Question

In: Finance

A project has fixed costs of $2,400 per year, depreciation charges of $300 a year, annual...

A project has fixed costs of $2,400 per year, depreciation charges of $300 a year, annual revenue of $21,600, and variable costs equal to two-thirds of revenues.

a. If sales increase by 19%, what will be the percentage increase in pretax profits?

b. What is the degree of operating leverage of this project?

Solutions

Expert Solution

Revenue $        21,600
Less: Variable cost (2/3 of revenue)

$    (14,400)

Contribution $          7,200
Less: Depreciation $           (300)
Less: Fixed Cost $        (2,400)
$          4,500

a. Sales increase by 19%; percentage increase in pretax profits?

Revenue (21600*1.19) $        25,704
Less: Variable cost (2/3 of revenue) $        17,136
Contribution $          8,568
Less Depreciation $           (300)
Less Fixed Cost $        (2,400)
$          5,868

Increase in pretax profit = (5868 - 4500) / 4500 = 1368 / 4500 = 0.304

Hence, Increase in pretax profit = 30.40%

b. Degree of operating leverage of project

Original structure Sales increase 19%
Revenue $                   21,600 $                      25,704
Less: Variable cost (2/3 of revenue) $                   14,400 $                      17,136
Contribution $                      7,200 $                        8,568
Less Fixed Cost $                   (2,400) $                      (2,400)
Net Operating income (NOI) $                      4,800 $                        6,168
Operating leverage Contribution / NOI =7200 / 4800 =8568 / 6168
1.50 1.39

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