Question

The _________ is the percentage change in EPS that results from a given percentage change in sales, and it equals the product of the degrees of operating and financial leverage.

Expert Analysts Resources (EAR) has provided you with the following information about three companies you are currently evaluating:

Galaxy Corp. Three Waters Co. General Products Co.
Degree of Operating Leverage 2.0 3.0 4.0
Degree of Financial Leverage 4.5 2.7 2.6

According to this information, which company would be considered the riskiest?

Answer 1

General Products Co. is considered to be the riskiest.

Step-by-step explanation:

The degree of total leverage (DTL) is the percentage change in EPS that results from a given percentage change in sales, and it equals the product of the degrees of operating and financial leverage.

Both degrees of operating and financial leverage help a company in quantifying its operational risk. Therefore, a company high level of degree of total leverage is much riskier than a company with less degree of total leverage. This is because a high degree of total leverage implies that there will be more fixed costs to the company.

Galaxy Corp:

Degree of Operating Leverage 2.0

Degree of Financial Leverage 4.5

degree of total leverage (DTL) = Degree of Operating Leverage ×

Degree of Financial Leverage

degree of total leverage (DTL) = 2 × 4.5 = 9

Three Waters Co:

Degree of Operating Leverage 3.0

Degree of Financial Leverage 2.7

degree of total leverage (DTL) = Degree of Operating Leverage ×

Degree of Financial Leverage

degree of total leverage (DTL) = 3 × 2.7 = 8.1

General Products Co:

Degree of Operating Leverage 4.0

Degree of Financial Leverage 2.6

degree of total leverage (DTL) = Degree of Operating Leverage ×

Degree of Financial Leverage

degree of total leverage (DTL) = 4 × 2.6 = 10.4

General Products Co has the highest of total leverage and would therefore be considered the riskiest.