Deck 20: Leverage

Question 1

Since high use of debt is associated with more risk, it may also lower the stock's price.

Answer 1

True

Question 2

The effect on earnings per share will be the same if a firm issues bonds with a 9 percent interest rate or preferred stock with a 9 percent dividend yield.

Answer 2

False

Question 3

If a firm has a large amount of operating leverage, that suggests its earnings may be volatile.

Answer 3

True

Question 4

As the use of operating leverage increases, the risk exposure of the firm decreases.

Question 5

The lower the debt ratio,​

A) ​the higher is the use of financial leverage
B) ​the lower is the use of financial leverage
C) ​the lower are the firm's total assets
D) ​the higher are the firm's total assets

Question 6

A firm increases its use of operating leverage by converting variable costs into fixed costs.

Question 7

A recession will cause earnings to fall more rapidly for more highly financially leveraged firms.​

Question 8

Since high use of financial leverage is associated with less risk, higher financial leverage may also result in higher stock prices.

Question 9

The variable dividend paid by preferred stock is a source of financial leverage.

Question 10

Financial leverage may result in lower total earnings but higher earnings per share.

Question 11

A recession will cause earnings to fall more rapidly for less financially leveraged firms.

Question 12

A firm may obtain financial leverage by​
1) issuing debt
2) leasing
3) issuing preferred stock

A)​1 and 2
B)1 and 3​
C)2 and 3​
D)1, 2, and 3​

Question 13

If a company calls a bond and retires it, the use of financial leverage is reduced.

Question 14

Increased operating leverage is associated with smaller amounts of fixed costs.

Question 15

Banks tend to have more operating leverage than railroads.

Question 16

A decrease in operating leverage may be achieved by increasing fixed costs relative to variable costs.

Question 17

Firms with substantial amounts of interest expense have a higher operating leverage.

Question 18

Financial leverage decreases with the retention of earnings.​

Question 19

A firm will prefer to issue preferred stock rather than debt because the dividend is tax deductible.

Question 20

If preferred stock paid a dividend that varied with the firm's earnings, preferred stock would not be a source of financial leverage.

Question 21

Which of the following involves a fixed payment?​
1) bonds
2) preferred stock
3) common stock

A)​1 and 2
B)​1 and 3
C)​2 and 3
D)​only 1

Question 22

If a firm's fixed costs rise relative to variable costs,​ and .

A) ​operating leverage, risk increase
B) operating leverage, financial leverage increase​
C) financial leverage, risk increase​
D) operating leverage increases, financial risk decreases​

Question 23

Fill in the table using the following information. Assets required for operation: $\$ 2,000$
Case $A$ - firm uses only equity financing
Case B - firm uses $30 \%$ debt with a $10 \%$ interest rate and $70 \%$ equity
Case $\mathrm { C }$ - firm uses $50 \%$ debt with a $12 \%$ interest rateand $50 \%$ equity
$\begin{array} { l c c c } & A & \text { B } & \text { C } \\ \text { Debt outstanding } & \$ & \$ & \$ \\ \text { Stockholders' equity } & & & \\ \text { Earnings before } & 300 & 300 & 300 \\ \text { interest and taxes } & & & \\ \text { Interest expense } & & & \\ \text { Earnings before taxes } & & & \\ \text { Taxes ( } 40 \% \text { of earnings) } & & & \\ \text { Net earnings } & & & \\ \text { Return on stockholders' } & \% & \% & \% \\ \text { investment } & & & \end{array}$ ​
What happens to the rate of return on the stockholders' investment as the amount of debt increases? Why did the rate of interest increase in case C?
​

Question 24

The increased use of financial leverage may​
1) affect the firm's credit rating
2) decrease risk
3) alter the firm's earnings

A)​1 and 2
B)1 and 3​
C)​2 and 3
D)​1, 2, and 3

Question 25

Higher fixed costs are associated with​
1) higher operating leverage
2) lower operating leverage
3) increased risk
4) lower risk

A)​1 and 3
B)​1 and 4
C)​2 and 3
D)​2 and 4

Question 26

A firm does not obtain financial leverage by​

A) ​issuing bonds
B) ​borrowing from a bank
C) issuing preferred stock​
D) issuing common stock​

Question 27

The lower the debt ratio,​

A) ​the higher is the use of financial leverage
B) the lower is the use of financial leverage​
C) the lower are the firm's total assets​
D) the higher are the firm's total assets​

Question 28

A firm may obtain financial leverage by​
1) issuing bonds
2) issuing preferred stock
3) issuing common stock
4) retaining earnings

A)​1 and 2
B)​1 and 3
C)​2 and 4
D)3 and 4​

Question 29

Operating leverage​

A) ​is affected by the demand for the product
B) results from use of fixed instead of variable costs​
C) is the result of using debt financing​
D) is associated with less risk and more certainty​

Question 30

Successful use of financial leverage may​
1) increase the firm's earnings per share
2) decrease the firm's earnings per share
3) increase investors' return on their funds
4) decrease investors' return on their funds

A)​1 and 3
B)​1 and 4
C)​2 and 3
D)​2 and 4

Question 31

Business risk refers to​
1) use of accelerated depreciation
2) the risk inherent in the nature of the business
3) the sources of the firm's finances

A)​1 and 2
B)​1 and 3
C)​2 and 3
D)​only 2

Question 32

​Given the following information, what happens to operating income and net income if output is increased by 10 percent? Verify your answer.​
Total assets $100,000
Debt (12% interest rate) $80,000
Equity $20,000
Variable costs of production $14 per unit
​
Fixed cost of production $27,000
Units sold 12,300
Sale price per unit $19.75
​

Question 33

Increased operating leverage is associated with additional risk because​
1) Lower variable costs increase the variability of total costs
2) Lower variable costs increase the variability of earnings before interest and taxes
3) Higher fixed costs increase the variability of earnings before interest and taxes
4) Higher fixed costs require higher sales to cover total costs.

A)​1 and 3
B)​1 and 4
C)​2 and 3
D)​3 and 4

Question 34

Increased variability of operating income is associated with​

A) ​increased interest expense
B) increased variable cost​
C) increased taxes​
D) increased fixed costs​

Question 35

The higher the debt ratio,​

A) ​the lower is the use of financial leverage
B) ​the greater is the use of financial leverage
C) ​the lower are the firm's total assets
D) ​the greater are the firm's total assets

Question 36

The greater the usage of financial leverage, the larger is the variability of​

A) ​revenues
B) gross profits​
C) operating earnings​
D) net earnings​

Question 37

The use of financial leverage​

A) ​alters operating leverage
B) magnifies the impact of changes in sales on operations​
C) magnifies changes in operating income relative to changes in revenues​
D) implies the volatility of net income is increased​

Question 38

Unsuccessful use of financial leverage​

A) ​increases earnings per share
B) increases investors' rate of return​
C) ​decreases earnings per share
D) ​decreases interest expense