Gibson Company sales for the year 2004 were $3 million. The firm’s variable operating cost ratio was 0.50, and fixed costs (that is, overhead and depreciation) were $900,000. Its average (and marginal) income tax rate is 40 percent. Currently, the firm has $2.4 million of long-term bank loans outstanding at an average interest rate of 12.5 percent. The remainder of the firm’s capital structure consists of common stock (100,000 shares outstanding at the present time).
a. Calculate Gibson’s degree of combined leverage for 2004.
b. Gibson is forecasting a 10 percent increase in sales for next year (2005). Furthermore, the firm is planning to purchase additional labor-saving equipment, which will increase fixed costs by $150,000 and reduce the variable cost ratio to 0.475. Financing this equipment with debt will require additional bank loans of $500,000 at an interest rate of 12.5 percent. Calculate Gibson’s expected degree of combined leverage for 2005.
c. Determine how much Gibson must reduce its debt in 2005 (for example, through the sale of common stock) to maintain its DCL at the 2004 level.