Question

Albatross Airlines’ fixed operating costs are $5.8 million, and its variable cost ratio is 0.20. The firm has $2 million in bonds outstanding with a coupon interest rate of 8 percent. Albatross has 300,000 shares of common stock outstanding. Revenues for the firm are $8 million, and the firm is in the 40 percent corporate income tax bracket. Compute the degree of operating leverage for the firm.

Using the information in the previous question, calculate the degree of financial leverage for Albatross Airlines.

Using the information in the two previous questions, calculate what Albatross’s EPS would be if the firm’s sales were to increase by 5%.

Hint: you first need to calculate the current EPS and then calculate the %change in EPS due to the 5% change in sales. Then, use the two to calculate the new EPS level.

Answer 1

Leverage means a given percentage change in one variable leads to more than proportionate change in other related variable. Three types of leverages are :

1) Operating leverage- It arises due to the presence of fixed operating cost. It is the use of fixed operating cost to to see the effect of change in sales on operating profit.

DOL= % change in operating profit / %change in sales

or

= (Sales - variable cost) / (sales -Variable cost - Fixed operating cost or EBIT)

Here, Sales/ Revenues = $8,000,000

                    Variable costs = 0.20 * ($8,000,000) = $1,600,000

                    Fixed costs = $5,800,000

                    EBIT = $8,000,000 - $5,800,000 - $1,600,000 = $600,000

                    DOL = ($8,000,000 - $1,600,000)/$600,000

                       = 10.67

2) Financial Leverage- It arises due to the presence of Fixed financial cost (interest). It implies that a given % change in EBIT results into a more than proportionate change in EPS of the company.

DFL = %change in EPS/ % change in EBIT

or

= EBIT / EBIT - Interest expense

Here, EBIT = $600,000

Interest expense = 8% * 2,000,000 = $160,000

DFL = $600,000 / ($600,000 - $160,000)

= $600,000 / $440,000

= 1.36

3) Combined Leverage- It is a measure of total risk of a company. It shows the change in sales revenue on EPS of company.

DCL = DOL * DFL

or

DCL = % change in EPS / % change in sales

Other way to calculate EPS is:

Particulars	Original sales	New sales (5%)
Sales	$8,000,000	$8,400,000
less: VC	.20	.20
Less: Fixed cost	$58,00,000	$58,00,000
EBIT	$600,000	$920,000
Less: Interest	$160,000	$160,000
EBT	$440,000	$760,000
Less: tax @40%	$176,000	$304,000
EAT	$264,000	$456,000
SHARES OUTSTANDING	300,000	300,000
EPS	=264,000 / 300,000= 0.89	456,000 / 300,000 =1.52

%Change in EPS = 1.52 - 0.89/ 0.89 = 0.63/ 0.89 = 0.707 or 70.78%