Self-Test Problems

1. Breakeven point and all forms of leverage TOR most recently sold 100,000 units at $7.50 each; its
variable operating costs are $3.00 per unit, and its fixed operating costs are $250,000. Annual
interest charges total $80,000, and the firm has 8,000 shares of $5 (annual dividend) preferred stock
outstanding. It currently has 20,000 shares of common stock outstanding. Assume that the firm is
subject to a 40% tax rate.

a. At what level of sales (in units) would the firm break even on operations (that is, EBIT $0)?

FC = $250,000

P = $7.50

VC = $3.00

=> Q = FC / (P – VC) = 55,556 unit

b. Calculate the firm’s earnings per share (EPS) in tabular form at (1) the current level of sales and (2)
a 120,000-unit sales level.

(1) (2)
Sales (in units) 100,000 120,000
Sales revenue $750,000 $900,000
Less: Variable operating cost $300,000 $360,000
Less: Fixed operating costs $250,000 $250,000
Earnings before interest and taxes $200,000 $290,000

EBIT $200,000 $290,000

Less: Interest $80,000 $80,000
Net profit before taxes $120,000 $210,000
Less: Taxes (T = 0.40) $48,000 $84,000
Net profit after taxes $72,000 $126,000
Less: Preferred stock $40,000 $40,000
Earnings available for common stockholders $32,000 $86,000

 Earnings per share (EPS) 32,000/20,000= $1.6 86,000/20,000= $4.3

=> % change in sales: +20%

=> % change in EBIT: +45%

=> % change in EPS: +169%

c. Using the current $750,000 level of sales as a base, calculate the firm’s degree of operating
leverage (DOL).

DOL = % change in EBIT / % change in sales = 2.25

d. Using the EBIT associated with the $750,000 level of sales as a base, calculate the firm’s degree of
financial leverage (DFL).

DFL = % change in EPS / % change in EBIT = 3.76

 e. Use the degree of total leverage (DTL) concept to determine the effect (in percentage terms) of a
50% increase in TOR’s sales from the $750,000 base level on its earnings per share.

DTL = DOL x DFL = 8.46

DTL = % change in EPS / % change in sales = % change in EPS / 50%

 % change in EPS = +43%

2. EBIT–EPS analysis Newlin Electronics is considering additional financing of $10,000. It currently

has $50,000 of 12% (annual interest) bonds and 10,000 shares of common stock outstanding. The
firm can obtain the financing through a 12% (annual interest) bond issue or through the sale of 1,000
shares of common stock. The firm has a 40% tax rate.

a. Calculate two EBIT–EPS coordinates for each plan by selecting any two EBIT values and finding
their associated EPS values.

Source of capital Bond Stok

Long term debt $60,000, 12% annual interest $50,000, 12% annual interest
Annual interest 0.12 × 60,000 = 7,200 0.12 × 50,000 = 6,000
Common stock 10,000 shares 11,000 shares

Bond Stock
EBIT $30,000 $40,000 $30,000 $40,000
Less: Interest $7,200 $7,200 $6,000 $6,000
Net profit before taxes $22,800 $32,800 $24,000 $36,000
Less: Taxes (T=0.40) $9,120 $13,120 $9,600 $13,600
Net profit after taxes $13,680 $19,680 $14,400 $20,400
EPS (10,000) 13,680/10,000=1.37 19,680/10,000=1.97
EPS (11,000) 14,400/11,000=1.31 20,400/11,000=1.85

b. Plot the two financing plans on a set of EBIT–EPS axes.

c. On the basis of your graph in part b, at what level of EBIT does the bond plan become superior to
the stock plan?

The bond plan (Plan A) becomes superior to the stock plan (Plan B) at approximately $20,000 EBIT, as
represented by the line dotted vertical in the image in part b. (Note: The actual point was $19,200,
which was determined algebraically using the same technique explained in footnote 18).

Warm-Up Exercises

1. Canvas Reproductions has fixed operating costs of $12,500 and variable operating costs of $10 per
unit and sells its paintings for $25 each. At what level of unit sales will the company break even in
terms of EBIT?

