Question

. Gibson Company sales for the year 2019 were $4.5 million. The firm’s variable operating cost ratio was 0.45 and fixed costs (that is, overhead and depreciation) were $1 million. Its average (and marginal) income tax rate is 25 percent. Currently, the firm has $2.4 million of long-term bank loans outstanding at an average interest rate of 12 percent. The remainder of the firm’s capital structure consists of common stock (110,000 shares outstanding at the present time). a. Calculate Gibson’s degree of combined leverage for 2019. b. Gibson is forecasting a 15 percent increase in sales for this year (2020). Furthermore, the firm is planning to purchase additional labor-saving equipment which will increase fixed costs by $200,000 and will reduce the variable cost ratio to 0.42. Financing this equipment with debt will require additional bank loans of $900,000. Calculate Gibson’s expected degree of combined leverage for 2020. c. Determine how much Gibson must reduce its interest expenses in 2020 (for example, through the sale of common stock) to maintain its DCL at the 2019 level. d. Assuming that the debt is permanent (or perpetual) what is the reduction in debt associated with the interest expense reduction in part c?

Answer 1

See solutions below

Step-by-step explanation:

1. The degree of combined leverage

= (Sales - Variable costs) / EBIT - Interest

Sales = $4.5 million

Variable costs = 0.45 × $4.5 million

= $2,025,000

EBIT = $4,500,000 - $2,025,000 - $1,000,000

= $1,475,000

Interest = 12% × $2,400,000

= $288,000

Therefore,

DCL = [$4,500,000 - $2,025,000] / $1,475,000 - $288,000

= $2,475,000 / $1,187,000

= 2.09

2. Gibson expected degree of leverage

Sales = 15% × $4.5 million

= $5,175,000

Fixed cost = $200,000 + $1,000,000

= $1,200,000

Variable cost = $0.42 × $2,025,000 - $2,025,000

= $2,025,000 - $850,500

= $1,174,500

EBIT = $5,175,000 - $1,174,500 - $1,200,000

= $2,800,500

Interest = $2,400,000 + $900,000

= 12% × $3,300,000

= $396,000

DCL = $5,175,000 - $1,174,500 / $2,800,500 - $396,000

= $4,000,500 / $2,404,500

= 1.66