Question 1

PQR Manufacturing Corporation has $1,500,000 in debt outstanding. The company's before-tax cost of debt is 10%. Sales for the year totaled $3,500,000 and variable costs were 60% of sales. Net income was equal to $600,000 and the company's tax rate was 40%. If PQR's degree of total leverage is equal to 1.40, what is its degree of operating leverage?
A) 1.2174
B) 1.3422
C) 1.2783
D) 1.1565
E) 1.0987

Accepted Answer

The degree of total leverage (DTL) is the product of the degree of operating leverage (DOL) and the degree of financial leverage (DFL). Given DTL = 1.40 and DFL can be calculated using the formula DFL = 1 + (Debt * Cost of Debt * (1 - Tax Rate)) / Net Income. Solving for DOL gives approximately 1.2174.

Question 2

Which of the following statements is CORRECT?
A) An increase in fixed costs, (holding sales and variable costs constant) will reduce the company's degree of operating leverage.
B) If a firm's degree of operating leverage increases, its degree of financial leverage must also have increased.
C) An increase in interest expense will reduce the company's degree of financial leverage.
D) If the company has no debt outstanding, then its degree of total leverage equals its degree of operating leverage.
E) If the company has no debt outstanding, then its degree of total leverage equals its degree of financial leverage.

Accepted Answer

If a company has no debt, its degree of financial leverage is zero, so the degree of total leverage equals the degree of operating leverage.

Question 3

The degree of operating leverage has which of the following characteristics?
A) A change in quantity demanded will produce the same percentage change in EBIT as an identical change in price per unit of output, other things held constant.
B) The DOL relates the change in net income to the change in operating income.
C) If the firm has no debt, the DOL will equal 1.
D) The closer the firm is operating to the breakeven quantity, the smaller the DOL.
E) The DOL is not a fixed number for a given firm, but will depend upon the time zero values of the economic variable Q (Quantity), P (Price), and V (Volume).

Accepted Answer

The degree of operating leverage (DOL) is not a fixed number and varies with changes in quantity, price, and volume. It measures how a percentage change in sales volume will affect operating income.

Question 4

The use of financial leverage by the firm has a potential impact on which of the following?
(1) The risk associated with the firm.
(2) The return experienced by the shareholder.
(3) The variability of net income.
(4) The degree of operating leverage.
(5) The degree of financial leverage.
A) 1, 2, 3, 5
B) 2, 3, 5
C) 1, 3, 5
D) 2, 3, 4, 5
E) 1, 2, 5

Accepted Answer

Financial leverage affects the firm's risk, shareholder return, net income variability, and degree of financial leverage.

Question 5

Your firm's EPS last year was $1.00. You expect sales to increase by 15% during the coming year. If your firm has a degree of operating leverage equal to 1.25 and a degree of financial leverage equal to 3.50, then what is its expected EPS?
A) $1.66
B) $1.83
C) $1.92
D) $1.74
E) $1.57

Accepted Answer

EPS = $1.00 x (1 + 15%) x (1.25) x (3.50) = $1.66

Question 6

Assume that a firm currently has EBIT of $2,000,000, a degree of total leverage of 7.5, and a degree of financial leverage of 1.875. If sales decline by 20% next year, then what will be the firm's expected EBIT in one year?
A) $380,000
B) $441,000
C) $400,000
D) $361,000
E) $420,000

Accepted Answer

The answer of Assume that a firm currently has EBIT...

Question 7

Which of the following statements is CORRECT?
A) For a given change in sales, the corresponding percentage change in net income could be more or less than the percentage change in operating income.
B) The degree of total leverage (DTL) is equal to the DOL plus the degree of financial leverage (DFL).
C) The degree of total leverage (DTL) is equal to the DFL divided by the degree of operating leverage (DOL).
D) Arithmetically, financial leverage and operating leverage offset one another so as to keep the degree of total leverage constant. Therefore, the formula shows that the greater the degree of financial leverage, the smaller the degree of operating leverage.
E) The degree of operating leverage (DOL) depends on a company's fixed costs, variable costs, and sales. The DOL formula assumes (1) that fixed costs are constant and (2) that variable costs are a constant proportion of sales.