FC = $12,500

VC = $10

P = $25

 Q = FC / (P-VC) = 833,33

Break Even point in dollar sales = 833,33 x 25 =20833,25

3. Chico’s has sales of 15,000 units at a price of $20 per unit. The firm incurs fixed operating costs of
$30,000 and variable operating costs of $12 per unit. What is Chico’s degree of operating leverage
(DOL) at a base level of sales of 15,000 units?

Q = 15,000

P = $20

VC = $12

FC = $30,000

DOL at base sales level Q = Q x (P-VC) / Q x (P-VC) – FC = 1.3

4. Parker Investments has EBIT of $20,000, interest expense of $3,000, and preferred dividends of
$4,000. If it pays taxes at a rate of 38%, what is Parker’s degree of financial leverage (DFL) at a base
level of EBIT of $20,000?

EBIT = $20,000

I = $3,000

PD = $4,000

T = 0,38

DFL at base level EBIT = EBIT / EBIT – 1 – (PD x 1 / (1-T)) = 1.9

Problems

1. Breakeven point—Algebraic Kate Rowland wishes to estimate the number of flower arrangements
she must sell at $24.95 to break even. She has estimated fixed operating costs of $12,350 per year
and variable operating costs of $15.45 per arrangement. How many flower arrangements must Kate
sell to break even on operating costs?
FC = 12,350

P = $24.95

VC = $15.45

 Q = FC / (P-VC) = 1300

4. Breakeven analysis Barry Carter is considering opening a music store. He wants to estimate the
number of CDs he must sell to break even. The CDs will be sold for $13.98 each, variable operating
costs are $10.48 per CD, and annual fixed operating costs are $73,500.

a. Find the operating breakeven point in number of CDs.

FC = $73,500

P = $13.98

VC = $10.48

=> Q = FC / (P-VC) = 21,000

b. Calculate the total operating costs at the breakeven volume found in part a.

FC = $73,500

Q = $21,000

VC = $10.48

Total operating costs  FC  (Q  VC)  $293,580

c. If Barry estimates that at a minimum he can sell 2,000 CDs per month, should he go into the music
business?

Annual sales = 2,000 x 12,000 = 24,000

-> 24,000 – 21,000 = 3,000

=> Barry sales exceeds the operating breakeven by 3,000 records per year. Barry should go into the
CD business.

d. How much EBIT will Barry realize if he sells the minimum 2,000 CDs per month noted in part c?

P = $13.98

Q = $24,000

FC = $73,500

VC = $10.48

EBIT = (P  Q)  FC  (VC  Q)  $10,500

8. EBIT sensitivity Stewart Industries sells its finished product for $9 per unit. Its fixed operating costs
are $20,000, and the variable operating cost per unit is $5.
 a. Calculate the firm’s earnings before interest and taxes (EBIT) for sales of 10,000 units. & b.
Calculate the firm’s EBIT for sales of 8,000 and 12,000 units, respectively.

8,000 10,000 12,000

Sales $72,000 $90,000 $108,000
Less: Variable costs 40,000 50,000 60,000
Less: Fixed costs 20,000 20,000 20,000
EBIT $12,000 $20,000 $28,000

c. Calculate the percentage changes in sales (from the 10,000-unit base level) and associated
percentage changes in EBIT for the shifts in sales indicated in part b.

8,000 10,000 12,000

% change in unit sales (8,000-10,000)/10,000= -20% 0 (12,000-10,000)/10,000 = +20%
% change in EBIT (12,00020,000)/20,000= -40% 0 (28,00020,000)/20,000 = +40%

d. On the basis of your findings in part c, comment on the sensitivity of changes in EBIT in response
to changes in sales.

=> A given % change in sales produces a larger % change in EBIT.

9. Degree of operating leverage Grey Products has fixed operating costs of $380,000, variable
operating costs of $16 per unit, and a selling price of $63.50 per unit.

a. Calculate the operating breakeven point in units.

