Question

OceanGate 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.

a. What is the firm's degree of operating leverage in going from a recession to a strong economy?
b. If the economy enters a recession, what will be the firm's after-tax profit?

Answer 1

a) 1.33

b) $21,000,000

Step-by-step explanation:

EBIT in normal economy = (total units sold x contribution margin) - total fixed costs = (2,000,000 x $60) - $30,000,000 = $90,000,000

EBIT in recessive economy = (total units sold x contribution margin) - total fixed costs = (1,000,000 x $60) - $30,000,000 = $30,000,000

degree of operating leverage = % change in EBIT / % change in sales

• % change in EBIT = ($30 - $90) / $90 = -66.67%
• % change in sales = (1 - 2) / 2 = -50%

degree of operating leverage = -66.67% / -50% = 1.33

firm's after tax profit in a recession = EBIT x (1 - tax rate) = $30,000,000 x 0.7 = $21,000,000