Question

Ocean Gate sells external hard drives for $200 each. Its total fixed costs are $30 million, and its variable costs per unit are $140. The corporate tax rate is 30%. If the economy is strong, the firm will sell 2 million drives, but if there is a recession, it will sell only half as many.

Answer 1

What is the firm's degree of operating leverage?

the degree of operating leverage measures the proportion of fixed costs vs. variable costs

total fixed costs = $30,000,000

contribution margin per hard drive = selling price - variable cost = $200 - $140 = $60

tax rate = 30%

expected sales = 2,000,000 hard drives

degree of operating leverage = contribution margin / (total sales - total costs) = (2,000,000 x $60) / ($400,000,000 - $280,000,000 - $30,000,000) = $120,000,000 / $90,000,000 = 1.33

DOL = 1.33

If the economy enters a recession, what will be the firm's after tax profit?

firm's EBIT = total revenue - variable costs - fixed costs

• total revenue = 1,000,000 x $200 = $200,000,000
• total variable costs = 1,000,000 x $140 = $140,000,000
• total fixed costs = $30,000,000

EBIT = $200,000,000 - $140,000,000 - $30,000,000 = $30,000,000

firm's after tax profit = EBIT x (1 - tax rate) = $30,000,000 x (1 - 30%) = $21,000,000

firm's after tax profit = $21,000,000

Answer 2

Percentage decline in sales = 50%

Profit in Recession is = $30,000,000

Decline in profit percentage is= 66.67%

Operating leverage is = 1.33 times..

Kindly see attached picture for explanation.