Question
A review of the degree of total leverage You and your colleague, Emily, are currently participating in a finance internship program at Carter Chemical Company.
A review of the degree of total leverage
You and your colleague, Emily, are currently participating in a finance internship program at Carter Chemical Company. Your current assignment is to work together to review Carters current and projected income statements. You will also assess the consequences of managements capital structure and investment decisions on the firms future riskiness. After much discussion, you and Emily decide to calculate Carters degree of operating leverage (DOL), degree of financial leverage (DFL), and degree of total leverage (DTL) based on this years data to gain insights into Carters risk levels.
The most recent income statement for Carter Chemical Company follows. Carter is funded solely with debt capital and common equity, and it has 2,000,000 shares of common stock currently outstanding.
| This Years Data | Next Years Projected Data |
---|---|---|
Sales | $80,000,000 | $86,000,000 |
Less: Variable costs | 32,000,000 | 34,400,000 |
Gross profit | 48,000,000 | 51,600,000 |
Less: Fixed operating costs | 28,000,000 | 28,000,000 |
Net operating income (EBIT) | 20,000,000 | 23,600,000 |
Less: Interest expense | 4,000,000 | 4,000,000 |
Taxable income (EBT) | 16,000,000 | 19,600,000 |
Less: Tax expense (40%) | 6,400,000 | 7,840,000 |
Net income | $9,600,000 | $11,760,000 |
Earnings per share (EPS) | $4.80 | $5.88 |
Given this information, complete the following table and then answer the questions that follow. When performing your calculations, round your EPS and percentage change values to two decimal places.
Carter Chemical Company Data | |
---|---|
DOL (Sales = $80,000,000) ____ a. 18.00 b. 2.40 c. 1.20 | |
DFL (EBIT = $20,000,000) ____ a. 1.20 b. 18.00 c. 1.25 | |
DTL (Sales = $80,000,000) a. 1.20 b. 3.00 c. 18.00 |
Everything else remaining constant, assume Carter Chemical Company decides to convert its labor-intensive manufacturing facility into a capital-intensive facility by laying off over 75% of its labor force and replacing the workers with robotic and technologically advanced manufacturing equipment. Assume that, over the next five years, the wages saved as a result of the layoffs will pay for the changes made to Carters plant and equipment changes. How would this affect Carters DOL, DFL, and DCL?
The DOL would be expected to _____ . a. increase b. remain unchanged c. decrease | |
The DFL would be expected to _____ . a. increase b. remain unchanged c. decrease | |
The DTL would be expected to _____ . a. increase b. remain unchanged c. decrease |
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