Metcalf, Inc. is planning to buy a new machine to begin making one of its component parts internally rather than contracting it out to a supplier. Since this is a major investment, they plan to fund it by issuing additional common stock. Assuming that this change has no initial impact on EBIT, the change should:
A)increase operating leverage and decrease financial leverage.
B)decrease operating leverage and increase financial leverage.
C)increase both operating and financial leverage.
D)decrease both operating and financial leverage.
E)The impact on financial and operating leverage cannot be determined.

Question

Quizplus · Accepted Answer

Issuing additional common stock to fund the purchase of a new machine increases the company's equity, thereby decreasing financial leverage (which measures the extent to which a company uses debt financing). Since the company is moving production in-house, it increases fixed costs associated with manufacturing the component, thus increasing operating leverage (which measures the proportion of fixed costs in a company's cost structure).