Question

The computation and interpretation of the degree of combined leverage (DCL)

You and your colleague, Malik, are currently participating in a finance internship program at Torres Industries. Your current assignment is to work together to review Torres’s current and projected income statements. You will also assess the consequences of management’s capital structure and investment decisions on the firm’s future riskiness. After much discussion, you and Malik decide to calculate Torres’s degree of operating leverage (DOL), degree of financial leverage (DFL), and degree of total leverage (DTL) based on this year’s data to gain insights into Torres’s risk levels.

The most recent income statement for Torres Industries follows. Torres is funded solely with debt capital and common equity, and it has 2,000,000 shares of common stock currently outstanding.

	This Year’s Data	Next Year’s Projected Data
Sales	$80,000,000	$86,000,000
Less: Variable costs	32,000,000	34,400,000
Gross profit	48,000,000	51,600,000
Less: Fixed operating costs	28,000,000	28,000,000
Net operating income (EBIT)	20,000,000	23,600,000
Less: Interest expense	4,000,000	4,000,000
Taxable income (EBT)	16,000,000	19,600,000
Less: Tax expense (40%)	6,400,000	7,840,000
Net income	$9,600,000	$11,760,000
Earnings per share (EPS)	$4.80	$5.88

Given this information, complete the following table and then answer the questions that follow. When performing your calculations, round your EPS and percentage change values to two decimal places.

Torres Industries Data
DOL (Sales = $80,000,000)
DFL (EBIT = $20,000,000)
DTL (Sales = $80,000,000)

Everything else remaining constant, assume Torres Industries decides to immediately repay 50% of a bank loan prior to its maturity. How would this affect Torres’s DOL, DFL, and DCL?

•	The DOL would be expected to _____ .
•	The DFL would be expected to _____ .
•	The DTL would be expected to _____ .

Answer 1

Torres Industries Data
DOL = Contribution margin/EBIT = 48000000/20000000 =	2.40
DFL = EBIT/EBT = 20,000,000/16000000 =	1.25
DTL = Contribution margin/EBT = 48000000/16000000 =	3.00
On repayment of 50% of Bank loan
The DOL would be expected to be the same.
The DFL would be expected to decrease to 1.11
[DFL = 20000000/18000000 = 1.11]
The DTL would be expected to decrease to 2.67. .
[DTL = 48000000/18000000 = 2.67]