A company currently sells 75,000 units annually. At this sales level, its EBIT is $4 million, and its degree of total leverage is 2.0. The firm's debt consists of $15 million in bonds with a 9.5% coupon. The company is considering a new production method which will entail an increase in fixed costs but a decrease in variable costs, and will result in a degree of operating leverage of 1.600. The president, who is concerned about the stand-alone risk of the firm, wants to keep the degree of total leverage at 2.0. If EBIT remains at $4 million, what dollar amount of bonds must be retired to accomplish this?
A) $6,250,000
B) $6,907,895
C) $6,578,947
D) $5,937,500
E) $5,640,625

Question

Quizplus · Accepted Answer

To maintain the degree of total leverage at 2.0 with a new degree of operating leverage of 1.6, the degree of financial leverage must be adjusted. The degree of financial leverage (DFL) is calculated as DTL / DOL. With DTL = 2.0 and DOL = 1.6, DFL = 2.0 / 1.6 = 1.25. The interest on the bonds is $15 million * 9.5% = $1.425 million. To achieve a DFL of 1.25, the new interest must be $4 million / 1.25 = $3.2 million. Therefore, the new bond amount is $3.2 million / 9.5% = $33.684 million. The amount of bonds to retire is $15 million - $33.684 million = $6,578,947.

A Company Currently Sells 75,000 Units Annually