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    Blackwell Company Operating Leverage

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    Blackwell 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:

    Blackwell 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%.

    Based on the data provided, answer to the following questions:

    a. Calculate the degree of operating leverage using the following formula:

    DC=S-TVC/S-TVC-FC-I

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    b. Calculate the degree of financial leverage using the following formula:

    DCL = S-TVC/S-TVC-FC-I

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    c. Calculate the degree of combined leverage before expansion using the following formula:

    DCL = S-TVC/S-TVC-FC-I

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    d. Construct the income statement for the two financial plans.

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    e. Calculate the degree of operating leverage, the degree of financial leverage, and the degree of combined leverage, after expansion, for the two financing plans.
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    f. Explain which financing plan you favor and the risks involved.

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