10. McFrugal, Inc. has expected sales of $20 million.

Question

10. 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 $12 million, 8 percent bank loan. The firm also has an outstanding 1 million shares of common stock ($1 per 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.

Answer 1

a) Degree of operating leverage = Total Contribution / (Total Contribution - Fixed Cost) = (20 * (1-0.65)) / ((20 * (1-0.65)) - 2.5) = 7 / (7 - 2.5) = 7 / 4.5 = 1.556

b) Degree of Financial Leverage = % Chg in EPS / % Chg in EBIT = 1.548 (Calculate EPS and EBIT for two different sales level to determine the % change in EPS and EBIT)

c) McFrugal's EPS if sales drops to $15m = {[15 - (15 * 0.65) - 2.5 - (12 * 0.08)] * [1 - 0.4] } / 1 = $1.07 using the following equations:

EPS = {[Sales - Variable costs - Fixed Cost - Interest Expense] * [1 - tax rate]} / No of Shares