PQR Manufacturing Corporation has $1,500,000 in debt outstanding.The company's before-tax cost of debt is 10%.Sales for the year totaled $3,500,000 and variable costs were 60% of sales.Net income was equal to $600,000 and the company's tax rate was 40%.If PQR's degree of total leverage is equal to 1.40,what is its degree of operating leverage?
A)1.0987
B)1.1565
C)1.2174
D)1.2783
E)1.3422

Question

Quizplus · Accepted Answer

Degree of total leverage = degree of operating leverage x degree of financial leverage

Given that degree of total leverage = 1.40 and degree of financial leverage can be calculated as follows:

Degree of financial leverage = (Earnings before interest and taxes (EBIT) / (EBIT - Interest expense))

Since net income was given, we can use the formula:

EBIT = Net income / (1 - Tax rate) = $1,000,000

Interest expense = Total debt x Before-tax cost of debt = $1,500,000 x 10% = $150,000

Therefore, degree of financial leverage = $1,000,000 / ($1,000,000 - $150,000) = 1.1765

Substituting the values:

1.40 = degree of operating leverage x 1.1765

Degree of operating leverage = 1.40 / 1.1765 = 1.2174

Therefore, the answer is (C)

PQR Manufacturing Corporation Has $1,500,000 in Debt Outstanding