Leverage
Martinsburg Manufacturing is involved in the production of hairdryers
for the beauty industry. Their financial information is as follows:
Capital Structure
Debt @12%				$600,000
Common stock, $10 per share		$400,000
Total					$1,000,000
Common shares				$40,000

Operating Plan
Sales (50,000 units at $20 each)	  $1,000,000
Less: Variable costs			  $500,000
Fixed costs				  $300,000
Earnings before interest and taxes (EBIT) $200,000

a.  What is the degree of leverage?

---

Request for Question Clarification by omnivorous-ga on 08 May 2005 19:42 PDT

Ezpikens --

There are multiple kinds of "leverage," including operating leverage
and financial leverage.  This firm enjoys both of the above (if not
more).  What are you concerned with?

Best regards,

Omnivorous-GA

Hi ezpikens!!


since you do not ask for a specific degree of leverage I will
calculate DOL (degree of operating leverage), DFL (degree of financial
leverage) and DTL (degree of total leverage).


- DOL:

Degree of operating leverage = Sales revenue less total variable cost
divided by sales revenue less total cost:

DOL = (Sales-Variable Costs) / (Sales-Variable Costs-Fixed Costs) =
    = ($1,000,000 - $500,000) / ($1,000,000 - $500,000 - $300,000) =
    = $500,000 / $200,000 =
    = 2.5

Degree of operating leverage:
- It measures the EBIT's percentage change as a result of a change of
one percent in the level of output.
- It helps in measuring the business risk.


- DFL:

The degree of financial leverage (DFL) is defined as the percentage
change in earnings per share [EPS] that results from a given
percentage change in earnings before interest and taxes (EBIT), and is
calculated as follows:

DFL = Percentage change in EPS divided by Percentage change in EBIT

The above equation is similar to this other:

DFL = EBIT / (EBIT-I)

Where I is the interest paid (on debt), in this case:

I = 0.12 * $600,000 = $72,000

Then :
DFL = $200,000 / ($200,000 - $72,000) =
    = $200,000 / $128,000 =
    = 1.5625

Degree of financial leverage:
- It measures the EPS' change in percentage that results from a change
in one percent in EBIT.
- It helps in measuring the financial risk of the company.


- DTL:

Degree of total leverage is the product of operating leverage and
financial leverage:

DTL = DOL * DFL =
    = 2.5 * 1.5625 =
    = 3.90625

Degree of total leverage
- It measures the percentage change in EPS that results from a change
in one percent in output.
- It assists in measuring the firm?s total risk.


For references see:
"DEGREE OF LEVERAGE": (PDF file - use Acrobat Reader)
At this page you will find the definitions and detailed development of
the formulas used in the resolution of the problem.
http://www.businessfaculty.utoledo.edu/lbowyer/buad3040%2012Appendix.pdf


"Operating and Financial Leverage": (PowerPoint presentation)
http://wps.pearsoned.co.uk/wps/media/objects/1670/1710211/0273685988_ch16.ppt



I hope that this helps you. Feel free to request for a clarification
if you need it.
Regards.
livioflores-ga

Exellant!  Thanks!