Question

In: Finance

You have developed the following analytical profit and loss statement for your company. It represents the...

You have developed the following analytical profit and loss statement for your company. It represents the most recent year’s operations, which ended yesterday.

Sales	$45,750,000
Variable costs	22,800,000
Revenue before fixed costs	$		22,950,000
Fixed costs	9,200,000
Earnings before interest and taxes (EBIT)				13,750,000
Interest expense	1,350,000
Earnings before taxes	$	12,400,000
Taxes (50%)		6,200,000
Net income	$ 6,200,000

Required

Your supervisor in the controller’s office has just handed you a memo asking for written responses to the following questions:

a At this level of output, what is the degree of operating leverage (DOL)?

b What is the degree of financial leverage (DFL)?

c What is the degree of combined leverage (DTL)?

What is the firm’s break-even point if it sold 915,000 units in the most recent year’s operations.

If sales increase by 25%, by what percentage would the following increase by (i) Earnings before interest and taxes and (ii) Net income?

Solutions

Expert Solution

a. Contribution margin = Revenue before fixed costs = $22950000

Earnings before interest and tax = EBIT = 13750000

Degree of operating leverage at this output = Contribution margin / EBIT = 22950000 / 13750000 = 1.6690

b. Earnings before taxes = EBT = EBIT - interest = 12400000,

Earnings before interest and tax = EBIT = 13750000

Degree of financial leverage = EBIT / EBT = 13750000 / 12400000 = 1.1088

c. Degree of operating leverage = 1.6690 and Degree of financial leverage = 1.1088

Degree of total leverage = Degree of operating leverage x degree of financial leverage = 1.6690 x 1.1088 = 1.8505

d. No of units sold = 915000 , Contribution margin = 22950000

Contribution margin per unit = Contribution margin / No of units sold = 22950000 / 915000 = 25.0819 = 25.08

Let Q = Breakeven Units

Then Q = Breakeven point units = (Fixed cost + interest expense) / (Contribution margin per unit) = (9200000 + 1350000) / 25.08 = 10550000 / 25.08 = 420653.90 = 420654 (rounding to next whole number)

Hence breakeven point units = 420654 units

e. i) Percentage Increase in sales = 25%

We know that

Degree of operating leverage = Percentage change in EBIT / Percentage change in sales

1.6690 = Percentage change in EBIT / 25%

Percentage change in EBIT = 25% x 1.6690 = 41.725%

Hence earnings before interest and tax will increase by 41.725%

ii) Percentage Increase in sales = 25%

We know that

Degree of Total leverage = Percentage change in net income / Percentage change in sales

1.8505 = Percentage change in net income / 25%

Percentage change in net income = 25% x 1.8505 = 46.2625%

Hence Net income will increase by 46.2625%

jeff jeffy answered 1 year ago

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