Corporate Finance - Corporate Finance Section 2

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61. Refer to the following data of companies producing similar products.

	Company A	Company B
Number of units produced and sold	1.5 million	1.5 million
Sale price per unit	$150	$150
Variable cost per unit	$90	$75
Fixed operating costs	$30 million	$60 million
Fixed financing expenses	$15 million	$7.5 million
Degree of operating leverage (DOL)	?	2.14
Degree of financial leverage (DFL)	1.33	1.17

Compared with Company B, Company A has:

Option :

Explanation :

	Company A	Company B
DOL = Q (P - V) / Q (P - V) - F	1.5 (150 - 90) / 1.5 (150 - 90) - 30 = 1.5	1.5 (150 - 75) / 1.5 (150 - 75) - 60 = 2.14
DFL = Q (P - V) - F / Q (P - V) - F - C	1.5 (150 - 90) - 30 / 1.5 (150 - 90) - 30 - 15 = 1.33	1.5 (150 - 75) - 60 / 1.5 (150 - 75) - 60 - 7.5 = 1.17
DTL = DOL x DFL	1.5 x 1.33 = 2.0	2.14 x 1.17 = 2.50

The DOL is lower for Company A than Company B (as per the table),meaning Company A’s operating income is less sensitive to a change in the units sold relative to Company B. Section 3.3, 3.4 and 3.5.

62. Which of the following is most likely to happen to the degree of total leverage (DTL) if a company decides to switch to accelerated depreciation from straight line depreciation, holding all other factors constant?

Option : A
Explanation : Bases of the following equation: DTL = [Q (P - V)] / [Q (P - V) - F - C] By switching to accelerated depreciation method, the fixed cost increases. Therefore, the DTL increases (i.e. the numerator does not change and denominator decreases).