Chapter 2: 21BP_c (page 150)

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.

Expert verified

	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

	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

	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

	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

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Sales	1,360,000
Shares outstanding	104,000
Cost of goods sold	700,000
Interest expenses	34,000
Selling and administration expenses	49,000
Depreciation expenses	23,000
Preferred stock dividend	86,000
Taxes	100,000

Current assets		Liabilities
Cash	\(15,000	Accounts payable	\)17,000
Accounts receivable	20,000	Notes payable	25,000
Inventory	30,000	Bonds payable	55,000
Prepaid expenses	12,500

Fixed assets		Stockholder’s equity
Plant and equipment (gross) Less: accumulated depreciation	\(255,000 51,000	Preferred stock	\)25,000
Net plant and equipment	\(204,000	Common stock	60,000
		Paid in capital	30,000
		Retained earnings	69,500
Total assets	\)281,500	Total liabilities and stockholder’s equity	\(281,500

Sales	$900,000
Shares outstanding	50,000
Cost of goods sold	400,000
Interest expenses	40,000
Selling and administration expenses	60,000
Depreciation expenses	20,000
Preferred stock dividend	80,000
Taxes	50,000

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