Question

You and your colleague, Ashley, are currently participating in a finance internship program at Torres Industries. Your current assignment is to work together to review Torres’s current and projected income statements. You will also assess the consequences of management’s capital structure and investment decisions on the firm’s future riskiness. After much discussion, you and Ashley decide to calculate Torres’s degree of operating leverage (DOL), degree of financial leverage (DFL), and degree of total leverage (DTL) based on this year’s data to gain insights into Torres’s risk levels.

The most recent income statement for Torres Industries follows. Torres is funded solely with debt capital and common equity, and it has 3,000,000 shares of common stock currently outstanding.

	This Year’s Data	Next Year’s Projected Data
Sales	$40,000,000	$43,200,000
Less: Variable costs	20,000,000	21,600,000
Gross profit	20,000,000	21,600,000
Less: Fixed operating costs	8,000,000	8,000,000
Net operating income (EBIT)	12,000,000	13,600,000
Less: Interest expense	800,000	800,000
Taxable income (EBT)	11,200,000	12,800,000
Less: Tax expense (40%)	4,480,000	5,120,000
Net income	$6,720,000	7,680,000
Earnings per share (EPS)	$2.24	$2.56

Given this information, complete the following table and then answer the questions that follow. When performing your computations, round your EPS value and the percentage change values to two decimal places.

Torres Industries Data
DOL (Sales = $40,000,000)	1. A. 1.79 B. 13.33 C.1.67 ?
DFL (EBIT = $12,000,000)	2. A 13.33 B. 1.79 C. 1.07 ?
DTL (Sales = $40,000,000)	3. A. 1.67 B. 13.33 C 1.79 ?

  

Everything else remaining constant, assume Torres Industries decides to immediately repay 50% of a bank loan prior to its maturity. How would this affect Torres’s DOL, DFL, and DCL?

•	The DOL would be expected to 4. A. Remain Constant B.Decrease C.Increase .
•	The DFL would be expected to 5..A. Remain Constant B.Decrease C.Increase
•	The DTL would be expected to 6. A. Remain Constant B.Decrease C.Increase .

Answer 1

* )

Degree of operating leverage ( DOL ) = Percentage change in EBIT / Percentage change in sales

= Contribution / EBIT

Contribution = Sales - Variable costs = $ 40000000 - $ 20000000 = $ 20000000

EBIT = Contribution - Fixed costs = $ 20000000 - $ 8000000 = $ 12000000

DOL = $ 20000000 / $ 12000000 = 1.67

Answer : C ) 1.67

* )

Degree of financial leverage ( DFL ) = Percentage change in EBT / Percentage change in EBIT

= EBIT / EBT

EBT = EBIT - Interest expense = $ 12000000 - $ 800000 = $ 11200000

DFL = $ 12000000 / $ 11200000 = 1.07

Answer : C ) 1.07

* )

Degree of total leverage ( DOL ) = DOL * DFL = Contribution / EBT

= 1.67 * 1.07 = 1.79 or

= $ 20000000 / $ 11200000 = 1.79

Answer : C ) 1.79

# ) Torres Industries decides to immediately repay 50% of a bank loan prior to its maturity ;

* The DOL would expected to A )  Remain constant . The DOL is computed by measuring percentage change in Sales and EBIT or dividing contribution by EBIT. Repayment of bank loan doesn't affect Sales and EBIT. So DOL would remain constant.

* The DFL would expected to B ) Decrease. The DFL is computed by measuring percentage change in EBIT and EBT or dividing EBIT by EBT. When 50% bank loan repaid , the interest relating to the loan will decrease, then EBT will increase. Because of denominator decreasing DFL will increase.

* The DTL would expected to B ) Decrease. The DTL is computed by multiplying DOL and DFL or dividing contribution by EBT. When 50% bank loan repaid , the interest relating to the loan will decrease, then EBT will increase.Because of denominator decreasing DTL will increase. DOL will remain constant and DFL will decrease . So when multiplying these two ratios the product also will decreased.