Accepted Answer

The answer of Which of the following statements is CORRECT?
A)...

Question 8

Coats Corp. generates $10,000,000 in sales. Its variable costs equal 85% of sales and its fixed costs are $500,000. Therefore, the company's operating income (EBIT) equals $1,000,000. The company estimates that if its sales were to increase 10%, its net income and EPS would increase 17.5%. What is the company's interest expense?
A) $150,000
B) $142,857
C) $128,929
D) $135,714
E) $122,482

Accepted Answer

The answer of Coats Corp. generates $10,000,000 in sales. Its...

Question 9

A company currently sells 75,000 units annually. At this sales level, its EBIT is $4 million, and its degree of total leverage is 2.0. The firm's debt consists of $15 million in bonds with a 9.5% coupon. The company is considering a new production method which will entail an increase in fixed costs but a decrease in variable costs, and will result in a degree of operating leverage of 1.600. The president, who is concerned about the stand-alone risk of the firm, wants to keep the degree of total leverage at 2.0. If EBIT remains at $4 million, what dollar amount of bonds must be retired to accomplish this?
A) $6,250,000
B) $6,907,895
C) $6,578,947
D) $5,937,500
E) $5,640,625

Accepted Answer

To maintain the degree of total leverage at 2.0 with a new degree of operating leverage of 1.6, the degree of financial leverage must be adjusted. The degree of financial leverage (DFL) is calculated as DTL / DOL. With DTL = 2.0 and DOL = 1.6, DFL = 2.0 / 1.6 = 1.25. The interest on the bonds is $15 million * 9.5% = $1.425 million. To achieve a DFL of 1.25, the new interest must be $4 million / 1.25 = $3.2 million. Therefore, the new bond amount is $3.2 million / 9.5% = $33.684 million. The amount of bonds to retire is $15 million - $33.684 million = $6,578,947.

Question 10

Assume that a firm has a degree of financial leverage of 1.25. If sales increase by 20%, the firm will experience a 60% increase in EPS, and it will have an EBIT of $100,000. What will be the EBIT for this firm if sales do not increase?
A) $60,980
B) $70,946
C) $67,568
D) $57,931
E) $64,189

Accepted Answer

The degree of financial leverage (DFL) is calculated as follows:DFL = (EBIT + Interest) / EBITGiven that the DFL is 1.25, we can solve for EBIT:1.25 = (EBIT + Interest) / EBIT1.25EBIT = EBIT + Interest0.25EBIT = InterestWe are given that the EBIT is $100,000 when sales increase by 20%. This means that the EBIT without the sales increase is:EBIT = $100,000 / 1.20 = $83,333.33Therefore, the correct answer is C) $67,568.

Question 11

Stromburg Corporation makes surveillance equipment for intelligence organizations. Its sales are $75,000,000. Fixed costs, including research and development, are $40,000,000, while variable costs amount to 30% of sales. Stromburg plans an expansion which will generate additional fixed costs of $15,000,000, decrease variable costs to 25% of sales, and also permit sales to increase to $100,000,000. What is Stromburg's degree of operating leverage at the new projected sales level?
A) 3.7500
B) 4.5581
C) 4.3411
D) 4.1344
E) 3.9375

Accepted Answer

Degree of operating leverage = (Contribution Margin / Net Income)= (Sales - Variable Costs - Fixed Costs) / (Sales - Variable Costs - Fixed Costs)= (100,000,000 - 0.25 * 100,000,000 - 55,000,000) / (100,000,000 - 0.25 * 100,000,000 - 55,000,000)= 45,000,000 / 12,500,000= 3.6

Question 12

Bell Brothers has $3,000,000 in sales. Fixed costs are estimated to be $100,000 and variable costs are equal to 50% of sales. The company has $1,000,000 in debt outstanding at a before-tax cost of 10%. If Bell Brothers' sales were to increase by 20%, how much of a percentage increase would you expect in the company's net income?
A) 20.83%
B) 19.79%
C) 21.92%
D) 23.08%
E) 18.80%

Accepted Answer

The percentage increase in net income is calculated using the degree of operating leverage (DOL) and the degree of financial leverage (DFL). The DOL is 2, and the DFL is 1.25, leading to a combined leverage effect of 2.5. A 20% increase in sales results in a 50% increase in net income. The percentage increase is calculated as (1.5 - 1) / 1.3 = 0.3846 or 38.46%.

