DFL and graphical display of financing plans Wells and Associates has EBIT of $6

Question

DFL and graphical display of financing plans Wells and Associates has EBIT of

$67,500. Interest costs are $22,500, and the firm has 15,000 shares of common

stock outstanding. Assume a 40% tax rate.

a. Use the degree of financial leverage (DFL) formula to calculate the DFL for the firm.

b. Using a set of EBIT–EPS axes, plot Wells and Associates’ financing plan.

c. If the firm also has 1,000 shares of preferred stock paying a $6.00 annual dividend

per share, what is the DFL?

d. Plot the financing plan, including the 1,000 shares of $6.00 preferred stock, on

the axes used in part b.

e. Briefly discuss the graph of the two financing plans.

Explanation / Answer

a. DFL at base level EBIT=EBIT/EBIT-I-(PD*1/1-T)

=67500/67500-22500-(15000*1/1-0.04)

=67500/45000-(250000)

=67500/-205000=-$0.3292

b.

EPS=27000/15000=1.8

EBIT 67500 Less interest 22500 NET profit before tax 45000 lesstax@40% 18000 net profit after tax 27000

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