Bristal Boats,Inc.reports sales of $4,000,000,variable costs of $500,000,fixed operating costs of $1,250,000,and interest expense of $350,000.The corporation's EBIT is $3,250,000 and its marginal tax rate is 30%.If the corporation is able to increase its sales by 25%,then
A) its EBIT will increase by 25% and its EPS will increase by 25%.
B) its EBIT will increase by more than 25% and its EPS will increase by less than 25%.
C) its EBIT and EPS will both increase, but less than 25% due to fixed costs and taxes.
D) its EBIT will increase by more than 25% and its EPS will increase by more than the percentage increase in EBIT.

Question

Quizplus · Accepted Answer

- The increase in sales by 25% will result in a proportional increase in total revenue, which will be $5,000,000 ($4,000,000 x 1.25).
- Variable costs are directly proportional to the increase in sales, so variable costs will be $625,000 ($500,000 x 1.25).
- The fixed operating costs will remain the same, so they will still be $1,250,000.
- The interest expense will remain the same, so it will still be $350,000.
- Therefore, the new EBIT will be $2,775,000 ($5,000,000 - $625,000 - $1,250,000 - $350,000).
- The increase in EBIT will be 14.6% [(EBIT new - EBIT old) / EBIT old x 100%], which is less than 25% due to the fixed operating costs.
- The earnings per share (EPS) will increase by more than the percentage increase in EBIT because of the tax savings resulting from the interest expense. The new net income will be $1,942,500 ($2,775,000 x 0.7), and the increase in EPS will be 20.2% [(EPS new - EPS old) / EPS old x 100%].