PQR Manufacturing Corporation has $1,500,000 in debt outstanding. The company's before-tax cost of debt is 10 percent. Sales for the year totaled $3,500,000 and variable costs were 60 percent of sales. Net income was equal to $600,000 and the company's tax rate was 40 percent. If PQR's degree of total leverage is equal to 1.40, what is its degree of operating leverage?
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A. B. C. D. E.B
First, calculate PQR's DFL as EBIT/(EBIT - I). Interest expense (I) on the debt is $1,500,000(10%) = $150,000. We can work backwards from NI to find EBIT as follows: EBT = NI/(1 - T) or $600,000/0.6 = $1,000,000. EBIT = EBT + I or $1,000,000 + $150,000 = $1,150,000. DFL is thus $1,150,000/($1,150,000- $150,000) =
1.15. Recognizing DTL = DFL x DOL, we can solve 1.40 = 1.15 x DOL for DOL = 1.22.