Deck 5: Operating and Financial Leverage

Question 1

If a firm has a DFL of 2.0, EPS will change 2% for every 1% change in volume.

Answer 1

False

Question 2

The degree of financial leverage measures the percentage change in EPS for every 1 percent move in EBIT.

Answer 2

True

Question 3

The degree of combined leverage is the sum of the degree of operating leverage and the degree of financial leverage.

Answer 3

False

Question 4

The closer a firm is to its break-even point, the lower the degree of operating leverage will be.

Question 5

Operating leverage is concerned with the use of capital assets in the business.

Question 6

Operating leverage determines how income from operations is to be divided between debtholders and shareholders.

Question 7

If economic conditions were expected to be favourable, an investor would likely prefer a firm with a low degree of leverage.

Question 8

Linear break-even analysis assumes that costs are linear functions of volume.

Question 9

The degree of operating leverage is a number indicating the relationship between the percentage change in sales to the percentage change in earnings per share.

Question 10

Firms with cyclical sales should employ a high degree of leverage.

Question 11

Financial leverage is concerned with the use of debt in the business.

Question 12

The contribution margin is equal to price per unit minus total costs per unit.

Question 13

Operating leverage influences the bottom half of the income statement while financial leverage deals with the top half.

Question 14

Cash break-even analysis eliminates the amortization expense and other non-cash charges from capital costs.

Question 15

Financial leverage primarily affects the left-hand side of the balance sheet.

Question 16

Managers who are risk averse and uncertain about the future would most likely minimize combined leverage.

Question 17

Leverage is the use of fixed costs to magnify returns at high levels of operation.

Question 18

Operating income is not the same thing as EBIT.

Question 19

As the contribution margin rises, the break-even point goes down.

Question 20

Leverage works best when volume is increasing.

Question 21

Use of financial leverage must consider risk, not just maximizing profit.

Question 22

A highly automated plant would generally have

A) more variable than fixed costs.
B) more fixed than variable costs.
C) all fixed costs.
D) all variable costs.

Question 23

For Japanese firms that have high levels of operating and financial leverage, maintaining sales volume is of critical importance even at the cost of price cuts.

Question 24

At the break-even point, a firm's profits are

A) greater than zero.
B) less than zero.
C) equal to zero.
D) not enough information to tell

Question 25

A firm with a high degree of combined leverage will, other things being equal, experience higher earnings in the expansionary part of the business cycle.

Question 26

The concept of operating leverage involves the use of __________ to magnify returns at high levels of operation.

A) fixed costs
B) variable costs
C) marginal costs
D) semi-variable costs

Question 27

If sales volume exceeds the break-even point, the firm will experience

A) an operating loss.
B) an operating profit.
C) an increase in plant and equipment.
D) an increase in share price.

Question 28

For firms in industries that offer some degree of stability, are in a positive stage of growth, and are operating in favourable economic conditions, the use of debt is not needed or recommended.

Question 29

A firm with a high degree of financial leverage could face financial difficulty even though it is in a stable industry.

Question 30

In break-even analysis the contribution margin is defined as

A) sales minus variable costs.
B) sales minus fixed costs.
C) variable costs minus fixed costs.
D) fixed costs minus variable costs.

Question 31

The degree of financial leverage is not influenced by the interest rate on debt, only the amount borrowed.

Question 32

The analysis of operating leverage assumes that relationships between revenues and costs are constant.

Question 33

The break-even point can be calculated as

A) variable costs divided by contribution margin.
B) total costs divided by contribution margin.
C) variable cost times contribution margin.
D) fixed cost divided by contribution margin.

Question 34

Operating leverage will change when a firm alters the mix of capital resources and labour that it uses.

Question 35

A lower price for the firm's product will reduce the firm's break-even point.

Question 36

The interwoven boundaries of banks and different trading companies in Japan make it easier to acquire credit in Japan than in Canada.

Question 37

Linear break-even analysis and operating leverage are only valid within a relevant range of production.

Question 38

Management should tailor the use of leverage to meet its own risk-taking desires.

Question 39

Operating leverage primarily affects the left hand side of the balance sheet while financial leverage affects the right hand side of the balance sheet.

Question 40

If a firm has a break-even point of 20,000 units and the contribution margin on the firm's single product is $3.00 per unit and fixed costs are $60,000, what will the firm's net income be at sales of 30,000 units?

