Question

In: Finance

Consider a firm that has fixed costs of 8M. Its sales are 30M and the variable...

Consider a firm that has fixed costs of 8M. Its sales are 30M and the variable costs are 50% of sales. The firm uses both debt and equity and has an interest expense of 1M. There are no taxes.

Determine the firm’s operating leverage and financial leverage.
Assume that the sales increase by 10%. By how much percentage points will the firm’s EBIT increase?
What would be the resulting increase in Net Income?

Expert Solution

First we will calculate the Earnings before taxes or net income with the given values.

Sales = 30M

Variable costs = 50% * 30M = 15M

Contribution = Sales - Variable cost = 30M - 15M = 15M

Fixed costs = 8M

Earnings before interest and taxes (EBIT) = Contribution - Fixed cost

EBIT = 15M - 8M = 7M

Interest expense = 1M

Earnings before taxes (EBT) or net income = EBIT - Interest expense

EBT = 7M - 1M = 6M

Now, we will calculate the required values with the calculated figures above, as per below:

(a) Operating leverage = Contribution / EBIT

Contribution = 15M , EBIT = 7M

Operating leverage = 15M / 7M = 2.14

Financial leverage = EBIT / EBT

EBIT = 7M, EBT = 6M

Financial leverage = 7M / 6M = 1.167

(b) Operating leverage tells the percentage change in EBIT as a result of percentage change in sales

Degree of operating leverage = % change in EBIT / % Change in sales

We have degree of operating leverage of 2.14 (as calculated in point (a) above)

2.14 = % change in EBIT / 10%

% change in EBIT = 10% * 2.14 = 21.4%

(c) Current EBIT = 7M

New EBIT = 21.4% increase = 7M * 121.4% = 8.498M

New EBT or net income = New EBIT - interest expense

New EBT or net income = 8.498M - 1M = 7.498M

Increase in net income = New net income - Old net income

Old net income = 6M (as calculated in the beginning), New net income = 7.498M

Increase in net income = 7.498M - 6M = 1.498M

jeff jeffy answered 1 year ago

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