A company has an EBIT of $4 million,and its degree of total leverage is 2.4.The firm's debt consists of $20 million in bonds with a YTM of 10%.The company is considering a new production process that will require an increase in fixed costs but a decrease in variable costs.If adopted,the new process will result in a degree of operating leverage of 1.4.The president wants to keep the degree of total leverage at 2.4.If EBIT remains at $4 million,what dollar amount of bonds must be outstanding to accomplish this (assuming the yield to maturity remains at 10%)?
A)$16,666,667
B)$17,500,000
C)$18,375,000
D)$19,293,750
E)$20,258,438

Question

Quizplus · Accepted Answer

The correct answer is A.The degree of total leverage is calculated as EBIT / (EBIT - Interest). If the degree of total leverage is to remain at 2.4, then the new EBIT / (EBIT - Interest) must also be 2.4.Given that EBIT remains at $4 million, the new interest expense must be $4 million / 2.4 - $4 million = $1.666667 million.The new bonds must have a face value of $1.666667 million / 0.10 = $16,666,667.

A Company Has an EBIT of $4 Million,and Its Degree