Question

DeSoto Tools Inc. is planning to expand production. The expansion will cost \(300,000, which can be financed either by bonds at an interest rate of 14 percent or by selling 10,000 shares of common stock at \)30 per share. The current income statement before expansion is as follows:

DeSOTO TOOLS, INC.
Sales		\(1,500,000
Less: Variable cost	\)450,000
Fixed cost	550,000	1,000,000
Earning before interest and taxes		\(500,000
Less: Interest expenses		100,000
Earning before taxes		\)400,000
Less: Taxes @34%		136,000
Earning after taxes		\(264,000
Shares		100,000
Earning per shares		\)2.64

After the expansion, sales are expected to increase by \(1,000,000. Variable costs will remain at 30 percent of sales, and fixed costs will increase to \)800,000. The tax rate is 34 percent.

c. Calculate the degree of operating leverage, the degree of financial leverage, and the degree of combined leverage, after expansion.

Short answer

	Alternative 1	Alternative 2
Degree of operating leverage	4.375	4.375
Degree of financial leverage	1.55	1.33
Degree of combined leverage	6.78	5.83

Step-by-step solution

Degree of operating leverage after expansion

	Alternative 1	Alternative 2
Sales (1,500,000+1,000,000)	$2,500,000	$2,500,000
Less: Variable cost (30% of sales)	750,000	750,000
Contribution	1,750,000	1,750,000
Less: Fixed cost (550,000+800,000)	1,350,000	1,350,000
Earning before interest and taxes (EBIT)	$400,000	$400,000
Degree of operating leverage (Contribution/EBIT)	4.375	4.375

Degree of Finacial leverage after expansion  

	Alternative 1	Alternative 2
Sales (1,500,000+1,000,000)	$2,500,000	$2,500,000
Less: Variable cost (30% of sales)	750,000	750,000
Contribution	1,750,000	1,750,000
Less: Fixed cost (550,000+800,000)	1,350,000	1,350,000
Earning before interest and taxes (EBIT)	$400,000	$400,000
Less: Interest	142,000 (100,000+(300,000 x 14%)	100,000
EBT	258,000	300,000
Degree of financial leverage (EBIT/EBT)	1.55	1.33

Degree of Combined leverage after expansion

	Alternative 1	Alternative 2
Sales (1,500,000+1,000,000)	$2,500,000	$2,500,000
Less: Variable cost (30% of sales)	750,000	750,000
Contribution	1,750,000	1,750,000
Less: Fixed cost (550,000+800,000)	1,350,000	1,350,000
Earning before interest and taxes (EBIT)	$400,000	$400,000
Less: Interest	142,000 (100,000+(300,000 x 14%)	100,000
EBT	258,000	300,000
Degree of financial leverage (Contribution/EBT)	6.78	5.83