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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Selling and administrative expenses	$112,000
Depreciation expenses	73,000
Sales	489,000
Interest expenses	45,000
Cost of goods sold	156,000
Taxes	47,000

Times mirror and glass company
Sales	\)126,000
Less: Cost of goods sold	93,000
Gross profit	\(33,000
Less: selling and administrative expenses	11,000
Lease Expenses	4,000
Operating profit*	\)18,000
Less: Interest expenses	3,000
Earning before taxes	\(15,000
Less: Taxes (30%)	4,500
Earning after taxes	\)10,500

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