Question

Bob's Burgers is planning an expansion. The initial investment is $156,000, and anticipated cash inflows are as listed below. The cost of capital is 12.5%. Based on the profitability index, should Bob go ahead with the project? ​ Years Cash Inflows 1. $ -25,000 2. 15,000 3. 45,000 4. 65,000 5. 85,000 6. 85,000 Last year Tammy Eyelashes experienced a 20% increase in earnings per share on 5% increase in sales. If management knows that Tammy’s DFL is 1.5, what is its DOL?

Answer 1

Answer to Question 1:

Present Value of Cash Flows = -$25,000/1.1250 + $15,000/1.1250^2 + $45,000/1.1250^3 + $65,000/1.1250^4 + $85,000/1.1250^5 + $85,000/1.1250^6
Present Value of Cash Flows = $150,910.67494

Profitability Index = Present Value of Cash Flows / Initial Investment
Profitability Index = $150,910.67494 / $156,000
Profitability Index = 0.97

Bob should not accept this project as its profitability index is less than 1.

Answer to Question 2:

Degree of Combined Leverage = % Change in EPS / % Change in Sales
Degree of Combined Leverage = 20% / 5%
Degree of Combined Leverage = 4.00

Degree of Combined Leverage = Degree of Operating Leverage * Degree of Financial Leverage
4.00 = Degree of Operating Leverage * 1.50
Degree of Operating Leverage = 2.67