Use the following information for questions 8-11: A company is trying to decide
ID: 2774032 • Letter: U
Question
Use the following information for questions 8-11: A company is trying to decide on their use of operating and financial leverage from among four choices. Their Interest Expense is the Interest Rate times Debt. Their Tax Rate is 40%
Option Fixed Costs Variable Costs Debt Interest Rate
1. 20000 70% of Sales 0 0%
2. 50000 40% of Sales 0 0%
3. 20000 70% of Sales 500,000 10%
4. 50000 40% of Sales 500,000 10%
8. What is their Degree of Operating Leverage under option 1 if sales are $200,000?
a) 1 b) 1.5 c) 2 d) 3
9. What is their Degree of Financial Leverage under option 4 if EBIT is $120,000?
a) 1 b) 1.2 c) 1.7 d) 2.2
10. If Sales rise by 10% from 300,000 to 330,000 under option 3, then EBT will increase by what percent?
a) 13% b) 25% c) 35% d) 45%
11. At what level of Sales will the Degree of Operating Leverage = 2 under Option 2?
a) 100,000 b) 166,667 c) 250,000 d) 333,333
12. Company A and Company B have the same EBIT, tax rate, total assets, and Cost of Debt. However, Company A has a higher debt ratio than Company B. Which of the following statements is correct? (ROA = Net Income / Assets and ROE = Net Income / Equity)
a. Company A has a higher net income than Company B.
b. Company A has a lower ROA than Company B.
c. Company A has a lower ROE than Company B.
d. The two companies have the same ROE.
13. Firms with _____________ should have _________________.
Higher Operating Leverage; More Debt
Less Business Risk; More Financial Leverage
Less Volatile EBITs; Less Debt
Lower Operating Leverage; Lower Financial Leverage
Omega Corp. currently has 100,000 shares of stock outstanding but is planning on issuing debt in order to buy back stock. Their EBIT is a constant $1,000,000 regardless of how much debt they issue and they pay all net income out as dividends. Their tax rate is 40%. They have estimated the following costs of debt and costs of equity for various levels of debt.
EBIT =
1,000,000
Tax Rate =
40%
Share
Shares
Debt
rd
re
Net Inc
StkValue
FirmValue
Debt %
WACC
Price
Outstding
0
6.00%
11.00%
600,000
5,454,545
5,454,545
0.00%
11.00%
100,000
500,000
6.30%
11.40%
581,100
5,097,368
8.93%
10.72%
55.97
91,067
1,000,000
6.80%
12.00%
559,200
1,500,000
8.00%
13.00%
4,061,538
5,561,538
26.97%
10.79%
55.62
2,000,000
9.50%
14.50%
2,500,000
11.50%
16.50%
2,590,909
5,090,909
49.11%
3,000,000
14.00%
19.00%
1,831,579
4,831,579
14. What will their Net Income be if they issue $2,000,000 in debt?
a. $190,000 b. $324,000 c. $486,000 d. $810,000
15. What will their Stock Value be if they issue $1,000,000 in debt?
a. $4,190,000 b. $4,660,000 c. $5,600,000 d. $6,710,400
16. What will their WACC be if they issue $2,500,000 in debt?
a. 10.7% b. 11.8% c. 12.7% d. 14.1%
17. What will their Share Price be if they issue $0 in debt?
a. $48.62 b. $51.23 c. $54.55 d. $60
18. What will their Shares Outstanding be if they issue $1,500,000 in debt?
a. 40,615 b. 55,615 c. 62,374 d. 73,023
19. As the level of debt rises, the _______________ always.
a)Cost of Equity rises
b)WACC rises
c)Basic Earning Power falls
d)ROE rises
EBIT =
1,000,000
Tax Rate =
40%
Share
Shares
Debt
rd
re
Net Inc
StkValue
FirmValue
Debt %
WACC
Price
Outstding
0
6.00%
11.00%
600,000
5,454,545
5,454,545
0.00%
11.00%
100,000
500,000
6.30%
11.40%
581,100
5,097,368
8.93%
10.72%
55.97
91,067
1,000,000
6.80%
12.00%
559,200
1,500,000
8.00%
13.00%
4,061,538
5,561,538
26.97%
10.79%
55.62
2,000,000
9.50%
14.50%
2,500,000
11.50%
16.50%
2,590,909
5,090,909
49.11%
3,000,000
14.00%
19.00%
1,831,579
4,831,579
Explanation / Answer
Per the rule, I can answer first four parts only.
8) Sales 200,000
Variable cost 200,000x70% = -140,000
Contribution =60,000
Fixed cost = -20,000
EBIT =40,000
Degree of operating leverage = Contribution / EBIT
= 60,000/40,000
=1.5
9)
EBIT 120,000
(-)Interest 500,000 x10% -50,000
EBT 700,000
Degree of financial leverage = EBT/ EBIT
=120,000/70,000
=1.71
10) sales 300,000
Variable cost 330,000x70% -210,000
Contribution 90,000
Fixed cost -20,000
EBIT 70,000
Interest 500,000x10% -50,000
EBT 20,000
Degree of combined leverage = Contribution/EBT
=90,000/20,000
=4.5
Degree of combined leverage = % change in ebt/ % change in sales
4.5 x 10% = % change in ebt
% change in EBT = 45%
11)
Degree of operating leverage = (sales – variable cost)/(Sales – variable cost- fixed cost)
2 = (Sales -0.40 sales)/( Sales -0.40 sales-50,000)
1.2 Sales – 100,000 = 0.60 Sales
Sales = 100,000/0.60
=166,667