kim226

If a 10% increase in sales causes EPS to increase from $1.00 to $1.50, and if the firm uses no debt, then what is its degree of operating leverage?

A) 5.0.

B) 4.7.

C) 4.2.

---

Upon first glance, it appears there is not enough information to complete the problem. However when one realizes DTL = (DOL)(DFL) it is possible to complete this problem.
DTL = %∆EPS/%∆Sales = 5
DFL =  EBIT/(EBIT-I) = 1.
(DOL)(1) =5
DOL= 5.

kim226

The management of Strings & All, Inc., a small, highly leveraged, electric guitar manufacturer, wants to reduce the company’s degree of total leverage (DTL) to 2.0. Currently, the company’s expected operating performance is as follows:

• Sales of $500,000.

• Variable Costs at 60% of sales.

• Fixed Costs of $120,000.

• Fixed-Interest Debt with annual interest payments of $25,000.

All else constant, to obtain a DTL of 2.0, management must:

A) reduce variable expenses by 30%.

B) increase variable expenses by 30%.

C) reduce variable expenses by 38.5%.

---

To obtain this result, we need to calculate the current variable costs, determine the variable costs that will result in a DTL ratio of 2.00, and calculate the percentage change.
Step 1: Calculate current variable costs (VC): VC = 0.6 × 500,000 = 300,000
Step 2: Calculate Variable costs needed to decrease the DTL to 2.0:

Rearranging the formula for DTL:
(Sales − Variable Costs) / (Sales − Variable Costs − Fixed Costs − Interest Expense)
results in:  
Variable Costs (VC) = Sales − (2 × Fixed Costs) − (2 × Interest Expense)

= 500,000 − (2 × 120,000) − (2 × 25,000) = 210,000

Step 3: Calculate percentage change:
DVC = (300,000 − 210,000) / 300,000 = 0.30, or 30%.

kim226

Which of the following statements about leverage is most accurate?

A) An increase in fixed costs (holding sales and variable costs constant) will reduce the company's degree of operating leverage.

B) A decrease in interest expense will increase the company's degree of total leverage.

C) If the company has no debt outstanding, then its degree of total leverage equals its degree of operating leverage.

---

If debt = 0 then DFL = 1 because DFL = EBIT/(EBIT - I)
If debt = 0 then I = 0 and DFL = EBIT/(EBIT - 0) = EBIT/EBIT = 1
DTL = (DOL)(DFL)
If DFL = 1 then DTL = (DOL)(1) which complies to DTL = DOL
A decrease in interest expense will decrease DFL, which will decrease DTL. An increase in fixed costs will increase the company’s DOL.

kim226

The following information reflects the projected operating results for Opstalan, a catalog printer.

• Sales of $5.0 million.
• Variable Costs at 40% of sales.
• Fixed Costs of $1.0 million.
• Debt interest payments on $1.5 million issued with an annual 7.0% coupon (current yield is 8.0%).
• Tax Rate of 0.0%.

Opstalan’s degree of total leverage (DTL) is closest to:

A) 2.58.

B) 1.59.

C) 1.41.

---

First, calculate the operating results:

Opstalan Annual Operating Results
Sales	$5,000,000
Variable Costs1	2,000,000
	3,000,000
Fixed Costs	1,000,000
EBIT	2,000,000
Interest Expense2	105,000
	1,895,000

1Variable costs = 0.40 × 5,000,000
2Interest Expense = 0.07 × 1,500,000

Second, calculate DOL = (Sales − Variable Costs) / (Sales − Variable Costs − Fixed Costs) = 3,000,000 / 2,000,000 = 1.50
Third, calculate DFL = EBIT / (EBIT − I) = 2,000,000 / 1,895,000 = 1.06.
Finally, calculate DTL = DOL × DFL = 1.50 × 1.06 = 1.59.

kim226

Stromburg Corporation's sales are $75,000,000. Fixed costs, including research and development, are $40,000,000, while variable costs amount to 30% of sales. Stromburg plans an expansion which will generate additional fixed costs of $15,000,000, decrease variable costs to 25% of sales, and permit sales to increase to $100,000,000. What is Stromburg's degree of operating leverage at the new projected sales level?

