Question

Show all your work (use of formula, etc.) in solving the problems. You still need to show your work even if you use the financial calculator to get the answers. Please do not use excel.

2. At an output level of 2,000 units, you calculate that the degree of operating leverage is 3. Fixed costs are $35,000.

(a) If output rises to 2,500 units, calculate the percentage change in OCF, new OCF and new DOL.

(b) If output falls to 1,500 units, calculate the percentage change in OCF, new OCF and new DOL. (hint: start by finding the OCF at 2,000 units using DOL equation of 1+ FC/OCF)

Answer 1

Output Level = 2,000 units
Degree of Operating Leverage = 3
Fixed Costs = $35,000

Degree of Operating Leverage = 1 + Fixed Costs / Operating Cash Flows
3 = 1 + $35,000 / Operating Cash Flows
2 = $35,000 / Operating Cash Flows
Operating Cash Flows = $17,500

Answer a.

% Change in Output Level = (2,500 - 2,000) / 2,000
% Change in Output Level = 0.25

Degree of Operating Leverage = % Change in Operating Cash Flows / % Change in Output Level
3 = % Change in Operating Cash Flows / 0.25
% Change in Operating Cash Flows = 0.75

New Operating Cash Flows = Old Operating Cash Flows * (1 + % Change in Operating Cash Flows)
New Operating Cash Flows = $17,500 * 1.75
New Operating Cash Flows = $30,625

New Degree of Operating Leverage = 1 + Fixed Costs / New Operating Cash Flows
New Degree of Operating Leverage = 1 + $35,000 / $30,625
New Degree of Operating Leverage = 2.14

Answer b.

% Change in Output Level = (1,500 - 2,000) / 2,000
% Change in Output Level = -0.25

Degree of Operating Leverage = % Change in Operating Cash Flows / % Change in Output Level
3 = % Change in Operating Cash Flows / -0.25
% Change in Operating Cash Flows = -0.75

New Operating Cash Flows = Old Operating Cash Flows * (1 + % Change in Operating Cash Flows)
New Operating Cash Flows = $17,500 * 0.25
New Operating Cash Flows = $4,375

New Degree of Operating Leverage = 1 + Fixed Costs / New Operating Cash Flows
New Degree of Operating Leverage = 1 + $35,000 / $4,375
New Degree of Operating Leverage = 9.00