QUESTION 2 (25 MARKS)

Diamond Berhad has sales of 100,000 units at RM2.00 per unit, variable operating costs of RM1.70 per unit, and fixed operating costs of RM6,000. Interest is RM10,000 per year. Jade Berhad has sales of 100,000 units at RM2.50 per unit, variable operating costs of RM1.00 per unit, and fixed operating costs of RM62,500. Interest is RM17,500 per year.

Assume that both firms are in the 40% tax bracket.

a. Compute the degree of operating, financial, and combine leverage for Diamond Berhad.

b. Compute the degree of operating, financial, and combine leverage for Jade Berhad.

c. Compare the relative risks of the two firms.

d. Illustrate the principles of leverage based on your answers in (a), (b) and (c).

e. Illustrate how changes in capital structure affect a firms earnings per share.