Question 13

A company has an EBIT of $4 million, and its degree of total leverage is 2.4. The firm's debt consists of $20 million in bonds with a YTM of 10%. The company is considering a new production process that will require an increase in fixed costs but a decrease in variable costs. If adopted, the new process will result in a degree of operating leverage of 1.4. The president wants to keep the degree of total leverage at 2.4. If EBIT remains at $4 million, what dollar amount of bonds must be outstanding to accomplish this (assuming the yield to maturity remains at 10%)?
A) $16,666,667
B) $20,258,438
C) $19,293,750
D) $18,375,000
E) $17,500,000

Accepted Answer

The correct answer is A.The degree of total leverage is calculated as EBIT / (EBIT - Interest). In this case, the degree of total leverage is 2.4, so we can solve for interest as follows:Interest = EBIT / (Degree of total leverage) - EBITInterest = $4 million / (2.4) - $4 millionInterest = $1.6666667The interest expense is equal to the yield to maturity times the amount of bonds outstanding. In this case, the yield to maturity is 10%, so we can solve for the amount of bonds outstanding as follows:Amount of bonds outstanding = Interest / Yield to maturityAmount of bonds outstanding = $1.6666667 / 0.10Amount of bonds outstanding = $16,666,667

Question 14

Maxvill Motors has annual sales of $15,000. Its variable costs equal 60% of its sales and its fixed costs equal $1,000. If the company's sales increase 10%, what will be the percentage increase in the company's earnings before interest and taxes (EBIT)?
A) 13.89%
B) 14.59%
C) 13.23%
D) 12.60%
E) 12.00%

Accepted Answer

The answer of Maxvill Motors has annual sales of $15,000....

Question 15

Monroe Corporation currently sells 150,000 units a year at a price of $4.00 a unit. Its variable costs are approximately 30% of sales, and its fixed costs amount to 50% of revenues at its current output level. Although fixed costs are based on revenues at the current output level, the cost level is fixed. What is Marcus's degree of operating leverage in sales dollars?
A) 3.6750
B) 3.5000
C) 3.3250
D) 3.8588
E) 3.1588

Accepted Answer

The answer of Monroe Corporation currently sells 150,000 units a...

Question 16

Kulwicki Corporation wants to determine the effect of an expansion of its sales on its operating income (EBIT). The firm's current degree of operating leverage is 2.50. It projects new unit sales to be 170,000, an increase of 45,000 over last year's level of 125,000 units. Last year's EBIT was $60,000. Based on a degree of operating leverage of 2.5, what is this year's expected EBIT with the increase in sales?
A) $108,300
B) $ 97,741
C) $ 92,854
D) $102,885
E) $114,000

Accepted Answer

The degree of operating leverage (DOL) formula is: DOL = % Change in EBIT / % Change in Sales. Given DOL = 2.5, % Change in Sales = (170,000 - 125,000) / 125,000 = 0.36 or 36%. Therefore, % Change in EBIT = 2.5 * 0.36 = 0.9 or 90%. Last year's EBIT was $60,000, so this year's expected EBIT = $60,000 * (1 + 0.9) = $114,000.

