Question

4. A review of the degree of operating leverage (DOL) It is December 31. Last year, Carter Chemical Co. had sales of $8,000,000, and it forecasts that next year’s sales will be $7,600,000. Its fixed costs have been and are expected to continue to be $4,400,000, and its variable cost ratio is 12.50%. Carter’s capital structure consists of a $13.5 million bank loan, on which it pays an interest rate of 9%, and 250,000 shares of common equity. The company’s profits are taxed at a marginal rate of 40%.

Given this data, complete the following sentences:

• The percentage change in the company’s sales is .

• The percentage change in Carter’s EBIT is .

• The degree of operating leverage (DOL) at $7,600,000 is .

There are several ways to use and interpret a firm’s DOL value. Consider the following statement and indicate whether it accurately reflects the meaning or an appropriate use of a firm’s DOL value. Assume that at a given sales level, a firm’s DOL is 2.5. This means that a 1% change in the firm’s sales will result in a corresponding 2.5% change in the firm’s EBIT. True or False: This statement accurately describes a firm’s DOL. True False

Answer 1

Given, Sales during last year= $8,000,000

Sales forecast for next year= $7,600,000

Increase in sales forecasted= $7,600,000-$8,000,000= -$400,000

Percentage change in sales= (-400,000/8,000,000)*100 = -5%

Fixed costs during last year= $4,400,000   (Expected to continue)

Variable costs Ratio is given at 12.5%.

Therefore, variable costs last year= $8,000,000 *12.5% = $1,000,000

Variable costs for next year= $7,600,000*12.5% = $950,000

EBIT= Sales-Fixed Costs-Variable costs

Fixed cost= $4,400,000

EBIT during last year= $8,000,000-$4,400,000-$1,000,000= $2,600,000

EBIT during next year= $7,600,000-$4,400,000-$950,000 = $2,250,000

Percentage change in EBIT= [($2,250,000-$2,600,000)/ $2,600,000]*100 =-13.4615%

Degree of Operating Leverage (DOL) = % Change in EBIT/ % Change in Sales

As ascertained above, % Change in EBIT = -13.4615%. % Change in sales= -5%

Therefore, DOL = -13.4615/-5 = 2.692

Degree of operating leverage (DOL) is a function of operating profit (EBIT) relative to sales. Hence the EBIT will change according to the change in sales. If DOL is 2.5, for a 1% change in sales, EBIT will change by 2.5%.

The statement given is True.