5-16.
DeSoto Tools, Inc., is planning to expand production. The expansion will cost
$300,000, which can be financed either by bonds at an interest rate of 14 percent
or by selling 10,000 shares of common stock at $30 per share. The current
income statement before expansion is as follows:
DeSoto Tools, Inc.
Income Statement
199X
Sales ..............................................................
Less: Variable costs.....................................
Fixed costs.................................................
Earnings before interest and taxes.................
Less: Interest expense .................................
Earnings before taxes ....................................
Less: Taxes @ 34% .....................................
Earnings after taxes .......................................
Shares ............................................................
Earnings per share .........................................
$1,500,000
$ 450,000
550,000
1,000,000
500,000
100,000
400,000
136,000
$ 264,000
100,000
$2.64
After the expansion, sales are expected to increase by $1,000,000. Variable costs
will remain 30 percent of sales, and fixed costs will increase to $800,000. The
tax rate is 34 percent.
a. Calculate the degree of operating leverage, the degree of financial leverage,
and the degree of combined leverage before expansion. (For the degree of
operating leverage, use the formula developed in footnote 2; for the degree
of combined leverage, use the formula developed in footnote 3. These
instructions apply throughout this problem.)
5-16. Continued
b. Construct the income statement for the two alternative financing plans.
c. Calculate the degree of operating leverage, the degree of financial leverage,
and the degree of combined leverage, after expansion.
d. Explain which financing plan you favor and the risks involved with each
plan.
Solution:
DeSoto Tools, Inc.
a.
DOL 

DFL 
S  TVC
S  TVC  FC
$1,500,000  $450,000
 2.1x
$1,500,000  $450,000  $550,000
EBIT
EBIT  I

$500,000
$500,000  $100,000

$500,000
 1.25x
$400,000
5-16. Continued
DCL 
S  TVC
S  TVC  FC  I

$1,500,000  $450,000
$1,500,000  $450,000  $550,000  $100,000

$1,050,000
 2.63x
$400,000
b. Income Statement After Expansion
Sales
Less: Variable Costs (30%)
Fixed Costs
EBIT
Less: Interest
EBT
Less: Taxes @ 34%
EAT (Net Income)
Common Shares
EPS
Debt
$2,500,000
750,000
800,000
950,000
142,0001
808,000
274,720
533,280
100,000
$5.33
Equity
$2,500,000
750,000
800,000
950,000
100,000
850,000
289,000
561,000
110,0002
$5.10
1
New interest expense level if expansion is financed with debt.
$100,000 + 14% ($300,000) = $142,000
2
Number of common shares outstanding if expansion is
financed with equity.
100,000 + 10,000 = 110,000
5-16. Continued
c.
DOL 
DOL Debt/Equit y  

DFL 
S  TVC
S  TVC  FC
$2,500,000  $750,000
$2,500,000  $750,000  $800,000
$1,750,000
 1.84x
$950,000
EBIT
EBIT  I
DFL Debt  
$950,000
$950,000

 1.18x
$950,000  $142,000 $808,000
DFL Equity  
$950,000
$950,000

 1.12x
$950,000  $100,000 $850,000
DCL Debt  

$2,500,000  $750,000
$2,500,000  $750,000  $800,000  $142,000
$1,750,000
 2.17 x
$808,000
5-16. Continued
DCL Equity  

$2,500,000  $750,000
$2,500,000  $750,000  $800,000  $100,000
$1,750,000
 2.06x
$850,000
d. The debt financing plan provides a greater earnings per share at the
new sales level, but provides more risk because of the increased use
of debt. However, the interest coverage ratio in both cases is
certainly satisfactory and interest expense is well protected. The
crucial point is expectations for future sales. If sales are expected to
decline, the debt plan will not provide higher EPS at sales of less
than about $2 million so cyclical swings in sales, earnings, and
profit margins need to be considered in choosing the financing plan.