A) $90,000
B) $30,000
C) $15,000
D) $45,000

Question 41

A firm would be indifferent between financing plans when

A) debt is equal to equity.
B) return on assets equals return on equity.
C) the cost of borrowed funds equals the return on equity.
D) the cost of borrowed funds equals the return on assets.

Question 42

Heavy use of long-term debt may be beneficial in an inflationary economy because

A) the debt may be repaid in more "expensive" dollars.
B) nominal interest rates exceed real interest rates.
C) inflation is associated with the peak of a business cycle.
D) the debt may be repaid in "cheaper" dollars.

Question 43

Combined leverage is concerned with the relationship between

A) changes in EBIT and changes in EPS.
B) changes in volume and changes in EPS.
C) changes in volume and changes in EBIT.
D) changes in EBIT and changes in net income.

Question 44

Under which of the following conditions could the overuse of financial leverage be detrimental to the firm?

A) stable industry
B) cyclical demand for the firm's products
C) upswing of business cycle
D) low interest cost compared to return on assets

Question 45

If the price per unit decreases because of competition but the cost structure remains the same

A) the break-even point rises.
B) the degree of combined leverage declines.
C) the degree of financial leverage declines.
D) all of the other answers are correct

Question 46

If fixed costs rise while other variables stay constant

A) the break-even point rises.
B) degree of operating leverage increases.
C) total profit declines.
D) all of the other answers are correct

Question 47

Firms with a high degree of operating leverage are

A) easily capable of surviving large changes in sales volume
B) usually trading off lower levels of risk for higher profits.
C) significantly affected by changes in interest rates.
D) trading off higher fixed costs for lower per-unit variable costs.

Question 48

When a firm employs no debt

A) it has a financial leverage of one.
B) it has a financial leverage of zero
C) its operating leverage is equal to its financial leverage.
D) it will not be profitable.

Question 49

Which of the following is not true about leverage?

A) Operating leverage influences the top half of the income statement, determining EBIT.
B) Financial leverage deals with the bottom half of the income statement, determining EPS.
C) Combined leverage utilizes the entire income statement, showing the impact of change in volume on EBIT.
D) none of the other answers are correct

Question 50

The degree of operating leverage may be defined as

A) the percent change in operating income divided by the percent change in unit volume.
B) Q (P-VC) divided by Q (P-VC) - FC.
C) S - TVC divided by S - TVC - FC.
D) all of the other answers are correct

Question 51

Which of the following is true about the concept of leverage?

A) at the break-even point, operating leverage is equal to zero.
B) combined leverage measures the impact of operating and financial leverage on EBIT.
C) financial leverage measures the impact of fixed costs on earnings.
D) combined leverage measures the impact of operating and financial leverage on EPS.

Question 52

Which of the following is concerned with the change in operating profit as a result of a change in volume?

A) financial leverage
B) break-even point
C) operating leverage
D) combined leverage

Question 53

The degree of operating leverage is computed as

A) percent change in operating profit divided by percent change in net income.
B) percent change in volume divided by percent change in operating profit.
C) percent change in EPS divided by percent change in operating income.
D) percent change in operating income divided by percent change in volume.

Question 54

Firm A employs a high degree of operating leverage; Firm B takes a more conservative approach. Which of the following comparative statements about firms A and B is true?

A) A has a lower break-even point than B, but A's profit grows faster after the break-even.
B) A has a higher break-even point than B, but A's profit grows slower after the break-even.
C) B has a lower break-even point than A, but A's profit grows faster after the break-even.
D) B has a lower break-even point than A, and profit grows the same rate for both companies after the break-even point.

Question 55

If the business cycle were just beginning its upswing, which firm would you anticipate would be likely to show the best growth in EPS over the next year? Firm A has high combined leverage and Firm B has low combined leverage.

A) firm A
B) firm B
C) indifferent between the two
D) it depends on how much financial leverage each firm has

Question 56

Financial leverage is concerned with the relation between

A) changes in volume and changes in EPS.
B) changes in volume and changes in EBIT.
C) changes in EBIT and changes in EPS.
D) changes in EBIT and changes in operating income.

Question 57

Conservatively leveraged Firm C and highly leveraged Firm H operate at the same level of earnings before interest and taxes where the return on assets is greater than the cost of debt.

A) Firm C will have a higher return on equity than H.
B) Firm H will have a higher return on equity than C .
C) The return on equity will not be affected by financial leverage.
D) The return on equity will be the same at an equal level of earnings.

