OceanGate sells external hard drives for $140 each. Its total fixed costs are $2
ID: 2792589 • Letter: O
Question
OceanGate sells external hard drives for $140 each. Its total fixed costs are $20 million, and its variable costs per unit are $100. The corporate tax rate is 30%. If the economy is strong, the firm will sell 5 million drives, but if there is a recession, it will sell only half as many.
What is the firms' degree of operating leverage (defined as the ratio of the percent change in EBIT to the percent change in sales)?
If the economy enters a recession, what will be the firm’s after-tax profit? (Enter your answer in millions.)
OceanGate sells external hard drives for $140 each. Its total fixed costs are $20 million, and its variable costs per unit are $100. The corporate tax rate is 30%. If the economy is strong, the firm will sell 5 million drives, but if there is a recession, it will sell only half as many.
Explanation / Answer
a) If economy is strong
Sales = 5*140 = $700 million
Variable cost = 100*5 = $500 million
Fixed cost = $20 million
EBIT = Sales - variable cost - fixed cost = 700-500-20 = $180 million
If there is recession,
Firm will sell 5/2 = 2.5 million drives
Sales = 2.5*140 = $350 million
Variable cost = 100*2.5 = $250 million
Fixed cost = $20 million
EBIT = sales - variable cost - fixed cost = 350 - 250 - 20 = $80 million
% change in sales if economy moves from strong to recession = (350-700)/700 = -50%
% change in EBIT if economy moves from strong to recession = (80-180)/180 = -55.6%
degree of operating leverage = percent change in EBIT/percent change in sales = -55.6%/-50.0% = 1.11
b) If there is recession,
Sales = 2.5*140 = $350 million
Variable cost = 100*2.5 = $250 million
Fixed cost = $20 million
EBIT = sales - variable cost - fixed cost = 350 - 250 - 20 = $80 million
There is no interest so profit before tax = $80 million
Tax = 30%
Profit after tax = Profit before tax *(1-tax) = 80*(1-0.3) = $56 million
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