CFA CFA Level 1 CFA Level 1 Question of the Week: Corporate Finance

CFA Level 1 Question of the Week: Corporate Finance

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      A company recently issued $1,000,000 in new debt to buy back 100,000 out of 500,000 of their existing common shares, and to finance an expansion. The end result of the expansion is that the company’s EBIT has increased by 25%, and the sales have increased by 50%. However, net income is only up 10%. If the company’s basic EPS before the transaction was $1.56, what is the new Degree of Total Leverage that would be calculated by an external analyst?

      • 0.75
      • 1.95
      • 1.17
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      thanks @crimsonmoose and @jak5189! i was a bit thrown off since my study notes say net income instead of EPS…hopefully thats the only thing they were off on

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      The best way to understand this is that EPS is largely affected by a company’s capital structure, which is more or less the composition of how a company finances its operations, or in other words…its financial risk. Net Income, although affected by many machinations and non-operating events, may not be fully affected by the capital structure of the company. I realize that my view on why Net Income might be a stretch so I would appreciate anyone else adding to my commentary. 

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      Ok, I think the answer is 0.75.

      simply_complex, your DTL formula is slightly incorrect.

      DTL is actually % change in EPS / % change in sales.

      Prior to the transaction, we had EPS of $1.56 on 500,000 shares. Backing out earnings using these two figures give us earnings of $780,000.

      The question states that after the transaction, net income (or earnings) increased by 10%. This means that earnings now are at $858,000. The number of outstanding shares have also decreased from 500,000 to 400,000. As such, EPS after transaction is $858,000 / 400,000 = 2.145.

      % change in EPS = (2.145 – 1.56) / 1.56 = 37.5%

      % change in sales = stated in question as 50%

      Therefore, DTL = 0.375 / 0.5 = 0.75

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      thanks!

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      Can someone post solution?

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      im getting .733. DTL = % change in NI/ % change in units sold so i calculated it as 1.1/1.25 = .7333 (which wasn’t an option so i blatantly guessed 🙂

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      Something to keep in mind – DOL = % change EBIT / % change in Sales; DFL = % change in EPS / % change in EBIT; DTL = DFL X DOL. 

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      Correct Answer:  A

      First we determine what the new earnings per share is by adjusting  for the simple buy back:  $1.56*(500,000/400,000) = $1.95.  Next, we need to increase the EPS by the growth in net income, so the EPS is $1.95*1.1 = $2.145.

      Finally we can calculate DTL as being the % change in EPS / % change in sales = (2.145/1.56 – 1) / .5 = .75

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      Why is it wrong to simply calculate 0,10 / 0,50 (% change net income / % change sales) ?

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      @thomasw, DTL is (% change in EPS/% change in sales). the two factors you need to take into account that resulted in the change in EPS in this situation is the the fact that the company bought back shares (reducing the denominator in EPS) and that net income rose (increasing the numerator of EPS). you have to use these two factors to calculate the new EPS. you can then calculate the % change in EPS and then divide it by the % change in sales. i also thought the numerator for DTL was % change in net income, but that’s the incorrect formula. glad i was able to find that out before the exam thanks to the forum!

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      Woo! I got right. 🙂 

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