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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 ﬁxedcost 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 lDSTI'V‘CCH ‘x . . _ .
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