/17680 = 1.344

DEGREE OF FINANCIAL LEVERAGE = EBIT/EBIT-I = 17680/7500 = 2.357

TOTAL LEVERAGE = O.L*F.L = 1.344*2.357 = 3.168

FIRM W

SALES = 99000*2.59 =256410

VC = 99000*0.99 = 98010

CONTIBUTION = S- VC = 256410 - 98010 = 158400

F.O.C = 62800

EBIT = SALES - V.C - F.O.C = 256410 - 98010 - 62800 = 95600

I = 17100

EBIT-I = 95600 - 17100 = 78500

DEGREE OF OPERATING LEVERAGE = CONTRIBUTION/ EBIT = 158400/95600 = 1.657

DEGREE OF FINANCIAL LEVERAGE = EBIT/EBIT-I = 95600/78500 = 1.218

TOTAL LEVERAGE = O.L*F.L = 1.657*1.218 = 2.018

a) FIRM Rs DEGREE OF OPERATING LEVERAGE 1.344

DEGREE OF FINANCIAL LEVERAGE 2.357

TOTAL LEVERAGE 3.168

b) FIRM Ws DEGREE OF OPERATING LEVERAGE 1.657

DEGREE OF FINANCIAL LEVERAGE 1.218

TOTAL LEVERAGE 2.018

c) FIRM R IS HAVING DOL LESSER THAN FIRM W. HERE FIRM R DEPENDS MORE ON VARIABLE COST FACTORS IN ITS OPERATIONS. SO FIRM R CANNOT TAKE MORE ADVANTAGE OF ITS FIXED COST FACTORS.

FIRM W IS HAVING DFL LESSER THAN FIRM R. HERE FIRM W DEPENDS MORE ON DEBTS. SO FIRM W HAS TO MAINTAIN ENOUGH PROFITABILITY AND LIQUID SOURCES TO PAY INTEREST.

OVERALL, FIRM W IS LAGGING BEHIND COMPARED TO FIRM R AS ITS TOTAL LEVERAGE IS LESSER THAN THAT OF FIRM R.

d) PRINCIPLES OF LEVERAGES

DEGREE OF OPERATING LEVERAGE DESCRIBES ABOUT OPERATIONAL EFFICIENCY TO ENHANCE OPERATING PROFITABILITY.

DEGREE OF FINANCIAL LEVERAGE DESCRIBES ABOUT TRADING ON EQUITY LEADING TO GET TAX BENEFITS ON ACCOUNT OF INTEREST PAID.

TOTAL LEVERAGE SHOWS OVERALL EFFICIENCY OF THE FIRM TO ENHANCE PROFITABILITY AND WEALTH OF SHAREHOLDERS.

jeff jeffy answered 2 years ago

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