Drake Company is planning to expand production because of the
increased volume of sales. The CFO estimates that the increased
capacity will cost $2,000,000. The expansion can be financed either by
bonds at an interest rate of 12% or by selling 40,000 shares of common
stock at $50 per share. The current income statement (before
expansion) is as follows:

Drake Company
Income Statement
200X
Sales		$3,000,000
Less: Variable costs (40%)	$1,200,000	
Fixed costs	800,000	
Earnings before interest and taxes		1,000,000
Less: Interest expense		400,000
Earnings before taxes		600,000
Less: Taxes (@ 35%)		210,000
Earnings after taxes			390,000
Shares		100,000
Earnings per share		$3.90

Assume that after expansion, sales are expected to increase by
$1,500,000. Variable costs will remain at 40% of sales, and fixed
costs will increase by $550,000. The tax rate is 35%.

a)	Calculate the degree of operating leverage, the degree of financial
leverage, and the degree of combined leverage, before expansion.
b)	Construct the income statement for the two financial plans.
c)	Calculate the degree of operating leverage, the degree of financial
leverage, and the degree of combined leverage, after expansion, for
the two financing plans.
d)	Explain which financing plan you favor and the risks involved.

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Request for Question Clarification by scriptor-ga on 17 Aug 2005 17:33 PDT

May I respectfully suggest that you do your homework assignment
yourself? Google Answers discourages and may remove such questions.

Scriptor

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Clarification of Question by hacc-ga on 17 Aug 2005 17:56 PDT

Thanks for the concern, but these are practice problems that I am
having trouble with!

Practice questions are also homework, maybe not assigned homework. 
But I seriously doubt that persons attempting to solve practice
questions which are not assigned, would ask here.  Their interest in
learning would preclude that, or they would ask for confiramtion that
their solution was correct.