Question

Sinclair Manufacturing and Boswell Brothers Inc. are both involved in the production of brick for the homebuilding industry. Their financial information is as follows:

	Sinclair			Boswell
Capital Structure
Debt @ 10%	$	1,740,000			0
Common stock, $10 per share		1,160,000		$	2,900,000
Total	$	2,900,000		$	2,900,000
Common shares		116,000			290,000
Operating Plan:
Sales (69,000 units at $15 each)	$	1,035,000		$	1,035,000
Variable costs		828,000			414,000
Fixed costs		0			319,000
Earnings before interest and taxes (EBIT)	$	207,000		$	302,000

The variable costs for Sinclair are $12 per unit compared to $6 per unit for Boswell.

a. If you combine Sinclair’s capital structure with Boswell’s operating plan, what is the degree of combined leverage? (Round your answer to 2 decimal places.)
  

b. If you combine Boswell’s capital structure with Sinclair’s operating plan, what is the degree of combined leverage? (Round your answer to the nearest whole number.)
  

c. In part b, if sales double, by what percentage will earnings per share (EPS) increase? (Round your answer to the nearest whole percent.)

Answer 1

First We have to have to understand what is Degree of Comine Leverage.

A degree of combined leverage (DCL) is a leverage ratio that summarizes the combined effect that the degree of operating leverage (DOL) and the degree of financial leverage have on earnings per share (EPS), given a particular change in sales.

Formula Deviation

Abbreviations

• EBIT means Earnings before interest and taxes.
• DOL is Degree of Operating Leverage
• DFL is Degree of Financial Leverage
• DCL is Degree of Combined Leverage

DCL = DOL * DFL

DOL = (EBIT + Fixed Cost) / EBIT

DFL = EBIT / (EBIT-Total Interest Expenses)

So DCL = (EBIT + Fixed Cost) / (EBIT - Total Interest Expenses)

The Income Structure under Each Part of Question will be as Under :-

Since the Tax Rate has not been mention in the question it is assumed that Tax Rate is of 25%. Other assumption could be simply ignored tax impact and give note that taxation aspect has been ignored in the absence of tax rate. But to understand the Tax impact too in computation I am assuming the Tax Rate of 25%.

(Amounts in $)

Particulars	Part A	Part B	Part C	Sinclair	Boswell
Capital Structure
Debt @ 10%	17,40,000	0	0	17,40,000	0
Common Stock @$10	11,60,000	29,00,000	29,00,000	11,60,000	29,00,000
Total	29,00,000	29,00,000	29,00,000	29,00,000	29,00,000
Common Shares	1,16,000	2,90,000	2,90,000	1,16,000	2,90,000
Operating Plan
Sales (@$15 each Unit)	10,35,000	10,35,000	20,70,000	10,35,000	10,35,000
Varible Cost	4,14,000	8,28,000	16,56,000	8,28,000	4,14,000
Fixed Cost	3,19,000	0	0	0	3,19,000
EBIT	3,02,000	2,07,000	4,14,000	2,07,000	3,02,000
Interest Expenses	1,74,000	0	0	1,74,000	0
Tax Saving on Interest Expenses (Int. * 25%)	43,500	0	0	43,500	0
Net Interest Expenses	1,30,500	0	0	1,30,500	0

Sub Part A

DCL = (EBIT + Fixed Cost) / (EBIT - Net Interest Expenses)

= ( 3,02,000 + 3,19,000) / (3,02,000 - 1,30,500)

= 3.61

So Answer to Sub Part A = 3.61

Sub Part B:-

DCL = (EBIT + Fixed Cost) / (EBIT - Net Interest Expenses)

= (2,07,000 + 0) / (2,07,000 - 0)

= 1

Since there is no Debt and Fixed Cost the Degree of Combine Leverage would always be 1.

So answer of sub part B is 1

Sub Part C :-

The EPS (Earning Per Share) Computation for Part B and Part C will be as under

Particulars	Part B	Part C
EBT (Since No Interest, EBIT = EBT)	2,07,000	4,14,000
Tax @ 25%	51,750	1,03,500
Profit After Tax (PAT)	1,55,250	3,10,500
No. of Shares	2,90,000	2,90,000
Earning Per Share (EPS)	0.535	1.07

Increase in EPS = 0.535 (1.07 - 0.535)

% Change in EPS = Change in EPS / Old EPS *100

= (0.535/0.535) *100

= 100%

Answer to Sub Part C is 100%.

Reason for 100% increase or why EPS increase in same % as increase in Sales :-

• Since there is No Fixed Cost the Increase in sales %, the EBIT would also Increase by same %.
• Since there is No Fixed Debt there increase in EBIT %, the EBT would also increase by same %.
• For Doubling sale no new capital or resources required hence the number of shares will remain the same. So the EPS would directly act in the same manner as the sales would do.

Notes :-

Whenever Interest will be cover for Levereage Ratio (Be it any) it would always be Net off Taxes (If it is Tax Deductable Interest Expense)

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