Question

Firm R has sales of 103,000 units at $1.98 per​ unit, variable operating costs of $1.69 per​ unit, and fixed operating costs of $6,010. Interest is $10,130 per year. Firm W has sales of 103,000 units at $2.54 per​ unit, variable operating costs of $0.96 per​ unit, and fixed operating costs of $62,500. Interest is $17,400 per year. Assume that both firms are in the 40% tax bracket.
(a) Compute the degree of operating, financial, and the total leverage for firm R.
(b) Compute the degree of operating, financial, and total leverage for firm W.
(c) Compute the relative risk of the two firms.
(d) Discuss the principles of leverage that your answers illustrate.

Answer 1

Answer:

degree of operating R = 1.25

degree of  financial = 1.51

total leverage for firm R = 1.88

degree of operating W = −4.98

degree of  financial W = 13.05

total leverage for firm W = −64.989  

Finance risk is more for Firm W as it has more interest to pay

Leverage is the use of fixed costs in a company’s cost structure.

Explanation:

given data

R sales = 103,000 units

sales cost = $1.98 per unit

fixed operating costs = $6,010

Interest = $10,130 per year

W sales = 103,000 units

sales cost =  $2.54 per​ unit

variable operating costs = $0.96 per​ unit

fixed operating costs = $62,500

Interest = $17,400 per year

tax bracket. = 40%

solution

degree of operating R = $\frac{103000\times (1.98-1.69)}{(103000\times (1.98-1.69)) - 6010}$  

degree of operating R = 1.25

and

degree of  financial = $\frac{103000\times (1.98-1.69)}{(103000\times (1.98-1.69)) - 10130}$

degree of  financial R = 1.51

and

total leverage for firm R = 1.25  × 1.51  

total leverage for firm R = 1.88

and

degree of operating W = $\frac{103000\times (2.54-0.96)}{(103000\times (1.98-1.69)) - 62500}$  

degree of operating W = −4.98

and

degree of  financial W = $\frac{103000\times (2.54-0.96)}{(103000\times (1.98-1.69)) - 17400}$  

degree of  financial W = 13.05

and

total leverage for firm W = -4.98  × 13.05

total leverage for firm W = −64.989  

and

Firm W has more fixed costs and therefore more operational risk.

and for overcome risk it have to achieve profit by increasing sales price and reduce variable operating cost.

so

Finance risk is more for Firm W as it has more interest to pay

and

Leverage is the use of fixed costs in a company’s cost structure.