DFL question

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ChadD

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What's the proper way to calculate DFL?

I thought DFL is the % change in EPS (or NI (should be the same, if tax rate is constant)/ $ change EBIT

or alternatively EBIT/(EBIT-I)

So for once, I actually knew the answer to a question:

Q. Over a period of one year, Mono Corp. saw it sales increase by 16%. Over the same period, its EBIT increased from $895,000 over to $1,235,000 and its net income rose from $254,000 over to $436,000. If Mono Corp.'s tax rate is 35%, what must be its degree of financial leverage?
A) 2.345
B) 0.530
C) 1.886
D) 1.536

Using % changes in NC/EBIT = .717/.380 = 1.886 or answer C. However, when I look at the answer, I'm correct but my way of approaching the problem is wrong.

http://www.investopedia.com/professionals/questionoftheweek/cfa/090805.asp however, it looks like I'm wrong.

So what is the preferred method of calculating DFL? Should I use % change in EBT (effectively adding back in interest to net income)/% change in EBIT? or % changes in NI/EBIT?
 
I'll ask the obvious question then, why does Investopedia use the %change EBT/%change EBIT then?
 
Blatant/olbvious answer, cus it's wrong.

%-change EPS (proxied by NI here)/%-change in EBIT

Conceptually the way this works is it shows how much the inclusion of debt increases income available to shareholders given a liquidation. The use of debt in financing, at the sametime,will both increase the capital budget and lowers the WACC, these effects directly have an effect on increasing overall wealth. Also with more Debt, the company can have less equity, given a finite need for funds for projects, this will reduce the amount of shares outstanding, increasing the proportion of income flowing to shareholders.

The only real downside is that costs faced by the firm increase and given a project that is either badly budgeted for or turns out to be a poor investment or given a recessionary environement, there may be a greater effect of reducing shareholder wealth or the rate of shareholder wealth creation, compared to what it could be given the exclusion of debt in financing..



Edited 1 time(s). Last edit at Thursday, September 28, 2006 at 01:25AM by jamespucyk.
 
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