LaGuerre Computer Animation Ltd. has a tax rate of 30%, has been trading around $44.50 for three years and has a consistent dividend payout of 35%. Last year, it had common shares outstanding of 4.2 million, no preferred shares, interest payments of $8 million and an EBIT of $29 million. Over the following year, the company repurchased 1.2 million shares with a bond issue that increased its interest payments by $2.7 million. If its EBIT rose to $32 million, what is the degree of financial leverage for LaGuerre?

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Quizplus · Accepted Answer

The degree of financial leverage (DFL) is calculated as: DFL = % change in EPS / % change in EBIT. Given the increase in EBIT from $29 million to $32 million, the % change in EBIT is ($32M - $29M) / $29M = 10.34%. To find the % change in EPS, we need to calculate the EPS before and after the share repurchase and increase in interest payments. Before: EPS = (EBIT - Interest)(1 - Tax Rate) / Shares Outstanding = ($29M - $8M)(1 - 0.3) / 4.2M = $14.7M * 0.7 / 4.2M = $2.45. After: New interest = $8M + $2.7M = $10.7M, New shares outstanding = 4.2M - 1.2M = 3M, EPS = ($32M - $10.7M)(1 - 0.3) / 3M = $14.91M * 0.7 / 3M = $3.47. % change in EPS = ($3.47 - $2.45) / $2.45 = 41.63%. DFL = 41.63% / 10.34% = 4.02, which rounds to approximately 4.06, indicating a high degree of financial leverage.