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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.

Short Answer

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

01

Degree of operating leverage after expansion

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

02

Degree of Finacial leverage after expansion  

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

03

Degree of Combined leverage after expansion

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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Most popular questions from this chapter

Martin Electronics has an accounts receivable turnover equal to 15 times. If accounts receivable are equal to $80,000, what is the value for average daily credit sales?

Arrange the following items in proper balance sheet presentation:

Accumulated depreciation

\(309,000

Retained earnings

187,000

Cash

14,000

Bonds payable

136,000

Accounts receivable

54,000

Plant and equipment 鈥� original cost

775,000

Accounts payable

35,000

Allowance for bad debts

9,000

Common stock, \)1 par, 100,000 share outstanding

100,000

Inventory

70,000

Preferred stock, $59 par, 1,000 share outstanding

59,000

Marketable securities

24,000

Investments

20,000

Notes payable

34,000

Capital paid in excess of par (common stock)

88,000

For December 31, 20X1, the balance sheet of Baxter Corporation was as follows:

Current assets

Liabilities

Cash

\(15,000

Accounts payable

\)17,000

Accounts receivable

20,000

Notes payable

25,000

Inventory

30,000

Bonds payable

55,000

Prepaid expenses

12,500

Fixed assets

Stockholder鈥檚 equity

Plant and equipment (gross)

Less: accumulated depreciation

\(255,000

51,000

Preferred stock

\)25,000

Net plant and equipment

\(204,000

Common stock

60,000

Paid in capital

30,000

Retained earnings

69,500

Total assets

\)281,500

Total liabilities and stockholder鈥檚 equity

\(281,500

Sales for 20X2 were \)245,000, and the cost of goods sold was 60 percent of sales. Selling and administrative expense was \(24,500. Depreciation expense was 8 percent of plant and equipment (gross) at the beginning of the year. Interest expense for the notes payable was 10 percent, while the interest rate on the bonds payable was 12 percent. This interest expense is based on December 31, 20X1 balances. The tax rate averaged 20 percent.

\)2,500 in preferred stock dividends were paid, and \(5,500 in dividends were paid to common stockholders. There were 10,000 shares of common stock outstanding.

During 20X2, the cash balance and prepaid expenses balances were

unchanged. Accounts receivable and inventory increased by 10 percent. A new machine was purchased on December 31, 20X2, at a cost of \)40,000. Accounts payable increased by 20 percent. Notes payable increased by \(6,500 and bonds payable decreased by \)12,500, both at the end of the year. The preferred stock, common stock, and paid-in capital in excess of par accounts did not change.

a. Prepare an income statement for 20X2.

Identify whether each of the following items increases or decreases cash flow:

Increase in accounts receivable

Decrease in prepaid expenses

Increase in notes payable

Increase in inventory

Depreciation expense

Dividend payment

Increase in investment

Increase in accrued expenses

Decrease in account payable

Cyber Security Systems had sales of 3,500 units at $75 per unit last year. The marketing manager projects a 30 percent increase in unit volume sales this year with a 40 percent price increase. Returned merchandise will represent 8 percent of total sales. What is your net dollar sales projection for this year?
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