Friendly Pie Inc., income statement for 2015 is as follows: FRIENDLY PIE, INC. I

Question

Friendly Pie Inc., income statement for 2015 is as follows:

FRIENDLY PIE, INC.

                            Income Statement

               For the Year Ended December 31, 2015

Sales (50,000 units at $60)          . . . . . . . .                . $3,000,000

            Less: Variable costs (50,000 units at $20) .    ... .1,000,000

                      Fixed costs               . . . . . . . . . . . . . .   .     500,000

Earnings before interest and taxes   . . . . . . .                   1,500,000

Interest expense . . . . . . . . . . . . . . . . . . . . .                .    300,000

Earnings before taxes (EBT)     . . .. . . . . . .               . 1,200,000

Income tax expense (40%)        . . . . . . . . . . ..                  480,000

Earnings after taxes (EAT)      . . . . . . . . . ..                   $720,000

Given this income statement, compute the following:

   A. Degree of operating leverage.            (1 point)

                B. Degree of financial leverage.                (1 point)

                C. Degree of combined leverage.              (1 point)

Explanation / Answer

1. Degree of operating leverage.

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)

For this problem:

DOL = ($3000,000-$1000,000) / ($3000,000-1000,000-$500,000) =

    = $2000,000 / $1500,000

   = 1.33

2. 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

The above equation can be worked to get the following equivalent one:

DFL = EBIT / (EBIT-I), where I is the interest expense.

For this problem:

DFL = $1500,000 / ($1500,000-$300,000)

=1500000/1200000=5/3

=1.25

3. Degree of combined leverage.

The degree of combined leverage is also known as degree of total leverage (DTL).

To compute it use the following formula:

DCL = DOL * DFL

For this problem:

DCL = 1.33 * 1.25 = 1.66

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