PROBLEM SOLVING:

1. Sales (75, 000 units) $750, 000; Variable costs 225, 000; Fixed manufacturing costs 187,
500; Interest 75, 000; Taxes (at 31%). The Degree of Financial Leverage is?
Answer: DFL= 1.29x

2. Sales (75, 000 units) $750, 000; Variable costs 225, 000; Fixed manufacturing costs 187,
500; Operating income 337, 500; Interest 75, 000; Earnings before taxes 262, 500; Taxes
(at 31%) 81, 375; Net income $181, 125. The Degree of Operating Leverage is?
Answer: DOL= 1.56X

3. Sales (75, 000 units) $750, 000; Variable costs 225, 000; Fixed manufacturing costs 187,
500; Interest 75, 000; Taxes (at 31%). The Degree of Combined Leverage is?
Answer: DCL = 2.0x

Sales $750, 000

Variable Costs ($225, 000)
Contribution Margin $525, 000
Fixed Manufacturing Costs ($187, 500)
Operating Income (EBIT) $337, 000
Interest Expense ($75, 000)
Earnings before Tax (EBT) $262, 500

Solution for no.1

DFL = EBIT
EBT
= $337, 000
$262, 000
= 1.29x

Solution for no.2

DOL = CM
EBIT
= $525, 000
$337, 000
= 1.56x

Solution for no.3

DCL = CM
EBT
= $525, 000
$262, 000
= 2.0x
4. Desjardin’s makes power tools. The budgeted sales are $550, 000, budgeted variable
costs are $230, 000, and budgeted fixed costs are $227, 500. What is the contribution
margin?
Answer: CM= $320, 000

Solution:
Contribution Margin= Sales – Variable Cost
= $550, 000 - $230, 000
= $320, 000

5. Desjardin’s makes power tools. The budgeted sales are $550, 000, budgeted variable
costs are $230, 000, and budgeted fixed costs are $227, 500. What is the budgeted
operating income?
Answer: Operating Income= $92, 500

Solution:
Sales $550, 000
Variable Costs ($230, 000)
Contribution Margin $320, 000
Fixed Manufacturing Costs ($227, 500)
Operating Income $92, 500

6. Green Acres Company provides home health care. Green Acres charges $35 per hour for
professional care. Variable costs are $21 per hour and fixed costs are $78, 000. Next
year, Green Acres expects to charge out 12, 000 hours of home health care. What is the
break-even point in hours (rounded to the nearest whole hour)?
Answer: 5, 571

7. If EBIT equals $140, 000 and interest equals $21, 000, with a tax rate of 31%, what is the
degree of financial leverage?
Answer: 1.18x

Solution:
DFL = EBIT
EBT
= $140, 000
$140, 000 – $21, 000
= $140, 000
$119, 000
= 1.18x
8. Vafeas Inc.’s capital structure consists of 20% common equity and 80% debt and its beta
is 1.60 and tax rate is 35%. However, the CFO thinks the company has too much debt,
and he is considering moving to a capital structure with 40% debt and 60% equity. The
risk-free rate is 5.0% and the market risk premium is 6.0%. By how much would the
capital structure shift change the firm’s cost of equity?
Answer: -5.82%

9. Magazine Inc. had the following income statement for the current year:

Sales $50, 000

Variable Expenses $30, 000
Contribution Margin $20, 000
Fixed Expenses $8, 000
Operating Income $12, 000

Required:
A. Calculate the degree of operating leverage ratio.
Solution:
DOL = CM
EBIT
= $20, 000
$12, 000
= 1.67x

B. If sales increase by 40 percent, what will be the percentage change in income?

Solution:
$50, 000 x 40% = $20, 000
$50, 000 + $20, 000 = $70, 000
$70, 000 - $30, 000 - $8, 000 = $32, 000
$32, 000 - $12, 000 = -$20, 000 (amount increased)

= $20, 000/$12, 000

= 166.67% (percentage increase)

C. If sales decrease by 10 percent, how much will income decrease as a percentage?

Solution:
$50, 000 x 10% = $5, 000
$50, 000 - $5, 000 = $45, 000
$45, 000 - $30, 000 - $8, 000 = $7, 000
$7, 000 - $12, 000 = -$5, 000 (amount decreased)

= -$5, 000/ $12, 000

= -41.67% (percentage decrease)
10. Harry Manufacturing incurs annual fixed costs of P250, 000 in producing and selling a
single product. Estimated unit sales are 125, 000. An after-tax income of P75, 000 is
desired by management. The company projects its income tax rate at 40 percent. What
is the maximum amount that Harry can expend for variable costs per unit and still meet
its profit objective if the sales price per unit is estimated at P6?

Annual Fixed Costs P250, 000

Unit Sales P125, 000
After-tax Income P75, 000
Tax rate 40%
Sales price per unit P6

Solution:

Earnings before tax

= 75, 000/1-40% or 75, 000/0.6
= P125, 000

Sales
= 125, 000 x 6
= P750, 000

Contribution Margin
= EBT + Fixed Costs
= 125, 000 + 250, 000
= P375, 000

Variable Cost
= 750, 000 – 375, 000
= P375, 000

Variable Cost per unit

= 375, 000/125, 000
= P3