Question

P13–16Integrative: 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.

1. Compute the degree of operating, financial, and total leverage for firm R.

2. Compute the degree of operating, financial, and total leverage for firm W.

3. Compare the relative risks of the two firms.

4. Discuss the principles of leverage that your answers illustrate.

Answer 1

Answer :  

(a.) Calculation of operating, financial, and total leverage for firm R

Operating Leverage = Contribution / Earning Before interest and Taxes

= [ Number of Units * ( Selling Price per unit - Variable Cost) ] / { [ Number of Units * ( Selling Price per unit - Variable Cost) ] - Fixed Cost }

= [100,000 * (2 - 1.70) ] / {[100,000 * (2 - 1.70)] - 6000}

= 30000 / 24000

= 1.25

Financial Leverage = Earning Before interest and Taxes /  (Earning Before interest and Taxes - Interest)

= {[100,000 * (2 - 1.70)] - 6000} / {[100,000 * (2 - 1.70)] - 6000 - 10,000}

= 24,000 / 14,000

= 1.71

Total Leverage = Operating Leverage * Financial Leverage

= 1.25 * 1.71

= 2.14

(b.) Calculation of operating, financial, and total leverage for firm W

Operating Leverage = Contribution / Earning Before interest and Taxes

= [ Number of Units * ( Selling Price per unit - Variable Cost) ] / { [ Number of Units * ( Selling Price per unit - Variable Cost) ] - Fixed Cost }

= [100,000 * (2.50 - 1.00) ] / {[100,000 * (2.50 - 1.00)] - 62500}

= 150000 / 87500

= 1.71

Financial Leverage = Earning Before interest and Taxes /  (Earning Before interest and Taxes - Interest)

= {[100,000 * (2.50 - 1.00)] - 62500} / {[100,000 * (2.50 - 1.00)] - 62500 - 17500}

= 87,500 / 70000

= 1.25

Total Leverage = Operating Leverage * Financial Leverage

= 1.71 * 1.25

= 2.14

(c.) We can see from the above computtion that Firm R has less operating leverge than Firm W means that firm has less opearting risk than Firm W but on the other hand Firm R has more financial Leverage than Firm W which means that Firm R has more financial risk than Firm W

(d.) There may be difference in operating and financial leverage of two firms but may have the same total leverage  as total leverage is product of operating leverage and financial leverage . Therefore even though the structure of two firms can be different but they may still manage to have total risk same.