Question

P13-16. Integrative—Leverage and risk Firm R has sales of 100,000

units at $2.00 per unit, variable operating costs of $1.70 per unit, and fixed operating costs of $6,000. Interest is $10,000 per year. Firm W has sales of 100,000 units at $2.50 per unit, variable operating costs of $1.00 per unit, and fixed operating costs of $62,500. Interest is $17,500 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.

Answer 1

Ans.

a)

Degree of Operating Leverage = Quantity * ( Selling Price - Variable Cost per unit) /  Quantity * ( Selling Price - Variable Cost per unit) - Fixed Operating Cost

Degree of Financial Leverage = EBIT / EBIT - Interest

Degree of Total Leverage = Degree of Operating Leverage * Degree of Financial Leverage

DOL_R = [(2 – 1.70)100,000] / [(2 – 1.70)100,000 – 6,000] = 30,000/24,000 = 1.25

DFL_R = 24000 / [24000 – 10000] = 1.71

DTL_R = 1.25 * 1.71 = 2.14

b)

DOL_W = [(2.50 – 1)100,000] / [(2.50 – 1)100,000 – 62,500] = 150,000/ 87,500 =1.71

DFL_W = 87,500 / (87,500 – 17,500) = 1.25

DTL_W = 1.71 * 1.25 = 2.14

c)

Firm R has less operating (business) risk but its financial risk is more than Firm W.

d)

Two firms with different operating and financial structure may be equally leveraged.

As total leverage is the product of operating and financial leverage, each firm may structure itself differently and still have the same amount of total leverage.