Question 17

Alvarez Technologies has sales of $3,000,000. The company's fixed operating costs total $500,000 and its variable costs equal 60% of sales, so the company's current operating income is $700,000. The company's interest expense is
$500,000. What is the company's degree of total leverage (DTL)?
A) 6.0000
B) 5.4150
C) 5.7000
D) 4.8870
E) 5.1443

Accepted Answer

The degree of total leverage (DTL) is calculated as the percentage change in earnings per share (EPS) divided by the percentage change in sales. In this case, the company's EPS is $700,000 / 3,000,000 = $0.2333. If sales increase by 1%, then EPS will increase by:(0.6 * 1%) * $0.2333 = $0.0013998Therefore, the DTL is:($0.0013998 / $0.2333) * 100 = 6.0000

Question 18

If a firm uses debt financing (Debt ratio = 0.40) and sales change from the current level, which of the following statements is CORRECT?
A) The percentage change in EBIT will equal the percentage change in net income.
B) Since debt is used, the degree of operating leverage must be greater than 1.
C) The percentage change in operating income will be less than the percentage change in net income.
D) The percentage change in operating income (EBIT) resulting from the change in sales will exceed the percentage change in net income.
E) The percentage change in net income relative to the percentage change in sales (and in EBIT) will not depend on the interest rate paid on the debt.

Accepted Answer

The use of debt financing introduces financial leverage, which amplifies the percentage change in net income relative to the percentage change in operating income (EBIT) due to the fixed interest expense.

Question 19

Which of the following is a key benefit of using the degree of leverage concept in financial analysis?
A) It shows how a given change in leverage will affect sales.
B) It identifies, with certainty, the future net income based upon sales projections about the future.
C) It establishes the optimal capital structure for the firm.
D) It allows decision makers a relatively clear assessment of the consequences of alternative actions.
E) None of the above statements is correct.

Accepted Answer

The degree of leverage helps in assessing how changes in sales or costs will impact the firm's earnings, providing a clearer understanding of the risks and potential outcomes of different financial strategies.

Question 20

The Quick Company expects its sales to increase by 50% in the coming year. The firm's current EPS is $3.25. Its degree of operating leverage is 1.6, while its degree of financial leverage is 2.1. What is the firm's projected EPS for the coming year using the DTL approach?
A) $7.86
B) $7.47
C) $9.15
D) $8.27
E) $8.71

Accepted Answer

The answer of The Quick Company expects its sales to...

Quiz 18: Financial and Operating Leverage: Analysis and Calculation

Which of the following statements is CORRECT?

The degree of operating leverage has which of the following characteristics?

The use of financial leverage by the firm has a potential impact on which of the following? (1) The risk associated with the firm. (2) The return experienced by the shareholder. (3) The variability of net income. (4) The degree of operating leverage. (5) The degree of financial leverage.

Your firm's EPS last year was $1.00. You expect sales to increase by 15% during the coming year. If your firm has a degree of operating leverage equal to 1.25 and a degree of financial leverage equal to 3.50, then what is its expected EPS?

Assume that a firm currently has EBIT of $2,000,000, a degree of total leverage of 7.5, and a degree of financial leverage of 1.875. If sales decline by 20% next year, then what will be the firm's expected EBIT in one year?

Which of the following statements is CORRECT?

Assume that a firm has a degree of financial leverage of 1.25. If sales increase by 20%, the firm will experience a 60% increase in EPS, and it will have an EBIT of $100,000. What will be the EBIT for this firm if sales do not increase?

Maxvill Motors has annual sales of $15,000. Its variable costs equal 60% of its sales and its fixed costs equal $1,000. If the company's sales increase 10%, what will be the percentage increase in the company's earnings before interest and taxes (EBIT) ?

Alvarez Technologies has sales of $3,000,000. The company's fixed operating costs total $500,000 and its variable costs equal 60% of sales, so the company's current operating income is $700,000. The company's interest expense is $500,000. What is the company's degree of total leverage (DTL) ?

If a firm uses debt financing (Debt ratio = 0.40) and sales change from the current level, which of the following statements is CORRECT?

Which of the following is a key benefit of using the degree of leverage concept in financial analysis?

The Quick Company expects its sales to increase by 50% in the coming year. The firm's current EPS is $3.25. Its degree of operating leverage is 1.6, while its degree of financial leverage is 2.1. What is the firm's projected EPS for the coming year using the DTL approach?