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Question - Gibson Company sales for the Year 1 were $3 million. The firm's variable operating cost ratio was 0.45, and fixed costs (that is, overhead and depreciation) were $700,000. Its average (and marginal) income tax rate is 40 percent. Currently, the firm has $2 million of long-term bank loans outstanding at an average interest rate of 11.5 percent. The remainder of the firm's capital structure consists of common stock (120,000 shares outstanding at the present time).
a. Calculate Gibson's degree of combined leverage for Year 1.
b. Gibson is forecasting a 8 percent increase in sales for next year (Year 2). Furthermore, the ?rm is planning to purchase additional labor-saving equipment, which will increase ?xed costs by $150,000 and reduce the variable cost ratio to 0.425. Financing this equipment with debt will require additional bank loans of $300,000 at an interest rate of 11.5 percent. Calculate Gibson's expected degree of combined leverage for Year 2.
c. Determine how much Gibson must reduce its debt in Year 2 (for example, through the sale of common stock) to maintain its DCL at the Year 1 level. Do not round intermediate calculations.
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