Assume that a firm has a degree of financial leverage of 1.25.If sales increase by 20%,the firm will experience a 60% increase in EPS,and it will have an EBIT of $100,000.What will be the EBIT for this firm if sales do not increase?
A)$57,931
B)$60,980
C)$64,189
D)$67,568
E)$70,946

Question

Quizplus · Accepted Answer

Given,
Degree of financial leverage = 1.25
Percentage change in sales = 20%
Percentage change in EPS = 60%
EBIT = $100,000

Using the formula of the percentage change in EPS,
60% = DFL × 20%
DFL = 3

Using the formula of DFL,
DFL = EBIT/EPS

So, EPS = EBIT/DFL

$100,000/3 = $33,333.33

Now, we can find the EBIT when there is no change in sales using the formula of DFL,
DFL = (EBIT - I) / (EBIT - I - PD)
1.25 = (EBIT - I) / (EBIT - I - PD)

We don't have any information about interest (I) and preferred dividends (PD), so we can assume them to be zero. Therefore,
1.25 = EBIT/EBIT
EBIT = $80,000

Hence, the EBIT for this firm if sales do not increase is $80,000.
Option D is correct.

Assume That a Firm Has a Degree of Financial Leverage