The University of Cambodia

Course: Foundations of Financial Management (FIN201)

Lecturer: Yem SamOrn
Session: Evening
Name: Vong Bopha
ID: 60-170603
Homework
Chapter 5: Operating & Financial Leverage

10. The Sterling Tire Company’s income statement for 2010 is as follows:

Sterling Tire Company

Income Statement
For the Year Ended December 31, 2010
Sales (20,000 tires at $60 each) ………………………………………… $ 1,200,000
Less: Variable costs (20,000 tires at $30) ……………………….... 600,000
Fixed costs ……………………………………………………… 400,000
Earnings before interest and taxes (EBIT) …………………………… 200,000
Interest Expense ………………………………………………………… 50,000
Earning before taxes (EBT) ……………………………………………. 150,000
Income tax expense (30%) ……………………………………………... 45,000
Earnings after taxes (EAT) ……………………………………………. $ 105,000

Given this income statement, compute the following:

a. Degree of operating leverage.
b. Degree of financial leverage.
c. Degree of combined leverage.
d. Break-even point in units.
Solution: Given this income statement, compute the following:
a. Degree of operating leverage.
Q( P−VC )
Formula: DOL=
Q ( P−VC ) −FC
By: Q = 20,000 units
P = $ 60 per unit
VC = $ 30 per unit
FC = $ 400,000
20,000( $ 60−$ 30) $ 600,000
 DOL= = $ 600,000−$ 400,000
=3 x
20,000 ( 60−30 )−$ 400,000

So: Degree of operating leverage is DOL=3x

b. Degree of financial leverage.

EBIT
Formula: DFL=
EBIT −I
By: EBIT = $ 200,000
I = $ 50,000
$ 200,000 $ 200,000
 DFL=
$ 200,000−$ 50,000
= $ 150,000
=1.33 x

So: Degree of financial leverage is DFL=1.33x

c. Degree of combined leverage.

Q( P−VC)
Formula: DCL=
Q ( P−VC )−FC−I
20,000($ 60−$ 30)
 DCL=
20,000 ( 60−30 )−$ 400,000−$ 50,000

$ 600,000
= =4 x
$ 150,000

So: Degree of combined leverage is DCL=4x

d. Break-even point in units.
FC
Formula: BE=
P−VC
$ 400,000
 BE=
$ 60−$ 30
= $ 400,000
$ 30
=13,333.33 ≈13,333 Tires

So: Break-even point in units is BE=13,333.33 ≈ 13,333 Tires

12. Mo & Chris’s Delicious Burgers., sells food to Military Cafeterias for $ 15 a box. The fixed
coasts of this operation are $80,000, while the variable cost per box is $10.
a. What is the break-even point in boxes?
b. Calculate the profit or loss on 15,000 boxes and on 30,000 boxes.
c. What is the degree of operating leverage at 20,000 boxes and at 30,000 boxes? Why does
the degree of operating leverage changes as the quantity sold increases?
d. If the firm has an annual interest expense of $10,000, calculate the degree of financial
leverage at both 20,000 and 30,000 boxes.
e. What is degree of combined leverage at both sales levels?
Solution:
a. Break-even point in boxes.
FC
Formula: BE=
P−VC
By: FC = $ 80,000
P = $ 15 per box
VC = $ 10 per box

$ 80,000 $ 80,000
 BE=
$ 15−$ 10
= $5
=16,000boxes

So: Break-even point in units is BE=16,000 boxes.

b. Calculate the profit or loss on 15,000 boxes and on 30,000 boxes.

Accounts 15,000 boxes 30,000 boxes

Sales ($ 15 per box) $ 180,000 $ 450,000
Less: variable cost ($ 10 per box) $ 150,000 $ 300,000
Fixed costs $ 80,000 $ 80,000
Profit or Loss - $ 50,000 $ 105,000

So: Since on 15,000 boxes, we will get Loss.

Since on 30,000 boxes, we will get Profit.

c. Degree of operating leverage at 20,000 boxes and at 30,000 boxes.