FC = $380,000

P = $63.50

VC = $16

Q = FC / (P-VC) = 8,000

b. Calculate the firm’s EBIT at 9,000, 10,000, and 11,000 units, respectively. & c. With 10,000 units as
a base, what are the percentage changes in units sold and EBIT as sales move from the base to the
other sales levels used in part b? & d. Use the percentages computed in part c to determine the
degree of operating leverage (DOL).

9,000 10,000 11,000

Sales $571,500 $635,000 $698,500
Less: Variable costs 144,000 160,000 176,000
Less: Fixed costs 380,000 380,000 380,000
EBIT $47,500 $95,000 $142,500

c.
change in unit sales 9,000 – 10,000 = 1,000 0 11,000 – 10,000 =1,000
% change in sales 1,000/10,000  10% 0 1,000/10,000  10%
change in EBIT 47,500 – 95,000 = $47,500 0 142,500 – 95,000=$47,500
% change in EBIT $47,500/95,000 = 50% 0 $47,500/95,000 = 50%

d. DOL
% change in EBIT -50/-10=5 50/10=5
% change in sales

e. Use the formula for degree of operating leverage to determine the DOL at 10,000 units.

Q = 10,000

P = $63.50

VC = $16.00

FC = $380,000

DOL = Qx(P-VC) / (Qx(P-VC)-FC = 5.00

10. Degree of operating leverage—Graphical Levin Corporation has fixed operating costs of $72,000,
variable operating costs of $6.75 per unit, and a selling price of $9.75 per unit.

a. Calculate the operating breakeven point in units.

FC = $72,000

P = $9.75

VC = $6.75

Q = FC / (P-VC) = 24,000

b. Compute the degree of operating leverage (DOL) using the following unit sales levels as a base:
25,000, 30,000, 40,000. Use the formula given in the chapter.

DOL = Qx(P-VC) / Qx(P-VC)-FC

Q = 25,000 -> DOL =25.0

Q = 30,000 -> DOL = 5.0

Q = 40,000 -> DOL = 2.5

c. Graph the DOL figures that you computed in part b (on the y axis) against base sales levels (on the
x axis).
d. Compute the degree of operating leverage at 24,000 units; add this point to your graph.

Q = 24,000 -> DOL = 

=> At the operating breakeven point -> DOL is infinite

e. What principle do your graph and figures illustrate?

DOL decreases as the firm expands beyond the operating breakeven point.

11. EPS calculations Southland Industries has $60,000 of 16% (annual interest) bonds outstanding,
1,500 shares of preferred stock paying an annual dividend of $5 per share, and 4,000 shares of
common stock outstanding. Assuming that the firm has a 40% tax rate, compute earnings per share
(EPS) for the following levels of EBIT:

a. $24,600

b. $30,600

c. $35,000

a b c
EBIT $24,600 $30,600 $30,600
Less: Interest 9,600 9,600 9,600
Net profits before taxes $15,000 $21,000 $25,400
Less: Taxes 6,000 8,400 10,160
Net profit after taxes $9,000 $12,600 $15,240
Less: Preferred dividends 7,500 7,500 7,500
Earnings available to common shareholders $1,500 $5,100 $7,740
EPS (4,000 shares) $0.375 $1.275 $1.935

12. Degree of financial leverage Northwestern Savings and Loan has a current capital structure
consisting of $250,000 of 16% (annual interest) debt and 2,000 shares of common stock. The firm
pays taxes at the rate of 40%.

Total interest amount = % annual interest × total debt value = % 16 × 250,000 = $ 40,000

a. Using EBIT values of $80,000 and $120,000, determine the associated earnings per share (EPS).

EBIT $80,000 $120,000

Less: Interest 40,000 40,000
Net profits before taxes $40,000 $80,000
Less: Taxes (40%) 16,000 32,000
Net profit after taxes $24,000 $ 48,000
EPS (2,000 shares) $ 12.00 $ 24.00

b. Using $80,000 of EBIT as a base, calculate the degree of financial leverage (DFL).

