ECG has a contribution margin of $196,000.If ECG earned $87,000 before taxes in the year,what is the firm's Degree of Combined Leverage?
A) 2.26x
B) 1.27x
C) 0.44x
D) 1.29x

Question

Quizplus · Accepted Answer

Degree of combined leverage = Degree of operating leverage x Degree of financial leverage
Degree of operating leverage (DOL) = Contribution margin/EBIT = ($196,000/$87,000) = 2.25x
Degree of financial leverage (DFL) = EBIT/EBT = ($87,000/EBT)
EBT = EBIT - Interest expense
Assuming no other expenses than interest expense, EBT = $87,000 - Interest expense
DFL = $87,000/($87,000 - Interest expense)
Degree of combined leverage (DCL) = DOL x DFL = 2.25x x [$87,000/($87,000 - Interest expense)]
We need to find the Interest expense to calculate DFL:
EBT = $87,000 - Interest expense
Since we don't have any information about the interest rate or the value of Interest expense, we cannot calculate the exact value of DFL and DCL. However, we can say with certainty that A) 2.26x is the best choice, as it is the closest to the calculated value of DOL multiplied with a DFL that assumes a 100% equity financing, which would be the highest possible value for DCL.

ECG Has a Contribution Margin of $196,000