 Degree of operating leverage at 20,000 boxes
Q( P−VC )
Formula: DOL=
Q ( P−VC ) −FC
By: Q = 20,000 boxes
P = $ 15 per box
VC = $ 10 per box
FC = $ 80,000
20,000($ 15−$ 10) $ 100,000
 DOL= = $ 100,000−$ 80,000
=5 x
20,000 ( 15−10 ) −$ 80,000
So: Degree of operating leverage at 20,000 is DOL=5x
 Degree of operating leverage at 30,000 boxes
 Q( P−VC )
Formula: DOL=
Q ( P−VC ) −FC
By: Q = 25,000 boxes
P = $ 10 per box
VC = $ 10 per box
FC = $ 80,000
30,000($ 15−$ 10) $ 150,000
 DOL= = $ 150,000−$ 80,000
=2.14 x
30,000 15−10 −$ 80,000
( )
So: Degree of operating leverage at 30,000 is DOL=2.14x
 The degree of operating leverage goes down because we are further away from the
break-even point, thus the firm is operating on a larger profit base and leverage is
reduced.

d. The degree of financial leverage at both 20,000 and 30,000 bags.

EBIT
Formula: DFL=
EBIT −I
By: I= $ 10,000
EBIT =?
Accounts 20,000 boxes 30,000 boxes
Sales ($ 15 per box) $ 300,000 $ 450,000
Less: variable cost ($ 10 per box) $ 200,000 $ 300,000
Fixed costs $ 80,000 $ 80,000
EBIT $ 20,000 $ 70,000
 Find EBIT

 Degree of financial leverage at 20,000 boxes

EBIT
Formula: DFL=
EBIT −I
By: EBIT = $ 20,000
I = $ 10,000
$ 20,000 $ 20,000
 DFL=
$ 20,000−$ 10,000
= $ 10,000
=2 x

So: Degree of financial leverage at 20,000 is DFL=2x

 Degree of financial leverage at 30,000 boxes

EBIT
Formula: DFL=
EBIT −I
By: EBIT = $ 70,000
I = $ 10,000
$ 70,000
 DFL=
$ 70,000−$ 10,000
= $$ 70,000
60,000
=1.17 x

So: Degree of financial leverage at 30,000 is DFL=1.17x

e. Degree of combined leverage at sales levels.
 Degree of combined leverage at 20,000 bags
 Q( P−VC)
Formula: DCL=
Q ( P−VC )−FC−I
By: Q = 20,000 boxes
P = $ 15 per box
VC = $ 10 per box
FC = $ 80,000
I = $ 10,000
20,000($ 15−$ 10)
 DCL=
20,000 ( 15−10 )−$ 80,000−$ 10,000
$ 100,000
= $ 100,000−$ 90,000 =10 x
So: Degree of combined leverage at 20,000 is DOL=10x

 Degree of combined leverage at 30,000 bags

Q( P−VC)
Formula: DCL=
Q ( P−VC )−FC−I
or DCL = DOL × DFL
 DCL = 2.14 × 1.17 = 2.50x
So: Degree of combined leverage at 30,000 is DCL=2.50x

13. United Snack Company sells 50-pound bags of peanuts to university dormitories for $10 a
bag. The fixed costs of this operation are $80,000, while the variable costs of peanuts are $0.10
per pound.
a. What is the break-even point in bags?
b. Calculate the profit or loss on 12,000 bags and on 25,000 bags.
c. What is the degree of operating leverage at 20,000 bags and at 25,000 bags? Why does
the degree of operating leverage changes as the quantity sold increases?
d. If United Snack Company has an annual interest expense of $10,000, calculate the
degree of financial leverage at both 20,000 and 25,000 bags.
e. What is the degree of combined leverage at both sales levels?
Solution:
a. Break-even point in bags.
FC
Formula: BE=
P−VC
By: FC = $ 80,000
P = $ 10 per bag
VC = $ 0.10 × 50 = $ 5 per bag
$ 80,000 $ 80,000
 BE=
$ 10−$ 5
= $5
=16,000bags

So: Break-even point in units is BE=16,000 bags.

b. Calculate the profit or loss on 12,000 bags and on 25,000 bags.
 Accounts 12,000 bags 25,000 bags
Sales ($ 10 per bag) $ 120,000 $ 250,000
Less: variable cost ($ 5 per bag) $ 60,000 $ 125,000
Fixed costs $ 80,000 $ 80,000
Profit or Loss - $ 20,000 $ 45,000
So: Since on 12,000 bags, we will get Loss.
Since on 25,000 bags, we will get Profit.

c. Degree of operating leverage at 20,000 bags and at 25,000 bags.