EBIT = $80,000

I = 40,000

DFL = EBIT / EBIT - I – (PD x 1/(1-T)) = 80,000 / (80,000-40,000) = 2

Total interest amount = % annual interest × total debt value = % 16 × 100,000 = $ 16,000

c. Rework parts a and b assuming that the firm has $100,000 of 16% (annual interest) debt and 3,000
shares of common stock.

EBIT $80,000 $120,000

Less: Interest 16,000 16,000
Net profits before taxes $64,000 $104,000
Less: Taxes (40%) 25,600 41,600
Net profit after taxes $38,400 $ 62,400
EPS (2,000 shares) $ 12.80 $ 20.80

DLF = 80,000 / (80,000-16,000) = 1.25

16. Integrative—Leverage and risk Firm R has sales of 100,000 units at $2.00 per unit, variable
operating costs of $1.70 per unit, and fixed operating costs of $6,000. Interest is $10,000 per year.

Firm W has sales of 100,000 units at $2.50 per unit, variable operating costs of $1.00 per unit, and
fixed operating costs of $62,500. Interest is $17,500 per year.

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

a. Compute the degree of operating, financial, and total leverage for firm R.

Q = 100,000

P = $2.00

VC = $1.70

FC = $6,000

I = $10,000

DOL at base sales level Q = Q x (P-VC) / Q x (P-VC) – FC = 1.25

DFL at base level EBIT = EBIT / EBIT – I – (PD x 1/(1-T)) = 24,000/(24,000-10,000) = 1.71

DTL = DOL x DFL = 2.14

b. Compute the degree of operating, financial, and total leverage for firm W.

Q = 100,000

P = $2.50

VC = $1.00

FC = $62,500

I = $17,500

DOL at base sales level Q = Q x (P-VC) / Q x (P-VC) – FC = 1.71

DFL at base level EBIT = EBIT / EBIT – I – (PD x 1/(1-T)) = 87,500 /(87,500 – 17,500) = 1.25

DTL = DOL x DFL = 2.14

c. Compare the relative risks of the two firms.

Operating (business) risk: Firm R < Firm W

Financial risk: Firm R > Firm W

d. Discuss the principles of leverage that your answers illustrate.

Two firms with differing operating and financial structures may be equally leveraged. Because total
leverage is the product of operating and financial leverage, each firm may structure itself differently
and still have the same amount of total risk.

17. Integrative—Multiple leverage measures and prediction Carolina Fastener, Inc., makes a
patented marine bulkhead latch that wholesales for $6.00. Each latch has variable operating costs of
$3.50. Fixed operating costs are $50,000 per year. The firm pays $13,000 interest and preferred
dividends of $7,000 per year. At this point, the firm is selling 30,000 latches per year and is taxed at a
rate of 40%.

a. Calculate Carolina Fastener’s operating breakeven point.

P = $6.00

FC = $50,000

VC = $3.50

=> Q = FC / (P-VC) = 20,000

b. On the basis of the firm’s current sales of 30,000 units per year and its interest and preferred
dividend costs, calculate its EBIT and earnings available for common.

Sales ($6  30,000) $180,000

Less: Fixed costs 50,000
Less: Variable costs ($3.50  30,000) 105,000
EBIT 25,000
Less interest expense 13,000
EBT 12,000
Less taxes (40%) 4,800
Net profits $7,200
Earnings available for common stockholders = Net profits – PD = $7,200 – $7,000 = $200

c. Calculate the firm’s degree of operating leverage (DOL).

Q = 30,000

P = $6.00

VC = $3.50

FC = $50,000

DOL at base sales level Q = Q x (P-VC) / Q x (P-VC) – FC = 3

d. Calculate the firm’s degree of financial leverage (DFL).

EBIT = 25,000

I = $13,000
PD = $7,000

T = 0.4

DFL = EBIT / EBIT – I – (PD x 1/(1-T)) = 75

e. Calculate the firm’s degree of total leverage (DTL).

DTL  DOL  DFL  3  75  225 = 22,5%