Question

The computation and interpretation of the degree of combined leverage (DCL)You and your colleague, Malik, are currently participating in a finance internship program at Torres Industries. Your current assignment is to work together to review Torres’s current and projected income statements. You will also assess the consequences of management’s capital structure and investment decisions on the firm’s future riskiness. After much discussion, you and Malik decide to calculate Torres’s degree of operating leverage (DOL), degree of financial leverage (DFL), and degree of total leverage (DTL) based on this year’s data to gain insights into Torres’s risk levels.The most recent income statement for Torres Industries follows. Torres is funded solely with debt capital and common equity, and it has 2,000,000 shares of common stock currently outstanding. This Year’s Data Next Year’s Projected DataSales $80,000,000 $86,000,000Less: Variable costs 32,000,000 34,400,000Gross profit 48,000,000 51,600,000Less: Fixed operating costs 28,000,000 28,000,000Net operating income (EBIT) 20,000,000 23,600,000Less: Interest expense 4,000,000 4,000,000Taxable income (EBT) 16,000,000 19,600,000Less: Tax expense (40%) 6,400,000 7,840,000Net income $9,600,000 $11,760,000Earnings per share (EPS) $4.80 $5.88Given this information, complete the following table and then answer the questions that follow. When performing your calculations, round your EPS and percentage change values to two decimal places.Torres Industries DataDOL (Sales = $80,000,000) DFL (EBIT = $20,000,000) DTL (Sales = $80,000,000) Everything else remaining constant, assume Torres Industries decides to immediately repay 50% of a bank loan prior to its maturity. How would this affect Torres’s DOL, DFL, and DCL?1. The DOL would be expected to _____ .2. The DFL would be expected to _____ .3. The DTL would be expected to _____ .

Answer 1

Answer:

1. expected to be the same

2. expected decrease to 1.11

3. expected decrease to 2.67

Explanation:

1. Degree of Operating Leverage = Contribution margin ÷ Earning before interest and tax

= $48,000,000 ÷ $20,000,000

= $2.40

2. Degree of Financial Leverage = Earning before interest and tax ÷ Earning before tax

= $20,000,000 ÷ $16,000,000

= $1.25

3. Degree of total leverage = Contribution margin ÷ Earning before tax

= $48,000,000 ÷ $16,000,000

= $3.00

The repayment 50% of bank loan

1. The Degree of Operating Leverage is expected to be the same.

2. Degree of Financial Leverage = $20,000,000 ÷ $18,000,000 = 1.11

The Degree of Financial Leverage is expected to be decrease to 1.11

3. Degree of total leverage = $48,000,000 ÷ $18,000,000 = 2.67

The Degree of total leverage is expected that it will decrease to 2.67