Kermit's Hardware's (KH) fixed operating costs are $20.8 million, and its variable cost ratio is 0.30. The firm has $10 million in bonds outstanding with a coupon interest rate of 9%. KH has 200,000 shares of common stock outstanding. The firm has revenues of $32.2 million, and its marginal tax rate is 40%. Compute KH's degree of financial leverage.
A) 1.22
B) 2.07
C) 1.09
D) 1.04

Question

Quizplus · Accepted Answer

First, we need to calculate KH's earnings before interest and taxes (EBIT):

EBIT = Revenues - Variable Costs - Fixed Costs
EBIT = $32.2 million - ($32.2 million x 0.30) - $20.8 million
EBIT = $3.94 million

Next, we can use EBIT to calculate KH's earnings per share (EPS):

EPS = (EBIT - Interest Expense) / Number of Shares
EPS = ($3.94 million - ($10 million x 0.09)) / 200,000
EPS = $3.39

Now, we can calculate the degree of financial leverage (DFL):

DFL = (EPS - EPS without interest) / (EBIT - Interest Expense)
DFL = ($3.39 - ($3.94 million - $0)) / ($3.94 million - ($10 million x 0.09))
DFL = 2.07

Therefore, the answer is B, with a degree of financial leverage of 2.07.

Kermit's Hardware's (KH) Fixed Operating Costs Are $20