 Degree of operating leverage at 20,000 bags
Q( P−VC )
Formula: DOL=
Q ( P−VC ) −FC
By: Q = 20,000 bags
P = $ 10 per bag
VC = $ 0.10 × 50 = $ 5 per bag
FC = $ 80,000
20,000( $ 10−$ 5) $ 100,000
 DOL= = $ 100,000−$ 80,000
=5 x
20,000 ( 10−5 )−$ 80,000
So: Degree of operating leverage at 20,000 is DOL=5x

 Degree of operating leverage at 25,000 bags

Q( P−VC )
Formula: DOL=
Q ( P−VC ) −FC
By: Q = 25,000 bags
P = $ 10 per bag
VC = $ 0.10 × 50 = $ 5 per bag
FC = $ 80,000
25,000( $ 10−$ 5) $ 125,000
 DOL= = $ 125,000−$ 80,000
=2.78 x
25,000 ( 10−5 )−$ 80,000
So: Degree of operating leverage at 20,000 is DOL=2.78x

 The degree of operating leverage goes down because we are further away from the
break-even point, thus the firm is operating on a larger profit base and leverage is
reduced.
d. The degree of financial leverage at both 20,000 and 25,000 bags.
EBIT
Formula: DFL=
EBIT −I
By: I= $ 10,000
EBIT =?

 Find EBIT
Accounts 20,000 bags 25,000 bags
Sales ($ 10 per bag) $ 200,000 $ 250,000
Less: variable cost ($ 5 per bag) $ 100,000 $ 125,000
Fixed costs $ 80,000 $ 80,000
EBIT $ 20,000 $ 45,000

 Degree of financial leverage at 20,000 bags

EBIT
Formula: DFL=
EBIT −I
By: EBIT = $ 20,000
I = $ 10,000
$ 20,000 $ 20,000
 DFL=
$ 20,000−$ 10,000
= $ 10,000
=2 x

So: Degree of financial leverage at 20,000 is DFL=2x

 Degree of financial leverage at 25,000 bags

EBIT
Formula: DFL=
EBIT −I
By: EBIT = $ 45,000
I = $ 10,000
$ 45,000 $ 45,000
 DFL=
$ 45,000−$ 10,000
= $ 35,000
=1.29 x

So: Degree of financial leverage at 25,000 is DFL=1.29x

e. Degree of combined leverage at sales levels.

 Degree of combined leverage at 20,000 bags
Q( P−VC )
Formula: DCL=
Q ( P−VC )−FC−I
By: Q = 20,000 bags
P = $ 10 per bag
VC = $ 0.10 × 50 = $ 5 per bag
FC = $ 80,000
I = $ 10,000
20,000($ 10−$ 5)
 DCL=
20,000 10−5 )−$ 80,000−$ 10,000
(
$ 100,000
= $ 100,000−$ 90,000 =10 x
So: Degree of combined leverage at 20,000 is DOL=10x

 Degree of combined leverage at 25,000 bags

Q( P−VC )
Formula: DCL=
Q ( P−VC )−FC−I
or DCL = DOL × DFL
  DCL = 2.78 × 1.29 =
So: Degree of combined leverage at 25,000 is DCL=3.58x

14. International Data Systems’ information on revenue and costs is only relevant up to a sales
volume of 100,000 units. After 100,000 units, the market becomes saturated and the price per
unit falls from $4.00 to $3.80. Also, there are cost overruns at a production volume of over
100,000 units, and variable cost per unit goes up from $2.00 to $2.20. Fixed costs remain the
same at $50,000.
a. Compute operating income at 100,000 units.
b. Compute operating income at 200,000 units.
Solution:
a. Compute operating income at 100,000 units.
International Data Systems
Accounts USD

Net Sales (100,000 × $4) ………………………………………………………. $ 400,000

Cost of goods sold (100,000 × $2) …………………………………………….. $ 200,000
Fixed cost ……………………………………………………………………… $ 50,000
Operating Income ……………………………………………………………… $ 150,000

So: Operating income at 100,000 units is $ 150,000

b. Compute operating income at 200,000 units.

International Data Systems
Accounts USD

Net Sales (200,000 × $3.80) …………………………………………………… $ 760,000

Cost of goods sold (200,000 × $2.20) …………………………………………. $ 440,000
Fixed cost ………………………………………………………………………. $ 50,000
Operating Income ………………………………………………………………. $ 270,000

So: Operating income at 200,000 units is $ 270,000