20. DeSoto Tools, Inc., is planning to expand production. The expansion will cost

$300,000, which can be financed either by bonds at an interest rate of 14 percent or by selling 10,000 shares of common stock at $30 per share. The current income statement before expansion is as follows:

After the expansion, sales are expected to increase by $1,000,000. Variable costs will remain at 30 percent of sales, and fixed costs will increase to $800,000. The tax rate is 34 percent.

a. Calculate the degree of operating leverage, the degree of financial leverage, and the degree of combined leverage before expansion. (For the degree of operating leverage, use the formula developed in footnote 2 on page 129; for the degree of combined leverage, use the formula developed in footnote 3 on page 137. These instructions apply throughout this problem.)

b. Construct the income statement for the two alternative financing plans.

c. Calculate the degree of operating leverage, the degree of financial leverage, and the degree of combined leverage, after expansion.

d. Explain which financing plan you favor and the risks involved with each plan.

Transcribed Image Text:

DESOTO TOOLS, INC. Income Statement 200X Sales..... Less: Variable costs. Fixed costs..... Earnings before interest and taxes Less: Interest expense.. Earnings before taxes Less: Taxes 34% Earnings after taxes Shares Earnings per share $1,500,000 $450,000 550,000 1,000,000 500,000 100.000 400,000 136,000 $ 264,000 100,000 $2.64