8 - 8 The computation and interpretation of the degree of...

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Unformatted text preview: 8. The computation and interpretation of the degree of combined leverage (DCL) A3 A3 You and your colleague Rafael are currently participating in a finance internship program at Campbell Construction (Campbell). Your current assignment is to work together to review Campbell'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 Rafael decide to calculate Campbell’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 Campbell’s risk levels. The most recent income statement for Campbell Construction follows. Campbell is funded solely with debt capital and common equity, and it has 3,000,000 shares of common stock currently outstanding. Next Year's This Year's Data Projected Data Sales $40,000,000 $43,200,000 Less: Variable costs 20,000,000 21,600,000 Gross profit 20,000,000 21,600,000 Less: Fixed operating costs 8,000,000 8,000,000 Net operating income (EBIT) 12,000,000 13,600,000 Less: Interest expense 800,000 800,000 Taxable income (EBT) 11,200,000 12,800,000 Less: Tax expense (40%) 4,480,000 5,120,000 Net income $5,720,000 7,530,000 Earnings per share {EPS) $2.24 $2.56 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. Campbell Construction Data DOL (Sales = $40,000,000) 1.67 v DFL (EBIT = $12,000,000) 1.07 v DTL (Sales = $40,000,000) 1.79 v Explanation: Close A At sales of $40,000,000, Campbell Construction exhibits a DOL of 1.67, a DFL of 1.07, and DTL of 1.79. There are two formulas that can be used to calculate a firm's degree of operating leverage (DOL) at a given level of sales ($40,000,000): DOL (Sales — Variable Costs) / EBIT DOL = Percentage Change in EBIT/ Percentage Change in Sales Using either equation, the firm's DOL is 1.67. That is: DOL (at Sales = $40,000,000} = (Sales — Variable Costs} / EBIT = ($40,000,000 — 20,000,000)/ $12,000,000 = 1.67 DOL (at Sales = $40,000,000} = Percentage Change in EBIT/ Percentage Change in Sales {[($13,600,000 — $12,000,000)/ $12,000,000] x 100}/ {[($43,200,000 — $40,000,000) / $40,000,000] x 100} 13.33% / 8.00% 1.67 There are also two formulas that can be used to calculate a firm's degree of financial leverage (DFL) at a given level of EBIT ($ 12,000,000): DFL = (EBIT — Interest Expense) / EBIT DFL = Percentage Change in EPS/ Percentage Change in EBIT Using either equation, the firm's DFL is 1.07. That is: DFL (EBIT = $12,000,000} = EBIT/ (EBIT — Interest Expense) $12,000,000 / ($12,000,000 — 800,000) 1.07 DFL (EBIT = $12,000,000} = Percentage Change in EPS/ Percentage Change in EBIT {[($2.56 — $2.24)/ $2.24] x 100} / {[($13.600,000 — $12,000,000)/ $12,000,000] x 100} 14.29%/ 13.33% 1.07 The two formulas that can be used to calculate the firm’s degree of total leverage (DTL) at a given level of sales ($40,000,000) are: DTL = DOL X DFL DTL = Percentage Change in EPS / Percentage Change in Sales Using either equation, the firm's DTL is 1.79. That is: DTL (Sales = $40,000,000) = DOL x DFL = 1.57 x 1.07 = 1.79 DTL (Sales = $40,000,000} = Percentage Change in EPS/ Percentage Change in Sales {[($2.06 — $1.43) / $1.43] x 100} / {[($43,200,000 — $40,000,000)/ $40,000,000] x 100} 14.29% / 8.00% 1.79 Everything else remaining constant, assume Campbell Construction decides to immediately repay 50% of a bank loan prior to its maturity. How would this affect Campbell's DOL, DFL, and DCL? The DOL would be expected to: Remain constant V The DFL would be expected to: The DTL would be expected to: Explanation: Close A When Campbell repays its 50% of its loan and reduces its use of fixed-cost financing, it reduces its DFL. Since the firm’s DOL is not changed by this action, the firm’s DTL will also decrease. ll lights lDS-TI'V‘CCH ‘x . . _ . :zic- Looming inc:th as not-id f‘xl "waits "czar-sod, ." Pomts' 6 [6 save 8‘ Contmue ...
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