Question

In 2011, Amigone Funeral Home has net income of $182,000, income tax of $80,000, and interest expense of $31,000.

Required:

a.	Compute the degree of financial leverage.
b.	In 2012, if earnings before interest and tax increase by 10%, what should be the change in net income?
c.	In 2012, if earnings before interest and tax decline by 50%, what should be the change in net income?

Answer 1

(a) Formula for degree of financial leverage is:

Financial leverage = EBIT / EBIT - interest

where EBIT = Net income + Income tax + Interest

So, EBIT = $182000 + $80000 + $31000 = $293000

Now, putting the given values in the above degree of financial leverage formula, we get,

Degree of financial leverage = $293000 / ($293000 - $31000)

Degree of financial leverage = $293000 / $262000 = 1.12

(b) According to degree of financial leverage,

Degree of financial leverage = % Change in net income / % Change in EBIT

Putting the values in the above formula, we get,

1.12 = % Change in net income / 10%

% Change in net income = 1.12 * 10% = 11.18%

So, net income will be increased by 11.18%

(c) According to degree of financial leverage,

Degree of financial leverage = % Change in net income / % Change in EBIT

Putting the values in the above formula, we get,

1.12 = % Change in net income / -50%

% Change in net income = 1.12 * (-50%) = -56%

So, net income will be decreased by 56%