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CA Intermediate · Financial Management and Strategic Management · Financing Decisions - Leverages

A firm has a degree of operating leverage (DOL) of 2.5 and a degree of financial leverage (DFL) of 1.6 at its current level of output. If sales volume increases by 10%, by what percentage will earnings per share (EPS) increase, other things remaining constant?

EPS will increase by 40%. Combined leverage is the product of operating and financial leverage, 2.5 times 1.6, which equals 4.0. A 10% rise in sales is therefore magnified four times, giving a 40% rise in earnings per share.

  1. A25%
  2. B16%
  3. C40%Correct
  4. D4.1%

Explanation

Degree of combined leverage = DOL x DFL = 2.5 x 1.6 = 4.0. A 10% rise in sales changes EPS by 4.0 x 10% = 40%. The 25% option uses only DOL, ignoring the financial leverage effect, while 16% uses only DFL.

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