Illinois Tool Company's (ITC) fixed operating costs are $1,260,000, and its variable cost ratio (i.e., variable costs as a fraction of sales) is 0.70. The firm has $3,000,000 in bonds outstanding at an interest rate of 8%. ITC has 30,000 shares of $5 preferred stock and 150,000 shares of common stock outstanding. ITC is in the 50% corporate income tax bracket. Forecasted sales for next year are $9 million. What is ITC's degree of combined leverage at a sales level of $10 million?
A) 2.00
B) 1.72
C) 2.50
D) 1.25

Question

Quizplus · Accepted Answer

The degree of combined leverage (DCL) is calculated as the percentage change in EPS divided by the percentage change in sales. First, calculate the contribution margin: Sales - Variable Costs = $10,000,000 - ($10,000,000 * 0.70) = $3,000,000. Then, calculate EBIT: Contribution Margin - Fixed Costs = $3,000,000 - $1,260,000 = $1,740,000. Interest expense is $240,000 ($3,000,000 * 0.08). EBT = EBIT - Interest = $1,740,000 - $240,000 = $1,500,000. Tax = $750,000 (50% of EBT). Net Income = $750,000. Preferred dividends = $150,000 (30,000 shares * $5). Earnings available to common shareholders = $600,000. DCL = (Sales / (Sales - Variable Costs - Fixed Costs - Interest)) = $10,000,000 / ($10,000,000 - $7,000,000 - $1,260,000 - $240,000) = 2.50.

Illinois Tool Company's (ITC) Fixed Operating Costs Are $1,260,000, and Its