Question

DeSoto Tools Inc. is planning to expand production. The expansion will cost $3,700,000, which can be financed either by bonds at an interest rate of 6 percent or by selling 74,000 shares of common stock at $50 per share. After the expansion, sales are expected to increase by $1,670,000. Variable costs will remain at 30 percent of sales, and fixed costs will increase to $1,384,000. The tax rate is 35 percent. The current income statement before expansion is as follows:

Sales: $3,170,000 | Variable Costs: 951,000 | Fixed Costs: 817,000 | Earnings before interest and taxes: 1,402,000 | Interest Expense: 570,000 | Earnings before taxes: 832,000 | Taxes @35%: 291,000 | Earnings after taxes: 540,000 | Shares: 270,000 | Earnings per share: 2.00

a. Calculate the degree of operating leverage, the degree of financial leverage, and the degree of combined leverage before expansion. (For the degree of operating leverage, use the formula: DOL = (S − TVC) / (S − TVC − FC). For the degree of combined leverage, use the formula: DCL = (S − TVC) / (S − TVC − FC − I). These instructions apply throughout this problem.) (Round your answers to 2 decimal places.) b. Construct an income statement for the two alternative financial plans. c. Calculate the degree of operating leverage, the degree of financial leverage, and the degree of combined leverage, after expansion.

Answer 1