35 - Measure of Leverage

Question 1

Given the following information on the annual operating results for ArtFrames, a producer of quality metal picture frames:

Sales of $3,500,000.
Variable costs at 45% of sales.
Fixed costs of $1,050,000.
Debt interest payments on $750,000 issued at par with an annual 9.0% coupon; market yield is currently 7.0%.
ArtFrames’s degree of operating leverage (DOL) and degree of financial leverage (DFL) are closest to:

DOL DFL

Answer 1

Explanation
DOL = (sales – variable costs) / (sales – variable costs – fixed costs)

Variable costs = $3,500,000 × 45% = $1,575,000

Fixed costs = $1,050,000

DOL = ($3,500,000 – $1,575,000) / ($3,500,000 – $1,575,000 – $1,050,000) = 2.20

DFL = EBIT / (EBIT – interest)

Interest = $750,000 × 9% = $67,500

EBIT = sales – variable costs – fixed costs = $3,500,000 – $1,575,000 – $1,050,000 = $875,000

DFL = $875,000 / ($875,000 – $67,500) = 1.08

(Module 35.1, LOS 35.b)