LECTURE AID

Operating Leverage (Fixed Cost)

LEVERAGE Total or Combined Leverage
Financial Leverage (Liabilities)
or Trading on Equity

LEVERAGE Means of accomplishing a purpose. It can refer to power or influence.

Any means to be employed which will improve the performance or obtain
an advantage.
Illustrative Problem (OPERATING LEVERAGE)

Last year This year

Qty. sold 4,000 4,400
Selling Price, P50
Variable cost 30
Fixed cost P 30,000
10% Bond payable P 100,000
6% Cumulative preferred stock P 200,000
Outstanding common shares 5,000
Income Tax 20%
 REQUIRED:

A. Ignoring the preferred dividend compute:

1. EPS for both year _______ _______

2. Operating break even sales P________
3. Over-all break even sales P _______
4. Degree of operating leverage (DOL) _______x
5. Degree of Financial Leverage (DFL) _______x
6. Degree of Combined Leverage (DCL) _______x
7. Assume EBIT will increase by 24% this year, what would be the sales? P _______
8. Assume that EAT will decrease by 4% this year, what would be the EBIT P_______
9. Assume that EAT will increase by 6% this year, what would be the sales? P _______
 Using Comparative Periods
Last year This year No. 7 No. 8 No. 9
Sales P __________ P __________ P __________ P __________ P __________
Variable Cost __________ __________ __________ __________ __________
Contribution Margin P __________ __________ __________ __________ __________
Fixed Costs __________ __________ __________ __________ __________
EBIT P __________ __________ __________ __________ __________
Interest __________ __________ __________ __________ __________
EBT 100% P __________ __________ __________ __________ __________
Tax 20 __________ __________ __________ __________ __________
EAT 80% P __________ __________ __________ __________ __________
Preferred Dividend __________ __________ __________ __________ __________
EAC P __________ P __________ __________ __________ __________
 OPERATING LEVERAGE (Fixed Cost)
A. Comparative Periods

1. Compute the earning after taxes (EAT) and the earnings per share (EPS) for both years.
2. Compute the operating break even peso sales.
3. What is the degree of operating leverage (DOL)?
4. Using the DOL in 200E, what will be the sales EBIT will increased by 15%?
5. What will be the EBIT if sales will increase by 5%?
6. What are the over-all break even peso sales?
7. What is the degree of financial leverage (DFL) in 200E?
8. Using the DFL in 200E, what will be the new earnings after tax (EAT) if EBIT will increase
by 10%?
9. What will be the new EBIT if EAT will decrease by 4%?
10. What is the degree of combined leverage (DCL) in 200E?
11. Using the DCL in 200E what will be the sales if the EAT will increase by 6%?
12. What will be the EAT if sales will decrease by 5%?
B. Assume that in problem A, there are preferred dividends in the amount of 12,000.

REQUIRED:

1. What will be the new EPS in 200E?

2. What will be the new DFL in 200E?
3. What will be the new DCL in 200E?

C. Single Period
1. In problem A, recompute the DOL, DFL and DCL using this year 200E only (ignore
preferred dividend).
2. In problem A, recompute the DFL and DCL (consider the preferred dividend)
 Exercises 1 (without preferred share capital)

Compute the missing items for the independent cases below.

Case 1 Case 2 Case 3 Case 4
Contribution Margin (CM) 45,000 120,000 ? ?
Fixed costs (FC) 30,000 ? 225,000 12,000
Earnings before interest and taxes (EBIT) ? ? ? 36,000
Interest (I) 5,000 ? 15,000 ?
Earnings before taxes (EBT) ? ? ? ?
Degree of operating leverage (DOL) ? 2.5x 4x ?
Degree of financial leverage (DFL) ? 6. x ? 3x
Degree of combined leverage (DCL) ? ? ? ?
D. Trinity Company has Sales of P 300,000 with contribution margin of 40%. Fixed
costs are P 70,000. 10 % bonds of 100,000 and 6% cumulative preferred stock of
P 200,000 are outstanding. Income taxes are 20%

REQUIRED:
1. Degree of operating leverage
2. Degree of financial leverage
3. Degree of combined operating leverage

E. A comparison of the income statements of two companies are reproduced below.

Company X Company Y
Sales P 3,000,000 P 3,000,000
Contribution margin 25% 40%
Return on sales 10% 10%

REQUIRED: Which of the two companies is more highly leveraged?

