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If we consider the effect of taxes, then the degree of operating leverage can be written as: DOL = 1 + [FC × (1 – TC) – TC × D]/OCF Consider a project to supply Detroit with 25,000 tons of machine screws annually for automobile production
| If we consider the effect of taxes, then the degree of operating leverage can be written as: |
| DOL = 1 + [FC × (1 – TC) – TC × D]/OCF |
|
Consider a project to supply Detroit with 25,000 tons of machine screws annually for automobile production. You will need an initial $5,400,000 investment in threading equipment to get the project started; the project will last for 6 years. The accounting department estimates that annual fixed costs will be $1,300,000 and that variable costs should be $245 per ton; accounting will depreciate the initial fixed asset investment straight-line to zero over the 6-year project life. It also estimates a salvage value of $675,000 after dismantling costs. The marketing department estimates that the automakers will let the contract at a selling price of $356 per ton. The engineering department estimates you will need an initial net working capital investment of $520,000. You require a return of 9 percent and face a tax rate of 21. |
| a. |
What is the percentage change in OCF if the units sold changes to 26,000? (Do not round intermediate calculations and enter your answer as a percent rounded to 4 decimal places, e.g., 32.1616.) |
| b. | What is the DOL at the base-case level of output? (Do not round intermediate calculations and round your answer to 4 decimal places, e.g., 32.1616.) |
Expert Solution
It is given Equipment will be depreciated to 0
Depreciation = cost / Useful life
= 5,400,000 / 6
= 900,000
OCF = [Units sold*(sale price - variable cost) - fixed costs] *(1-tax) + depreciation * tax
OCF when units sold = 25000
OCF = [25000*(356 - 245) - 1,300,0000 ] * (1-21%) + 900,000*21% = $1,354,250
OCF when units sold = 26,000
OCF = [26000*(356 - 245) - 1,300,0000 ] * (1-21%) + 900,000*21% = $1,441,940
a)
% Change in ocf = (1,441,940 - 1,354,250) / 1,354,250
= 6.4752%
b)
Using the DOL formula given
DOL = 1 + [1,300,000*(1-21%) - 900,000*21%] / 1,354,250
= 1.6188
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