Question

Delsing Canning Company is considering an expansion of its facilities. Its Current income statement is as follows:

Sales	\(5,500,000
Less: variable expenses (50% of sales)	2,750,000
Fixed expenses	1,850,000
Earnings before interest and taxes (EBIT)	\)900,000
Interest (10% cost)	300,000
Earning before taxes (EBT)	\(600,000
Tax @40%	240,000
Earning after tax (EAT)	\)360,000
Share of common stock-250,000
Earning per share	\(1.44

The company is currently financed with 50 percent debt and 50 percent equity (common stock, par value of \)10). In order to expand the facilities, Mr. Delsing estimates a need for \(2.5 million in additional financing. His investment banker has laid out three plans for him to consider:

1. Sell \)2.5 million of debt at 13 percent.

2. Sell \(2.5 million of common stock at \)20 per share.

3. Sell \(1.25 million of debt at 12 percent and \)1.25 million of common stock at \(25 per share.

Variable costs are expected to stay at 50 percent of sales, while fixed expenses will increase to \)2,350,000 per year. Delsing is not sure how much this expansion will add to sales, but he estimates that sales will rise by \(1.25 million per

year for the next five years.

Delsing is interested in a thorough analysis of his expansion plans and methods

of financing. He would like you to analyze the following:

b. The degree of operating leverage before and after expansion. Assume sales

of \)5.5 million before expansion and $6.5 million after expansion. Use the

formula in footnote 2 of the chapter.

Short answer

The degree of operating leverage, before expansion at sales of $5,500,000 is 3.05 and after expansion at sales $6,500,000 is 3.61

Step-by-step solution

Degree of operating leverage, before expansion, at sales of $5,500,000

$$\begin{gathered} \mathbf{DOL}\mathbf{=}\frac{\mathbf{Sales}\mathbf{-}\mathbf{Variablecost}}{\mathbf{Sales}\mathbf{-}\mathbf{Variablecost}\mathbf{-}\mathbf{Fixedcost}} \\ \mathbf{=}\frac{\mathbf{\$}\mathbf{5}\mathbf{,}\mathbf{500}\mathbf{,}\mathbf{000}\mathbf{-}\mathbf{\$}\mathbf{2}\mathbf{,}\mathbf{750}\mathbf{,}\mathbf{000}}{\mathbf{\$}\mathbf{5}\mathbf{,}\mathbf{500}\mathbf{,}\mathbf{000}\mathbf{-}\mathbf{\$}\mathbf{2}\mathbf{,}\mathbf{750}\mathbf{,}\mathbf{000}\mathbf{-}\mathbf{\$}\mathbf{1}\mathbf{,}\mathbf{850}\mathbf{,}\mathbf{000}} \\ \mathbf{=}\mathbf{3}\mathbf{.}\mathbf{05} \end{gathered}$$

Degree of operating leverage, after expansion, at sales of $6,500,000

$$\begin{gathered} \mathbf{DOL}\mathbf{=}\frac{\mathbf{Sales}\mathbf{-}\mathbf{Variablecost}}{\mathbf{Sales}\mathbf{-}\mathbf{Variablecost}\mathbf{-}\mathbf{Fixedcost}} \\ \mathbf{=}\frac{\mathbf{\$}\mathbf{6}\mathbf{,}\mathbf{500}\mathbf{,}\mathbf{000}\mathbf{-}\mathbf{\$}\mathbf{3}\mathbf{,}\mathbf{250}\mathbf{,}\mathbf{000}}{\mathbf{\$}\mathbf{6}\mathbf{,}\mathbf{500}\mathbf{,}\mathbf{000}\mathbf{-}\mathbf{\$}\mathbf{3}\mathbf{,}\mathbf{250}\mathbf{,}\mathbf{000}\mathbf{-}\mathbf{\$}\mathbf{2}\mathbf{,}\mathbf{350}\mathbf{,}\mathbf{000}} \\ \mathbf{=}\mathbf{3}\mathbf{.}\mathbf{61} \end{gathered}$$