Question 58

Cash break-even analysis

A) is helpful in analyzing the short-term outlook of the firm, particularly when it is in trouble financially.
B) is important when analyzing long-term profitability.
C) includes amortization expense as a fixed cost when calculating the degree of financial leverage.
D) none of the other answers are correct

Question 59

A conservative financing plan involves

A) heavy reliance on debt.
B) heavy reliance on equity.
C) high degree of financial leverage.
D) high degree of combined leverage.

Question 60

If EBIT equals $140,000 and interest equals $21,000, with a tax rate of 31%, what is the degree of financial leverage?

A) 6.67x
B) 5.67
C) 3.91x
D) 1.18x

Question 61

If a firm has fixed costs of $30,000, a price of $4.00, and a break-even point of 15,000 units, the variable cost per unit is

A) $5.00.
B) $2.00.
C) $0.50.
D) $4.00.

Question 62

If a firm has fixed costs of $20,000, variable cost per unit of $0.50, and a break-even point of 5,000 units, the price is

A) $2.50.
B) $5.00.
C) $4.00.
D) $4.50.

Question 63

$\begin{array}{lr}\text { Sales }(75,000 \text { units) } & \$ 750,000 \\\text { Variable costs } & \underline{225,000} \\\text { Contribution margin } & 525,000 \\\text { Fixed manufacturing costs } & \underline{187,500} \\\text { Operating income } & 337,500 \\\text { Interest } & \underline{75,000} \\\text { Earnings before taxes } & \underline{262,500} \\\text { Taxes (at } 31 \%) & \underline{81.375} \\\text { Net income } & \underline{\$181.125} \\\text { Shares outstanding } & 15,000\end{array}$

-The Degree of Financial Leverage is

A) 1.29x.
B) 4.50x.
C) 3.50x.
D) 1.32x.

Question 64

If a firm has a price of $4.00, variable cost per unit of $2.50, and a break-even point of 20,000 units, fixed costs are equal to

A) $13,333.
B) $10,000.
C) $30,000.
D) $50,000.

Question 65

Financial leverage is determined to a large extent by the firm's

A) working capital choice.
B) capital budgeting choice.
C) capital structure choice.
D) dividend policy choice.

Question 66

A firm's indifference point between debt and equity financing plans would occur when the

A) amount of debt used is equal to the amount of equity.
B) cost of borrowing is low.
C) cost of borrowed funds equals return on equity.
D) current level of EBIT generates the same EPS under both plans.

Question 67

$\begin{array}{lc} \text { Sales ( } 30,000 \text { units) } & \$ 150,000 \\ \text { Variable costs } & \underline{100.800} \\ \text { Contribution margin } & 49,200 \\ \text { Fixed manufacturing costs } & \underline{24.000} \\ \text { Operating Income } & 25,200 \\ \text { Interest } & \underline{18.000} \\ \text { Earnings Before Taxes } & 7,200 \\ \operatorname{Taxes}\left(30\%\right) & 2.160 \\ \text { Net Income } & \$ 5.040 \\ \text { Shares Outstanding } & 600 \\\end{array}$

-The Degree of Financial Leverage (DFL) is

A) 3.50x.
B) 1.40x.
C) 1.95x.
D) 1.58x.

Question 68

$\begin{array}{lr}\text { Sales }(75,000 \text { units) } & \$ 750,000 \\\text { Variable costs } & \underline{225,000} \\\text { Contribution margin } & 525,000 \\\text { Fixed manufacturing costs } & \underline{187,500} \\\text { Operating income } & 337,500 \\\text { Interest } & \underline{75,000} \\\text { Earnings before taxes } & \underline{262,500} \\\text { Taxes (at } 31 \%) & \underline{81.375} \\\text { Net income } & \underline{\$181.125} \\\text { Shares outstanding } & 15,000\end{array}$

-The Degree of Operating Leverage is

A) 1.43x.
B) 1.56x.
C) 3.33x.
D) 2.22x.

Question 69

Which of the following questions does break-even analysis attempt to address?

A) How much do changes in volume affect costs and profits?
B) At what point does the firm break even?
C) What is the most efficient level of capital assets to employ?
D) All of the other answers are correct

Question 70

A high DOL means

A) there are high labour costs.
B) there is high debt.
C) there is a large amount of equity.
D) there are high fixed costs.