FINANCIAL LEVERAGE (Liabilities) Dupont Formula

A. Shown below are the operating data provided by Pontdu Company

Sales P 2,400,000
Total Assets 1,200,000
Total Liabilities 240,000
Gross profit rate 30% of sales
Expenses 13 1/3% of sales
Income taxes 25%

REQUIRED:

1. Compute the net profit after taxes.

2. Compute the return on assets (ROA), return on sales (ROS) and assets turnover
(ATO) and express their relationship in an equation form.
3. Compute the return on equity (ROE), return on sales (ROS) and equity turnover
(ETO) and express their relationship in an equation form.
B. Compute the missing items for the independent cases below:

Case 1 Case 2 Case 3

Sales ? 2,500,000 ?
Net Income 280,000 ? 800,000
Total Assets ? 2,000,000 ?
Total Liabilities 224,000 ? ?
Owner’s Equity ? ? ?
Return on Sales (ROS) 20% ? ?
Return on Assets (ROA) ? ? 16%
Return on Equity (ROE) ? 8% 20%
Asset Turnover (ATO) 1.25x ? 2x
Equity Turnover (ETO) 1.5625x 2x ?
C. The return on assets (ROA) of Barbi Company was 24% last year with a return on
sales (ROS) of 4% the return on sales (ROS) for both years remained the
same on assets (ROA) this year is 20% and the debt ratio is 20%

1. What was the increase or decrease in the equity turnover (ETO)?

D. The return on equity (ROE) of Charlie Company increased from 20% last year to
24% this year with the same return on sales (ROS) of 5%. The equity ratio
(ETO) was 75%.

1. What was the increase or decrease in the asset turnover (ATO)?

E. Darwin Company has an asset turnover (ATO) of 1.2x and a profit margin ratio
(ROS) of 10%. The return (ROA) can be doubled by increasing the profit margin
(ROS) by 50% and increasing the asset turnover (ATO). The equity ratio (ETO) is
80%

1. What was the increase or decrease in the equity turnover (ETO)?

F. Erwin Company has an asset turnover (ATO) of 4x and a profit margin (ROS) of 4%
with a debt ratio of 20%. The company wants to double the return on equity (ROE)
by increasing the profit margin (ROS) by 2% with the same asset turnover (ATO).

1. What will be the new debt ratio?

Problem 1
Company Nel and Company Son are engaged in the same line of business. Show
are their considered Balance Sheets.
Company Nel Company Son
Current Assets P 600,000 P 600,000
Non-Current Assets 1,400,000 1,200,000
Total 2,000,000 2,000,000

Current Liabilities P 500,000 P 200,000

8% Bonds Payable - 1,000,000
Stockholder’s Equity 1,500,000 800,000
Total 2,000,000 2,000,000
 The earnings before interest and taxes (EBIT) for both companies are P 400,000.
Income taxes are 25%

REQUIRED:
1. For both companies, compute the return on assets (ROA)
2. For both companies, compute return on equity (ROE)
3. Did both companies obtain a favorable financial leverage?
4. For Company Son, compute the net benefit
Problem 2
You are provided with the following comparative condensed Balance Sheets of Violet
Company:
200F 200G
Total Assets P 1,800,000 P 2,200,000
Current Liabilities:
Accounts Payable 200,000 450,000
Long-term Notes Payable (current) 150,000 250,000
Lon-term Notes Payable 450,000 900,000
Stockholder’s Equity 1,000,000 600,000
Total P 1,800,000 P 2,200,000

Earnings before interest and taxes P 486,000 P 520,000

Interest on the long-term notes, 6%
Income tax, 20%
REQUIRED:

1. For both years, compute the return on assets (ROA)

2. For both years, compute return on equity (ROE)
3. Did both years obtain a favorable financial leverage?
4. To what extent did the financial leverage improve the net income for both years.