Integrative long dash— Leverage and risk??? Firm R has sales of 97,000 units at

Question

Integrativelong dash—Leverage

and risk???Firm R has sales of 97,000 units at $1.97 per? unit, variable operating costs of $1.73 per? unit, and fixed operating costs of $6,070. Interest is $10,150 per year. Firm W has sales of 97,000 units at $2.52 per? unit, variable operating costs of $0.98 per? unit, and fixed operating costs of $62,600. Interest is $17,100 per year. Assume that both firms are in the 40% tax bracket.??

a. Compute the degree of? operating, financial, and total leverage for firm R.

b. Compute the degree of? operating, financial, and total leverage for firm W.

c. Compare the relative risks of the two firms.

d. Discuss the principles of leverage that your answers illustrate.

Explanation / Answer

Answer a:

Firm R:

Sales in units = 97,000

Sales price per unit = $1.97

Variable operating costs per unit = $1.73

Contribution per unit = $1.97 - $1.73 = $0.24

Contribution margin = $0.24 * 97,000 units = $23,280

EBIT = Contribution margin - Fixed operating costs = $23,280 - $6,070 = $17,210

Degree of Operating Leverage (DOL) = Contribution margin / EBIT = $23,280 / $17,210 = 1.3527

Degree of Financial leverage (DFL) = EBIT / (EBIT - Fixed Financial cost) = $17,210 / ($17,210 - $10,150) = 2.437677

Degree of Total leverage = DOL * DFL = 1.3527 * 2.437677 = 3.30

Answer b:

Firm W:

Sales in units = 97,000

Sales price per unit = $2.52

Variable operating costs per unit = $0.98

Contribution per unit = $2.52 - $0.98 = $1.54

Contribution margin = $1.54 * 97,000 units = $149,380

EBIT = Contribution margin - Fixed operating costs = $149.380 - $62.600 = $86,780

Degree of Operating Leverage (DOL) = Contribution margin / EBIT = $149,380 / $86,780= 1.7214

Degree of Financial leverage (DFL) = EBIT / (EBIT - Fixed Financial cost) = $86,780 / ($86,780 - $17,100) = 1.2454

Degree of Total leverage = DOL * DFL = 1.7214 * 1.2454 = 2.14

Answer c:

Firm R is exposed to less operating risk (business risk) compared to Firm W .

Firm R has higher financial risk compared to Firm W.

Answer d:

A firm with lower operating risk may have a higher total leverage risk in case it is exposed to higher financial risk.

In other words, A significantly higher financial risk may expose a firm to higher total risk even if it is comparatively better off in terms of operating risk in comparison to another firm..

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