Question 71

$\begin{array}{lc} \text { Sales ( } 30,000 \text { units) } & \$ 150,000 \\ \text { Variable costs } & \underline{100.800} \\ \text { Contribution margin } & 49,200 \\ \text { Fixed manufacturing costs } & \underline{24.000} \\ \text { Operating Income } & 25,200 \\ \text { Interest } & \underline{18.000} \\ \text { Earnings Before Taxes } & 7,200 \\ \operatorname{Taxes}\left(30\%\right) & 2.160 \\ \text { Net Income } & \$ 5.040 \\ \text { Shares Outstanding } & 600 \\\end{array}$

-The Degree of Operating Leverage (DOL) is

A) 1.58x.
B) 1.95x.
C) 3.50x.
D) 1.40x.

Question 72

A weakness of break-even analysis is that it assumes

A) revenue and costs are a linear (constant) function of volume.
B) prices and costs increase when the economy is strong and confidence is high.
C) cost of goods sold go up as revenue increase.
D) there is no weakness

Question 73

$\begin{array}{lc} \text { Sales ( } 30,000 \text { units) } & \$ 150,000 \\ \text { Variable costs } & \underline{100.800} \\ \text { Contribution margin } & 49,200 \\ \text { Fixed manufacturing costs } & \underline{24.000} \\ \text { Operating Income } & 25,200 \\ \text { Interest } & \underline{18.000} \\ \text { Earnings Before Taxes } & 7,200 \\ \operatorname{Taxes}\left(30\%\right) & 2.160 \\ \text { Net Income } & \$ 5.040 \\ \text { Shares Outstanding } & 600 \\\end{array}$

-The Degree of Combined Leverage (D.C.L.) is

A) 3.08x.
B) 5.45x.
C) 2.73x.
D) 6.83x.

Question 74

From the following income statement for 2005, calculate:

A) Degree of financial leverage
B) Degree of operating leverage
C) Degree of combined leverage

Question 75

Heister Corporation produces class rings to sell to college and high school students. These rings sell for $75 each, and cost $35 each to produce. Heister has fixed costs of $50,000.

A) Calculate Heister's break-even point.
B) How much profit (loss) will Heister have if it sells 1,000 rings? 8,000 rings?
C) Heister's president, J. R. D'Angelo, expects an annual profit of $100,000. How many rings must be sold to attain this profit?

Question 76

Operating leverage primarily affects the __________ while financial leverage primarily affects the __________.

A) left-hand side of the balance sheet: the lower part of the income statement
B) right-hand side of the balance sheet: the upper part of the income statement
C) the lower part of the income statement: the right-hand part of the balance sheet
D) the upper part of the income statement: the left-hand side of the balance sheet

Question 77

Financial leverage primarily affects the _________ while operating leverage primarily affects the __________.

A) left-hand side of the balance sheet: the right-hand side of the balance sheet
B) right-hand side of the balance sheet: the upper part of the income statement
C) lower part of the income statement: the right-hand side of the balance sheet
D) the upper part of the income statement: the left-hand side of the balance sheet

Question 78

$\begin{array}{lc} \text { Sales ( } 30,000 \text { units) } & \$ 150,000 \\ \text { Variable costs } & \underline{100.800} \\ \text { Contribution margin } & 49,200 \\ \text { Fixed manufacturing costs } & \underline{24.000} \\ \text { Operating Income } & 25,200 \\ \text { Interest } & \underline{18.000} \\ \text { Earnings Before Taxes } & 7,200 \\ \operatorname{Taxes}\left(30\%\right) & 2.160 \\ \text { Net Income } & \$ 5.040 \\ \text { Shares Outstanding } & 600 \\\end{array}$

-This firm's break-even point is

A) 4,800 units.
B) 14,634 units.
C) 7,142 units.
D) 18,000 units.

Question 79

Financial leverage deals with

A) the relationship of fixed and variable costs.
B) the relationship of debt and equity in the capital structure.
C) the entire income statement.
D) the entire balance sheet.

Question 80

$\begin{array}{lr}\text { Sales }(75,000 \text { units) } & \$ 750,000 \\\text { Variable costs } & \underline{225,000} \\\text { Contribution margin } & 525,000 \\\text { Fixed manufacturing costs } & \underline{187,500} \\\text { Operating income } & 337,500 \\\text { Interest } & \underline{75,000} \\\text { Earnings before taxes } & \underline{262,500} \\\text { Taxes (at } 31 \%) & \underline{81.375} \\\text { Net income } & \underline{\$181.125} \\\text { Shares outstanding } & 15,000\end{array}$

-The Degree of Combined Leverage is

A) 2.1x.
B) 1.9x.
C) 2.9x.
D) 2.0x.