Corporate Finance - Corporate Finance Section 2

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61. Refer to the following data of companies producing similar products.

 Company A Company B
Number of units produced and sold 1.5 million1.5 million
Sale price per unit $150$150
Variable cost per unit  $90$75
Fixed operating costs  $30 million$60 million
Fixed financing expenses $15 million$7.5 million
Degree of operating leverage (DOL) ?2.14
Degree of financial leverage (DFL) 1.331.17

  • Option :
  • Explanation :
     Company A Company B
    DOL
    = Q (P - V) / Q (P - V) -
    F


    1.5 (150 - 90) / 1.5 (150 - 90)
    - 30 = 1.5
    1.5 (150 - 75) / 1.5 (150 - 75) -
    60 = 2.14
    DFL
    = Q (P - V) - F / Q (P -
    V) - F - C


    1.5 (150 - 90) - 30 / 1.5 (150 -
    90) - 30 - 15 = 1.33
    1.5 (150 - 75) - 60 / 1.5 (150 -
    75) - 60 - 7.5 = 1.17
    DTL
    = DOL x DFL
     
    1.5 x 1.33 = 2.02.14 x 1.17 = 2.50
    The DOL is lower for Company A than Company B (as per the table),meaning Company A’s operating income is less sensitive to a change in the units sold relative to Company B. Section 3.3, 3.4 and 3.5.
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62. Which of the following is most likely to happen to the degree of total leverage (DTL) if a company decides to switch to accelerated depreciation from straight line depreciation, holding all other factors constant?

  • Option : A
  • Explanation : Bases of the following equation: DTL = [Q (P - V)] / [Q (P - V) - F - C] By switching to accelerated depreciation method, the fixed cost increases. Therefore, the DTL increases (i.e. the numerator does not change and denominator decreases).
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