OceanGate sells external hard drives for $200 each. Its total fixed costs are $3

Question

OceanGate sells external hard drives for $200 each. Its total fixed costs are $30 million, and its variable costs per unit are $140. The corporate tax rate is 30%. If the economy is strong, the firm will sell 2 million drives, but if there is a recession, it will sell only half as many.

a. What is the firm's degree of operating leverage (defined as the ratio of the percent change in EBIT to the percent change in sales) in going from a recession to a strong economy?

Degree of operating leverage            

b. If the economy enters a recession, what will be the firm’s after-tax profit? (Enter your answer in millions.)

After-tax profit            $  million

Explanation / Answer

a. Sales if economy is strong=2 million

Sales if economy is in recession=1 million

Percentage increase in sales=100% from recession to strong economy

EBIT=Sales-Variable Cost-Fixed Cost

EBIT(strong economy)=2*(200-140)-30=$90 million

EBIT(recession)=1*(200-140)-30=$30 million

Percentage increase in EBIT=(90-30)/30=200%

So, operating leverage=200/100=2

b. EBIT if there is recession=$30 million

Corporate tax=30%, so after tax profit=30(1-0.3)=$21 million

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