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# Degree of operating leverage

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(See attached file for full problem description)

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1) Tyson 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:
Tyson 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 the following questions:
a) Calculate the degree of operating leverage using the following formula:
DOL = S-TVC
S-TVC-FC
b) Calculate the degree of financial leverage using the following formula:
DFL = EBIT
EBIT-I
c) Calculate the degree of combined leverage before expansion using the following formula:
DCL = S-TVC
S-TVC-FC-I

2) You are the Vice President of Finance for Richmond Resources, headquartered in Phoenix, Arizona. In January 2002, your firm's Canadian subsidiary obtained a 6-month loan of \$100,000 Canadian dollars from a bank in Tucson to finance the acquisition of a titanium mine in Quebec province. The loan will be repaid in Canadian dollars. At the time when Richmond's Resources obtained the loan, the spot exchange rate was USD \$0.6580/\$1 Canadian dollar and the currency was selling at a discount in the forward market. The June 2002 contract (face value = \$100,000 USD per contract) was quoted at USD \$0.6520/\$1 Canadian dollar.

a) Explain how the Tucson bank could lose on this transaction assuming no hedging.

b) If the bank does hedge with the forward contract, what is the maximum amount it can lose?

3) Mary Watson has \$100,000 that she can deposit in any of three savings accounts for a 3-year period. Bank A compounds interest on an annual basis, bank B compounds interest twice each year, and bank C compounds interest each quarter. All three banks have a stated annual interest rate of 4 percent.

a) What amount would Ms. Watson have at the end of the third year-including interest?

b) What effective interest rate would she earn at each bank?

c) On the basis of your finding in a and b, which bank should Ms. Watson deal with? Why?

4) Smith Industries has a \$1,000 par value bond with an 8 percent coupon interest rate outstanding. The bond has 12 years remaining to maturity date.
If interest is paid annually, what is the value of the bond when the required return is:
&#61492; 7%
&#61492; 8%
&#61492; 10%

5) Given the following lists of outlays, indicate whether each is normally considered a capital or an operating expenditure. Explain your answers.

a) Initial lease payment of \$5,000 for electronic point-of-sale cash register systems.
b) Outlay of \$20,000 to purchase patent rights from an inventor.
c) Outlay of \$240,000 for a new building.
d) An \$80,000 investment in a portfolio of marketable securities.
e) A \$300 outlay for an office machine.
f) An outlay of \$1,000 for a marketing research report.
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(See attached file for full problem description)

#### Solution Preview

1) Tyson 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:
Tyson 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 ...

#### Solution Summary

This explains the calculation of degree of operating leverage and other financial concepts

\$2.19