1215

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

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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

1215

As financial leverage increases, what will be the impact on the expected rate of return and financial risk?

A) Both will rise.

B) Both will fall.

C) One will rise while the other falls.

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A higher breakeven point resulting from increased interest costs associated with debt financing increases the risk of the company. Since the risk is tied to firm financing, it is referred to as financial risk. Given the positive risk-return relationship, the expected return of the company’s common stock also rises.

1215

 

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%.

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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%.

1215

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

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

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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.

1215

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.

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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.