Question

Indiana Tool Company's (ITC) fixed operating costs are $1,260,000 and its variable cost ratio is 0.70. The firm has $3,000,000 in bonds outstanding at an interest rate of 8 percent. ITC has 30,000 shares of $5 preferred stock and 150,000 shares of common stock outstanding. ITC is in the 50% corporate income tax bracket. What is the firm's DCL at a sales level of $9 million?

Group of answer choices

3.33

3.00

4.33

2.00

1.72

Answer 1

Solution:-

Income statement of Indiana tool company;

Particulars	Amount($)
Sales	9,000,000
- Variable costs(0.70 on sales)	(6,300,000)
Contribution	2,700,000
- Fixed cost	(1,260,000)
EBIT	1,440,000
- Interest(3,000,000 * 8%)	(240,000)
EBT	1,200,000
- Taxes	(600,000)
Net Income	600,000
Preffered dividend (30,000 * 5)	150,000

Degreee of combined leverage = Contribution / EBT-[Preffered dividend/(1-t)]

= $2,700,000 / 1,200,000-[150,000/(1-0.5)]

= $2,700,000 / (1,200,000 - 300,000)

= $2,700,000 / $900,000

= 3

Therefore the degree of combined leverage of Indiana tool company is 3.00 which is option 2.