A firm's degree of financial leverage is 2 and the degree of operating leverage is 2.5. An uncertain economic outlook could mean a 10% reduction in the current level of sales. The firm is considering an increase of its degree of financial leverage to 3 by issuing additional debt. The degree of total leverage suggests that the sales volatility could result in a decrease in EPS of as much as:
A)5.5% if the additional debt is not issued.
B)7.5% if the additional debt is issued.
C)55% if the additional debt is issued.
D)75% if the additional debt is issued.

Question

Quizplus · Accepted Answer

The degree of total leverage (DTL) is the product of the degree of operating leverage (DOL) and the degree of financial leverage (DFL). Initially, DTL = 2.5 * 2 = 5. If the firm increases its DFL to 3, then DTL = 2.5 * 3 = 7.5. A 10% decrease in sales with a DTL of 7.5 results in a 75% decrease in EPS.

A Firm's Degree of Financial Leverage Is 2 and the Degree