Tutorial 9 (Topic 9)

Analysis and Impact of Leverage

Question 1
Famous Caterer Berhad (FCB) has an expected sales of RM20 million. Fixed
operating costs are RM2.5 million, and the variable cost ratio is 65%. It has an
outstanding RM12 million, 8% bank loan and an outstanding shares of 1 million
ordinary shares (RM1 par). Assume corporate tax rate is 28%.
(a) What is FCB’s degree of operating leverage at a sales level of RM20 million?
(b) What is FCB’s current degree of financial leverage?
(c) What is the combined leverage of FCB?
(d) Forecast FCB’s earnings per share if sales drop to RM15 million.
(e) What information does the degree of financial leverage provide in decision
making?

Answers:
Variable operating costs = 0.65(RM20,000,000) = RM13,000,000
Earnings before interest and taxes = RM20,000,000 - RM13,000,000 - RM2,500,000
= RM4,500,000
Earnings per share = [RM4,500,000 - 0.08(RM12,000,000)](1- 0.28) / 1,000,000
= RM 2.5488
(a) DOL at sales level RM20,000,000
= (RM20,000,000 - RM13,000,000) / RM4,500,000
= 1.5556
(b) DFL at EBIT level $4,500,000
= RM4,500,000/[RM4,500,000 - 0.08(RM12,000,000)]
= 1.2712
(c) DCL = 1.5556 x 1.2712 = 1.9775
(d) A drop in sales from RM20 million to RM15 million represents a 25% drop in
sales.
Using the DCL, a 25% drop in sales should result in a 25% x 1.9775 = 49.4375% drop
in earnings per share.
New earnings per share = RM2.5488 (1 – 0.494375) = RM1.2887
(e) It reflects how the use of fixed financing costs by the firm magnifies the effects of
changes in operating income on earnings to shareholders.

Question 2
Footwear, Inc., manufactures a complete line of men’s and women’s shoes for
independent merchants. The average selling price of its finished product is $85 per
pair. The variable cost for this same pair of shoes is $58. Footwear, Inc., incurs fixed
costs of $170,000 per year.
(a) What is the break-even point in pairs of shoes for the company?
(b) What is the dollar sales volume the firm must achieve to reach the break-
even point?
(c) What would be the firm’s profit or loss at the following units of production
sold: 7,000 pairs of shoes? 9,000 pairs of shoes? 15,000 pairs of shoes?

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 (d) Find the degree of operating leverage for the production and sales levels
given in the part (c).

Answers: F $170,000 = $170,000 = 6,296 pairs of shoes

$85  $58 $27
(a) QB = =
PV

(b) S* F $170,000
= = $170,000 = $170,000
= = $535,185
VC $58 1  .682 .318
1 S 1  $85

(c)
7,000 9,000 15,000
Pairs of Shoes Pairs of Shoes Pairs of Shoes
Sales $595,000 $765,000 $1,275,000
Variable Costs 406,000 522,000 870,000
Revenue before
fixed costs $189,000 $243,000 $405,000
Fixed costs 170,000 170,000 170,000
EBIT $ 19,000 $ 73,000 $ 235,000
(d)
7,000 9,000 15,000
Pairs of Shoes Pairs of Shoes Pairs of Shoes
$189,000 $243,000 $405,000
$19,000 $73,000 $235,000
= 9.95 times 3.33 times 1.72 times
Notice that the degree of operating leverage decreases as the firm's sales level rises
above the break-even point of 6,296 pairs.

Question 3
Northwestern Savings and Loan has a current capital structure consisting of
$250,000 of 16% (annual interest) debt and 2,000 shares of common stock. The firm
pays taxes at the rate of 40%.
(a) Using EBIT values of $80,000 and $120,000, determine the associated
earnings per share (EPS).
(b) Using $80,000 of EBIT as a base, calculate the degree of financial leverage
(DFL).
(c) Rework parts (a) and (b) assuming that the firm has $100,000 of 16%
(annual interest) debt and 3,000 shares of common stock.

