A company has an EBIT of $4 million, and its degree of total leverage is 2.4. The firm's debt consists of $20 million in bonds with a YTM of 10%. The company is considering a new production process that will require an increase in fixed costs but a decrease in variable costs. If adopted, the new process will result in a degree of operating leverage of 1.4. The president wants to keep the degree of total leverage at 2.4. If EBIT remains at $4 million, what dollar amount of bonds must be outstanding to accomplish this (assuming the yield to maturity remains at 10%)?
A) $16,666,667
B) $20,258,438
C) $19,293,750
D) $18,375,000
E) $17,500,000

Question

Quizplus · Accepted Answer

The correct answer is A.The degree of total leverage is calculated as EBIT / (EBIT - Interest). In this case, the degree of total leverage is 2.4, so we can solve for interest as follows:Interest = EBIT / (Degree of total leverage) - EBITInterest = $4 million / (2.4) - $4 millionInterest = $1.6666667The interest expense is equal to the yield to maturity times the amount of bonds outstanding. In this case, the yield to maturity is 10%, so we can solve for the amount of bonds outstanding as follows:Amount of bonds outstanding = Interest / Yield to maturityAmount of bonds outstanding = $1.6666667 / 0.10Amount of bonds outstanding = $16,666,667

A Company Has an EBIT of $4 Million, and Its