You and your colleague Ian are currently participating in a finance internship p
ID: 2652332 • Letter: Y
Question
You and your colleague Ian are currently participating in a finance internship program at Torres Industries (Torres). Your current assignment is to work together to review Torres'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 Ian decide to calculate Torres'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 Torres's risk levels The most recent income statement for Torres Industries follows. Torres 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 $40,000,000 $43,200,000 Sales Less: Variable costs 20,000,000 21,600,000 Gross profit 20,000,000 21,600,000 8,000,000 8,000,000 Less: Fixed operating costs Net operating income (EBIT) 12,000,000 13,600,000 800,000 800,000 Less: Interest expense Taxable income (EBT) 11,200,000 12,800,000 Less: Tax expense (40%) 4,480,000 5,120,000 $6,720,000 7,680,000 Net income $2.24 $2.56 Earnings per share (EPS) 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. Torres Industries Data DOL (Sales $40,000,000) DFL (EBIT $12,000,000) DTL (Sales $40,000,000) Everything else remaining constant, assume Torres Industries decides to immediately repay 50% of a bank loan prior to its maturity. How would this affect Torres's DOL, DFL, and DCL? The DOL would be expected to The DFL would be expected to: The DTL would be expected toExplanation / Answer
1. Degree of Operating Leverage = Changes in Operating Income / Changes in Sales
Change in Operating Income = 13,600,000 - 12,000,000 = $1,600,000 or 13.33%
Change in Sales = 43,200,000 - 40,000,000 = $3,200,000 or 8%
Degree of Operating Leverage = 0.1333 / 0.08 = 1.67
2. Degree of Financial Leverage = Percentage Change in EPS / Percentage Change in EBIT
% change in EPS = 2.56 - 2.24 = 0.32 / 2.24 = 14.29%
% change in EBIT = 13,600,000 - 12,000,000 = $1,600,000 / 12,000,000 = 13.33%
Degree of Financial Leverage = 0.1429 / 0.1333
Degree of Financial Leverage = 1.07
3. Degree of Total Leverage = % Change in EPS / % Change in Sales
% Change in EPS = 14.29%
% Change in Sales = 43,200,000 - 40,000,000 = $3,200,000 / 40,000,000 = 8%
Degree of Total Leverage = 0.1429 / 0.08 = 1.79
If Torres Industries repay 50% of Loan:
The DOL would be expected to - Remain Same (Because DOL consider only change in Operating Income and Sales and Repayment would not affect any of them.)
The DFL would be expected to - Reduce (Because repayment will reduce interest expenses)
The DTL would be expected to - Reduce (Because of reduction in Financial Leverage)
Related Questions
Navigate
Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.