Mr. Gold is in the widget business. He currently sells 1.5 million widgets a year at $6 each. His variable cost to produce the widgets is $4 per unit, and he has $1,550,000 in fixed costs. His sales-to-assets ratio is six times, and 30 percent of his assets are financed with 10 percent debt, with the balance financed by common stock at $10 par value per share. The tax rate is 35 percent. His brother-in-law, Mr. Silverman, says he is doing it all wrong. By reducing his price to $5.00 a widget, he could increase his volume of units sold by 60 percent. Fixed costs would remain constant, and variable costs would remain $4 per unit. His sales-to-assets ratio would be 7.5 times. Furthermore, he could increase his debt-to-assets ratio to 50 percent, with the balance in common stock. It is assumed that the interest rate would go up by 1 percent and the price of stock would remain constant.

For two firms in the same industry, report the Degree of Operating Leverage and the Degree of Financial Leverage. (Be sure these formulas are the same as in the textbook. One or both may need to be calculated.) Comment on which company is more highly leveraged.

NOTE: Use the Earnings before interest and taxes and sales approach for DOL:

Degree of Operating Leverage Formula

The formula for the DOL takes into account two variables. They are:

1) The percentage change in EBIT from time period one to time period two

2) The percentage change in sales from time period one to time period two

The formula is then, DOL = % change in EBIT / % change in sales

EBIT can be calculated by taking the sales revenue and subtracting the operating expenses.

And use this for DFL DFL = %change in EPS / %change in EBIT