Question

In: Finance

20XW 20XX 20XY 20XZ change in EBIT 34 44 23 49 change in sales 25 40...

	20XW	20XX	20XY	20XZ
change in EBIT	34	44	23	49
change in sales	25	40	40	37
DOL	1.36	1.1	0.6	1.3

	Degree of Financial Leverage (DFL) = operating profit/EBT
	20XW	20XX	20XY	20XZ
operating profit	1810	2604	3201	4767
Earning/income before taxes (EBT)	1716	2402	2899	4333
DFL	1.05	1.08	1.10	1.10

DCL	1.43	1.19	0.63	1.46

Given is the companies DOL, DFL and DCL for 20XW, 20XX, 20XY and 20XZ Discuss the risks of the company.

Solutions

Expert Solution

Degree of operating leverage = Contribution/EBIT or change in EBIT/change in sales

= Contribution/(contribution-fixed Cost).

If the degree of operating leverage is high, the earnings before interest and taxes (EBIT) experiences volatility with respect to a percentage change in sales.

This means in the given question the percentage increase in sales from 20xw to 20xx is 32% i.e., let us assume the normal sale is 100 and the sale in 20xw is increased to 125 and the sale in 20xx is increased to 165.

The percentage change in sales from 20xw to 20xx is (165-125)/125*100 = 32%.

The DOL in 20xw is 1.36. This means that sales increased to 1% the operating profit Will be increased by 1.36%.

In our question, the percentage increase from 20xw to 20xx is increased to 32%.

This means the operating profit will be increased by 44%. I.e., (1.36*32)

ie., it is increased from 1810 to 2604.

This rule is applicable as long as there is no difference in fixed cost. When there is difference in fixed cost the % increase or decrease in operating profit differes.

The percentage increase of sales from 20xx to 20xy is 24% I.e., (205-165)/165*100.

The DOL in 20xx is 1.1.

This means the operating profit is increased by 26%. I.e., it is increased from 2604 to 3201.

similarly the percentage change from 20xy to 20xz is 18% I.e., (205-242)/205*100.

The DOL in 20xy is 0.6. This means the operating profit should increase by 10.8% i.e., 18*0.6

But actually the operating profit is increased by 48.92%. This is due to change in fixed cost in the year 20xz. In 20xz, the fixed costs may be reduced compared to the previous year.

Analysis of DFL:

Degree of financial leverage = Operating profit/EBT

=EBIT/(EBIT-Interest).

The degree of financial leverage (DFL) is a leverage ratio that measures the sensitivity of a company’s earnings per share to fluctuations in its operating income.

In the given question the DFL in 20xw is 1.05.

This means if operating profit increases by 1% the EPS will be increased by 1.05%, provided the interest cost remains same.

If there is increase in DFL from one year to another this may be due to increase in operating income or decrease in interest expense.

Analysis of DCL:

Degree of combined leverage= DOL*DFL or Change in EPS/Change in sales

Degree of combined leverage is the combined effect that the degree of operating leverage (DOL) and the degree of financial leverage have on earnings per share (EPS). In other way it is the combined leverage effect of fixed cost and interest expense.

For year, 20xw, DCL= 1.36*1.05= 1.43.

20xx, DCL= 1.1*1.08= 1.19

20xy, DCL = 0.6*1.1= 0.63

20xz, DCL= 1.3*1.1=1.46

In year 20xw the DCL is 1.43 this means where there is 1% change in sales the EPS changes by 1.43%, provided as long as the fixed cost and interest expense remains same.

If there is increase in DCL compared to the previous years, it is due to increase in sales or reduction fixed cost or interest expense.

jeff jeffy answered 9 months ago

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