Integrative — Leverage and risk Firm R has sales of 98,000 units at $ 1.99 per u

Question

Integrative—Leverage and riskFirm R has sales of 98,000 units at $ 1.99 per unit, variable operating costs of $1.73 per unit, and fixed operating costs of $6,060. Interest is $10,040 per year. Firm W has sales of 98,000 units at $2.58 per unit, variable operating costs of $0.98 per unit, and fixed operating costs of $62,400. Interest is $17,100 per year. Assume that both firms are in the 40% tax bracket.

a. Compute the degree of operating, financial, and total leverage for firm R.

b. Compute the degree of operating, financial, and total leverage for firm W.

c. Compare the relative risks of the two firms.

d. Discuss the principles of leverage that your answers illustrate.

Round answers two decimal places

Explanation / Answer

Answer:

R Firm (all figures in $)

Sales=98000 units Sales per unit=1.99 unit variable cost=1073 per unit fixed operating cost=6060 Interest=10040

Degree of operating leverage=Contribution margin/Net operating income

=(sales- variable cost)/ net operating income

Contribution margin

sales = units*Per unit sales

= 98000*1.99=195020

Variable cost=98000*1.73=169540

Contribution Margin=(195020-169540)=25480

Net operating income= sales -(Fixed cost+variable cost)

=195020-(6060+16540)

=19420

DOL= 25480/19420= 1.31

Financial leverage of R= EBIT/EBIT -Interst cost

EBIT= Sales -(Fixed cost+ variable cost)

EBIIT - interest cost=sales-(Fixed cost+ variable cost)- Interest cost

EBIT=19420 Interest cost=10040

EBIT - Interst rate=19420-10040=9380

DFL =19420/9380=2.07

DTL= DOL *DFL

=1.31*2.07=2.71 times

b)w firm

sales =98000 units sales per unit=2.58 Variable cost=0.98 fixed cost=62400 Interest cost=17100

Degree of operating leverage = (98000*2.58)-(98000*0.98)/(98000*2.58)-(62400+(98000*0.98)

=1.66

DFL= (EBIT/ EBIT- interest cost)

= 94400/77300=1.22

DTL =2.02

Note: I have taken into account the tax rate since in companies.

c) Finacial risk can be assessed through a degree of financial leverage assessment. The interest outgo repayment determine an impact on earnings

R firm DFL=2.07 times

W firm DFL=1.22 times

The reason of higher DFL in the R firm is due to the fact that the company has a lower Fixed cost which has attributed to better-operating income as compared to W firm which has lower net operating income owing to the higher fixed cost which has dented the profitability Since both the firm has almost similar interest cost, the impact is higher on W firm since it has resulted in it repayment of more interest cost from lesser profits.

DOL

R firm=1.33

W firm=1.66

The firm has the lower operating leverage of firm R as compared to W owing to better sales price even though W firm has higher fixed cost.

d) The principle of leverage is as follows:

1. As per answer which I have provided while calculating the Degree of operating leverage implies that the higher the degree of leverage means if there is a minor increase in sales price it will impact the ratio in a better way. For instance, DOL of W firm is 1.66 as compared to 1.31 is merely due to the higher sales price of W firm which is $2.58 as compared to $1.99 which has resulted in higher operating income despite the comparatively higher fixed cost of W firm. This also means earing per unit is comparatively as compared to cost of producing same units.

2.As per the answer, DFL of the W has lower DFL 1.22 as compared to 2.07 this is due to fact that company has higher Interest repayment of existing income. This also signifies that company has higher debt which is good in the expansionary economic condition but can be troublesome while economy in recessionary mode. so higher the DFL its good in expansionary economy when higher debt can be utillised to produce more goods since consumption is high but cant become negative while economy in recessionary mode.

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