It\'s December 31, Last year Abderdeen Petroleum Refiners Corp. had sales of $16

Question

It's December 31, Last year Abderdeen Petroleum Refiners Corp. had sales of $16,000,000, and it forecasts that next year's sales will be $14,560,000. Its fixed costs have been and are expected to continue to be $8,800,000, and its variable cost ratio is 12.50%. Aberdeen's capital structure consists of a $13.5 million bank loan, on which it pays an interest rate of 9%, and 250,000 shares of common equity. The company's profits are taxed at a marginal rate of 40%.

Given this data, complete the following sentences:

1. The percentage change in sales is _______.

2. The percentage change in EBIT is________.

3. The degree of operating leverage (DOL) at $14,560,000 is _______.

There are several ways to use and interpret a firm's DOL value. Consider the following statement and indicate whether it accurately reflects the meaning or an appropriate use of a firm's DOL value.

"Assume that a given sales level, a firm's DOL is 2.5. This means that a 1% change in the firm's sales will result in a corresponding 2.5% change in the firm's EBIT"

This statement accurately describes a firm's DOL. (TRUE OR FALSE) Please explain.

Explanation / Answer

Hi,

Please find the answer as follows:

Part A:

% Change in Sales = (14560000 - 16000000)/16000000*100 = -9%

Part B

% Change in EBIT = (3940000 - 5200000)/5200000*100 = -24.23%

Part C:

DOL = -24.23/-9 = 2.69%

Thanks.

Year 1 Year 2 Sales 16000000 14560000 Less Variable Costs 2000000 1820000 Contribution 14000000 12740000 Fixed Costs 8800000 8800000 EBIT 5200000 3940000

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