Degree of Financial Leverage: Northwestern Savings and Loan has current capital

Question

Degree of Financial Leverage: Northwestern Savings and Loan has 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 value 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.

Explanation / Answer

Degree of Financial Leverage: Northwestern Savings and Loan has a current capital structure consisting of $250,000 of 16% (annual interest) debt and 2,00 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).

EBIT = $80,000

EPS =($80,000 -16%*$250,000 )*(1-40%)/2000 = $12.00

EBIT = $120,000
EPS =($120,000 -16%*$250,000 )*(1-40%)/2000 = $24.00 = EPS

B) Using $80,000 of EBIT as a base, calculate the degree of financial leverage (DFL).

Degree of Financial Leverage (DFL) = EBIT / ( EBIT - Total Interest expense )
= $80,000/($80,000-16%*$250,000)

= 2.0 = 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.

EBIT = $80,000

EPS =($80,000 -16%*$100,000 )*(1-40%)/3,000= $12.8

EBIT = $120,000
EPS = ($120,000 -16%*$100,000 )*(1-40%)/3,000

= $20.8

Thus the Degree of Financial Leverage (DFL) =

EBIT / (EBIT - Total Interest expense) =

= $80,000/($80,000-16%*$100,000) = 1.25 = DFL

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