A) 4.20.

B) 3.50.

C) 3.75.

---

Sales = $100,000,000
VC of 25% of sales = 25,000,000
FC of 40,000,000 + 15,000,000 = 55,000,000
DOL= [100,000,000 – 25,000,000] / [100,000,000 – 25,000,000 – 55,000,000] = 3.75

kim226

Given the following information on the annual operating results for ArtFrames, a producer of quality metal picture frames, what is the degree of operating leverage (DOL) and the degree of financial leverage (DFL)?

• Sales of $3.5 million
• Variable Costs at 45% of sales
• Fixed Costs of $1.05 million
• Debt interest payments on $750,000 issued with an annual 9.0% coupon (current yield is 7.0%)

Which of the following choices is closest to the correct answer? ArtFrame’s DOL and DFL are:

DOL

DFL

A) 3.00 1.50

B) 2.20 1.08

C) 2.20 1.50

---

The calculations are as follows:
First, calculate the operating results:

ArtFrames Annual Operating Results
Sales	$3,500,000
Variable Costs1	1,575,000
	1,925,000
Fixed Costs	1,050,000
Earnings before interest and taxes (EBIT)	875,000
Interest Expense2	67,500
	807,500
1Variable costs = 0.45 × 3,500,000
2Interest Expense = 0.09 × 750,000

Second,calculate DOL:

DOL = (Sales – Variable Costs) / (Sales – Variable Costs – Fixed Costs)
= (3,500,000 – 1,575,000) / (3,500,000 – 1,575,000 – 1,050,000) = 2.20

Third, calculate DFL:

DFL = EBIT / (EBIT – I) = 875,000 / 807,500 = 1.08

kim226

Which of the following statements regarding leverage is most accurate?

A) A firm with high business risk is more likely to increase its use of financial leverage than a firm with low business risk.

B) A firm with low operating leverage has a small proportion of its total costs in fixed costs.

C) High levels of financial leverage increase business risk while high levels of operating leverage will decrease business risk.

---

A firm with high operating leverage has a high percentage of its total costs in fixed costs.

kim226

A firm expects to produce 200,000 units of flour that can be sold for $3.00 per bag. The variable costs per unit are $2.00, the fixed costs are $75,000, and interest expense is $25,000. The degree of operating leverage (DOL) and the degree of total leverage (DTL) is closest to:

DOL

DTL

A) 1.6 2.0

B) 1.3 1.3

C) 1.6 1.3

---

DOL = Q(P – V) / [Q(P – V) – F]
DOL = 200,000 (3 – 2) / [200,000(3 – 2) – 75,000] = 1.6
DTL = [Q(P - V) / Q(P - V) - F - I]
DTL = 200,000 (3 - 2) / [200,000 (3 - 2) - 75,000 - 25,000] = 2

kim226

All else equal, which of the following statements about operating leverage is least accurate?

A) Lower operating leverage generally results in a higher expected rate of return.

B) Operating leverage reflects the tradeoff between variable costs and fixed costs.

C) Firms with high operating leverage experience greater variance in operating income.

---

Operating leverage is the trade off between fixed and variable costs. Higher operating leverage typically is indicative of a firm with higher levels of risk (greater income variance). Given the positive risk/return relationship, higher operating leverage firms are expected to have a higher rate of return. And, lower operating leverage firms are expected to have a lower rate of return.

kim226

Jayco, Inc. sells 10,000 units at a price of $5 per unit. Jayco's fixed costs are $8,000, interest expense is $2,000, variable costs are $3 per unit, and earnings before interest and taxes (EBIT) is $12,000. What is Jayco’s degree of financial leverage (DFL) and total leverage (DTL)?

DFL

DTL

A) 1.33 1.75

B) 1.33 2.00

C) 1.20 2.00

---

DOL = [Q(P − V)] / [Q(P − V) − F] = [10,000(5 − 3)] / [10,000(5 − 3) − 8,000] = 1.67
DFL = EBIT / (EBIT − I) = 12,000 / (12,000 − 2,000) = 1.2
DTL = DOL × DFL = 1.67 × 1.2 = 2.0