Answers:
Degree of Financial Leverage
(a)
EBIT $80,000 $120,000
Less: Interest 40,000 40,000
Net profits before taxes $40,000 $80,000
Less: Taxes (40%) 16,000 32,000
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 Net profit after taxes $24,000 $48,000

EPS (2,000 shares) $12.00 $24.00

DFL = 1 
 EBIT
(b) 

EBIT - I - PD 
  (1- T)

DFL = $80,000 2

 $80,000 -$40,000 - 0
(c)
EBIT $80,000 $120,000
Less: Interest 16,000 16,000
Net profits before taxes $64,000 $104,000
Less: Taxes (40%) 25,600 41,600
Net profit after taxes $38,400 $62,400

EPS (3,000 shares) $12.80 $20.80

DFL =
 $80,000  1.25

$80,000 -$16,000 - 0
Decrease in gearing has caused DFL to reduce from 2 to 1.25.

Question 4
The following information pertains to the Classic Burger Restaurant chain:

Sales $600,000
Variable costs 300,000
Total contribution margin 300,000
Fixed costs 100,000
EBIT 200,000
Interest expense 50,000
Earnings before taxes 150,000
Taxes (30%) 45,000
Net income $105,000

(a) If sales increase by 10%, what will be the new level of EPS if the firm has 10,000
shares outstanding?
(b) What is the percentage increase in EPS? Explain the difference between the
percentage increase in sales and the percentage increase in EPS.

Answers:
(a).

Sales
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 Variable costs 300,000 × 1.1 = 330,000
Total contribution margin 300,000 330,000
Fixed costs 100,000 100,000
EBIT 200,000 230,000
Interest expense 50,000 50,000
Earnings before taxes 150,000 180,000
Taxes (30%) 45,000 54,000
Net income $105,000 $126,000
Earnings Per Share $10.50 $12.60

(b) ($12.60 - $10.50)/$10.50 = .20 or 20%; A 10% increase in sales results in a 20%
increase in EPS due to leverage. Classic Burger uses both operating leverage (fixed cost
of operations) and financial leverage (debt financing reflected in interest expense).

Question 5
Welker Products sells small kitchen gadgets for $14 each. The gadgets have a
variable cost of $4 per unit, and Welker Products' fixed operating costs are $220,000
per year. Welker Products' capital structure includes 55% debt and 45% equity.
Annual interest expense is $25,000, and the corporate tax rate is 35%.
(a) Calculate the break-even point in units.
(b) If Welker Products sells 25,000 units, calculate the firm's EBIT and net income.
(c) If sales increase ten percent from 25,000 units to 30,000 units, estimate the firm's
expected EBIT and net income.
(d) Does Welker Products use operating leverage and/or financial leverage? Explain.

Answers:
(a) Break-even = ($220,000/($14 - $4)) = 22,000 units
(b) Sales = 25,000 ∗ $14 = $350,000
Variable Costs = 25,000 ∗ $4 = $100,000
Fixed Costs = $220,000
EBIT = $350,000 - $100,000 - $220,000 = $30,000
EBT = $30,000 - $25,000 = $5,000
Net Income = $5,000 (1 - 0.35) = $3,250
(c) Sales = 30,000 ∗ $14 = $420,000
Variable Costs = 30,000 ∗ $4 = $120,000
Fixed Costs = $220,000
EBIT = $420,000 - $120,000 - $220,000 = $80,000
EBT = $80,000 - $25,000 = $55,000
Net Income = $55,000 (1 - 0.35) = $35,750
(d) EBIT increased by (80,000 - 30,000)/30,000 = 167% and Net Income
increased by (35,750 - 3,250)3,25 = 1,000%
Since EBIT increased by a higher percentage than sales (167% compared to 20%), the
company uses operating leverage. Since the change in EPS is greater than the change in
EBIT (1,000% compared to 167%), the company uses financial leverage.

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