Question 1

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

Accepted Answer

False

Question 2

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

Accepted Answer

The degree of financial leverage (DFL) is a ratio that measures the percentage change in earnings per share (EPS) resulting from a percentage change in earnings before interest and taxes (EBIT). Therefore, the statement is true.

Question 3

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

Accepted Answer

The degree of combined leverage is not the sum but the product of the degree of operating leverage and the degree of financial leverage.

Question 4

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

Accepted Answer

The closer a firm is to its break-even point, the higher the degree of operating leverage will be. This is because fixed costs represent a larger proportion of total costs at or near the break-even point, causing a relatively small change in sales volume to have a big impact on the firm's profitability.

Question 5

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

Accepted Answer

Operating leverage refers to the degree to which a company relies on its fixed costs in its operations. This includes the use of capital assets such as equipment, buildings, and property. Therefore, operating leverage is indeed 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.

Accepted Answer

Operating leverage determines the percentage change in operating income due to a change in sales. It does not determine how income from operations is to be divided between debtholders and shareholders, which is determined by the capital structure and contractual obligations of the company.

Question 7

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

Accepted Answer

If economic conditions are expected to be favourable, investors may be willing to take on more risk and therefore may prefer a firm with a higher degree of leverage. A high degree of leverage can amplify returns during a period of economic growth, but also increases the risk of losses during a downturn. Therefore, investor preferences for leverage may vary depending on economic conditions and overall market sentiment.

Question 8

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

Accepted Answer

Linear break-even analysis assumes that costs vary directly with volume, meaning they are linear functions. This assumption is used to calculate the level of sales needed to cover all costs and generate a profit.

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.

Accepted Answer

The degree of operating leverage (DOL) is a number indicating the relationship between the percentage change in sales to the percentage change in operating income (not earnings per share).

Question 10

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

Accepted Answer

Firms with cyclical sales should not employ a high degree of leverage as their cash flows can be significantly impacted during economic downturns, making it difficult to meet debt obligations. Instead, these firms should maintain lower levels of debt and build up cash reserves during high sales periods to weather potential downturns.

Question 11

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

Accepted Answer

Financial leverage refers to the use of debt financing to increase the return on investment. It involves taking on a higher level of debt in order to amplify potential gains or losses. Therefore, it 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.

Accepted Answer

The answer of The contribution margin is equal to price...

Question 13

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

Accepted Answer

Operating leverage and financial leverage both impact the entire income statement, including the top and bottom halves. Operating leverage refers to the impact of fixed costs on profits, while financial leverage refers to the impact of interest payments on profits. Both can affect net income, which is the bottom line of the income statement.

Question 14

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

Accepted Answer

Cash break-even analysis only considers the cash inflows and outflows to determine the level of sales necessary to cover all cash expenses. It does not include non-cash charges like amortization expense, depreciation, or stock-based compensation.

Question 15

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

Accepted Answer

The answer of Financial leverage primarily affects the left-hand side...

Question 16

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

Accepted Answer

Managers who are risk averse and uncertain about the future tend to avoid high amounts of debt and prefer lower combined leverage. This is because higher leverage often means higher financial risk and the potential for financial distress if the company's cash flows are not sufficient to cover debt obligations.

Question 17

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

Accepted Answer

This is a correct definition of leverage. By using fixed costs, a company can increase its profits as it operates at higher levels of production. However, it can also magnify losses if the company is not generating enough revenue to cover those fixed costs.

Question 18

Operating income is not the same thing as EBIT.

Accepted Answer

Operating income is also known as EBIT (Earnings Before Interest and Taxes).

Question 19

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

Accepted Answer

This is because the contribution margin is the amount left over after covering variable costs, which means that each unit sold contributes more towards covering fixed costs and moving towards the break-even point.

Question 20

Leverage works best when volume is increasing.

Accepted Answer

Leverage is the use of borrowed funds to increase the potential return on investment. When the volume of trades is increasing, there are more opportunities to use leverage effectively as there is more liquidity in the market. This can provide more potential for gains or losses depending on the direction of the trade. However, it is important to note that using leverage can also amplify losses.

Quiz 5: Operating and Financial Leverage