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McFrugal, Inc. - Leverage and EPS

McFrugal, Inc. has expected sales of $20 million. Fixed operating costs are $2.5 million, and the variable cost ratio is 65 percent. McFrugal has outstanding a $12 million, 8 percent bank loan. The firm also has outstanding 1 million shares of common stock ($1 par value). McFrugal's tax rate is 40 percent.

a. What is McFrugal's degree of operating leverage at a sales level of $20 million?

b. What is McFrugal's current degree of financial leverage?

c. Forecast McFrugal's EPS if sales drop to $15 million.

Solution Preview

Solution also attached as a fully formatted Excel spreadsheet.

Bank loan= $12,000,000

Revenue= $20,000,000
Less: Variable costs @ 65% 13,000,000 =65.% x $20,000,000.
Contribution 7,000,000
Less Fixed costs 2,500,000
Earnings before interest and taxes (EBIT) . . . . . . . . . . . . . . . . . 4,500,000
Less Interest expense @ 8% 960,000 =8.% x $12,000,000.
Earnings before taxes (EBT) . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,540,000
Less Taxes @ 40% 1,416,000 =40.% x $3,540,000.
Net Income= 2,124,000

Number of shares= 1,000,000
EPS= $2.124 =$2,124,000. / ...

Solution Summary

The solution calculates the operating and financial leverage and calculates EPS at a particular sales level.

$2.19