Question

1. Consider the following information regarding Pink Tartan Inc.

Number of units produced                 1,000,000

Total fixed cost                                    $250,000

Per unit variable cost                          $0.32

Interest on outstanding debt              $400,000

Per unit selling price                           $3.80

1. Calculate the DOL, DFL, and DCL for Pink Tartan Inc. (4)
2. If the firm would like to double their EBIT, what percentage increase in sales would be needed? (3)
3. Pink Tartan Inc. has 1,000,000 shares outstanding currently selling in the market for $10. The firm is evaluating a new project that would require an initial investment of $2,400,000.

To raise the additional $2,400,000, the firm is considering two alternatives: (6)

1. Debt: sell $2,400,000 worth of bonds that would carry a 14% coupon rate.
2. Equity: sell $2,400,000 worth of new shares that would net the firm $16 per share.

What level of EBIT would yield the same EPS for the above alternatives? What EPS corresponds to this level of EBIT?

Answer 1

(a)	Calculating DOL, DFL & DCL:
	Degree of Operating Leverage(DOL)	=[No of unit(Selling price per unit-variable cost per unit)] /{[No of unit(Selling price per unit-variable cost per unit)]-Fixed Cost}
		DOL measures how sensitive a company’s operating income is to changes in no of units sold.
	DOL	(1000000*(3.8-0.32))/((1000000*(3.8-0.32))-250000)
	DOL	1.08
	DOL can also be calculated bt	=% change in operating income/% change in units sold
	Degree of Financial Leverage (DFL)	={[No of unit(Selling price per unit-variable cost per unit)]-Fixed Cost}/{[No of unit(Selling price per unit-variable cost per unit)]-Fixed Cost-Interest Cost}
		DFL refers to the sensitivity of the cash flows available to the owners of a company to change in operating income.
		((1000000*(3.8-0.32))-250000)/((1000000*(3.8-0.32))-250000-400000)
	DFL	1.14
		DOL measures how sensitive a company’s net income to changes in number of units sold.
	Degree of Combined Leverage (DCL)	=DFL*DOL
	DCL	1.229681979
(b)	EBIT	=No of units sold*(Selling price-Variable price)-fixed cost
	EBIT	32,30,000.00
	Expected EBIT (Double)	64,60,000.00
	EBIT+Fixed Cost	67,10,000.00
	No of unit sold	=(EBIT+Fixed cost)/(Selling price-Variable Cost)
	No of unit sold	19,28,160.92
	Percentage increase in unit Sold	93%
Alternatively	Percentage increase in unit Sold	92.82	=% Change in EBIT/DOL
©	EBIT	32,30,000.00
	EPS now	2.83
Alternative 1	EBIT should be more by interest on new bonds to yield same EPS
	EBIT	35,66,000.00
	EPS in this case	2.83
Alternative 2	No of shares issued	1,50,000.00
	EPS required	2.83
	EBIT Should be (EPS*No of shares)	32,54,500.00