Jones Creations produces hand warmers, selling 400,000 warmers a year. Each warm
ID: 2670295 • Letter: J
Question
Jones Creations produces hand warmers, selling 400,000 warmers a year. Each warmer produced has a variable operating cost of $0.84 and sells for $1.00. Fixed operating costs are $28,000. The firm has annual interest charges of $6,000, preferred dividends of $2,000, and a 40% tax rate.a) Calculate the operating breakeven point in units
b) Use the degree of operating leverage (DOL) formula to calculate DOL.
c) Use the degree of financial leverage (DFL) formula to calculate DFL.
d) Use the degree of total leverage (DTL) formula to calculate DTL.
Explanation / Answer
We have SP pu = $1 & VC pu = 0.84 So COnt pu = SP pu- VCpu = 1-0.84 = 0.16 pu EBIT = Sales - VC - FC = 400000*(1-0.84) - 28000 = $36,000 a) So operating breakeven point = FC/Cont pu = 28000/0.16 = 175,000 ....Ans b) Degree of operating leverage (DOL): - It measures the EBIT's percentage change as a result of a change of one percent in the level of output. - It helps in measuring the business risk. To compute it just use the following formula: Degree of operating leverage = Sales revenue less total variable cost divided by sales revenue less total cost: DOL = (Sales-Variable Costs) / (Sales-Variable Costs-Fixed Costs) ie DOL = 400000*(1-0.84)/[400000*(1-0.84)-28000] = 1.78............Ans (b) c) Degree of financial leverage. The degree of financial leverage (DFL) is defined as the percentage change in earnings per share [EPS] that results from a given percentage change in earnings before interest and taxes (EBIT): DFL = Percentage change in EPS divided by Percentage change in EBIT ie DFL = EBIT / (EBIT-I), where I is the interest expense. ie RFL = 36000/(36000-6000) = 1.20..........................Ans (c) d)Degree of Total leverage (DTL). The degree of Total leverage is also known as degree of combined leverage To compute it use the following formula: DCL = DOL * DFL = 1.78*1.20 = 2.14........................Ans (d)
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