Question

DeSoto Tools Inc. is planning to expand production. The expansion will cost $3,800,000, which can be financed either by bonds at an interest rate of 5 percent or by selling 76,000 shares of common stock at $50 per share. The current income statement before expansion is as follows:

DESOTO TOOLS INC. Income Statement 20X1
Sales	$	3,180,000
Variable costs		1,272,000
Fixed costs		818,000
Earnings before interest and taxes	$	1,090,000
Interest expense		580,000
Earnings before taxes	$	510,000
Taxes @ 40%		204,000
Earnings after taxes	$	306,000
Shares		280,000
Earnings per share	$	1.09

     

After the expansion, sales are expected to increase by $1,680,000. Variable costs will remain at 40 percent of sales, and fixed costs will increase to $1,386,000. The tax rate is 40 percent.

a. Calculate the degree of operating leverage, the degree of financial leverage, and the degree of combined leverage before expansion. (For the degree of operating leverage, use the formula: DOL = (S − TVC) / (S − TVC − FC). For the degree of combined leverage, use the formula: DCL = (S − TVC) / (S − TVC − FC − I). These instructions apply throughout this problem.) (Round your answers to 2 decimal places.)
  

b. Construct the income statement for the two alternative financing plans. (Round EPS to 2 decimal places.)
  

c. Calculate the degree of operating leverage, the degree of financial leverage, and the degree of combined leverage, after expansion. (Round your answers to 2 decimal places.)
  

Answer 1

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