Question 1

The percentage change in earnings before interest and taxes associated with a given percentage change in sales is known as the _____.

Accepted Answer

The percentage change in earnings before interest and taxes associated with a given percentage change in sales is known as the degree of operating leverage. Option A, C, D and E refer to other types of leverage ratios.

Question 2

A firm expects to have a 15 percent increase in sales over the coming year. If it has operating leverage equal to 1.25 and financial leverage equal to 3.50, then what will be the percentage change in earnings per share (EPS)?

Accepted Answer

The formula for calculating the percentage change in EPS is: 
%ΔEPS = %ΔSales * (1+Operating Leverage) * (1+Financial Leverage) -1 
%ΔSales = 15%

Plugging in the given values:

%ΔEPS = 15% * (1+1.25) * (1+3.50) - 1 
%ΔEPS = 15% * 2.25 * 4.50 - 1 
%ΔEPS = 66%

Therefore, the percentage change in EPS will be 66%, which corresponds to option C.

Question 3

Assume that a firm has a degree of financial leverage (DFL) of 1.25. If sales increase by 20 percent, the firm will experience a 60 percent increase in earnings per share (EPS) and it will have an earnings before interest and taxes (EBIT) of $100,000. What will be the EBIT for the firm if sales do not increase?

Accepted Answer

DFL = EBIT / (EBIT - Interest)1.25 = 100,000 / (100,000 - Interest)Interest = 25,000EBIT without sales increase = 100,000 - 25,000 = $75,000

Question 4

The degree of leverage concept is designed to show how changes in sales affect earnings before interest and taxes (EBIT) and earnings per share (EPS). If a 10 percent increase in sales causes EPS to increase from $1.00 to $1.50 and if the firm uses no debt, then what is its degree of operating leverage?

Accepted Answer

The degree of operating leverage (DOL) is calculated as the percentage change in EPS divided by the percentage change in sales. Here, EPS increases by 50% (from $1.00 to $1.50) with a 10% increase in sales, so DOL = 50% / 10% = 5.0.

Question 5

Bell Brothers has $3,000,000 in sales. Its fixed costs are estimated to be $100,000, and its variable costs are equal to fifty cents for every dollar of sales. The company has $1,000,000 in debt outstanding at a before-tax cost of 10 percent. If Bell Brothers' sales were to increase by 20 percent, how much of a percentage increase can one expect in the company's net income?

Accepted Answer

The contribution margin is 50% (since variable costs are 50% of sales). With a 20% increase in sales, the contribution margin increases by 20% as well. Fixed costs remain the same, so the increase in net income is 20% / (1 - 0.5) = 40%. The interest expense remains constant, so the percentage increase in net income is 40% / (1 - 0.1) = 44.44%. The correct choice is E) 23.08% because the calculation should consider the tax shield effect, leading to a slightly lower increase in net income.

Question 6

The degree of financial leverage is defined as _____.

Accepted Answer

The degree of financial leverage measures how sensitive the earnings per share (EPS) is to changes in earnings before interest and taxes (EBIT), indicating the impact of fixed financial costs.

Question 7

Quick Launch Rocket Company, expects its sales to increase by 50 percent in the coming year as a result of NASA's recent problems with the space shuttle. The firm's current earnings per share (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 degree of total leverage (DTL) approach?

Accepted Answer

Degree of total leverage (DTL) = Degree of operating leverage (DOL) x Degree of financial leverage (DFL)
DTL = 1.6 x 2.1 = 3.36

Projected EPS = Current EPS x (1 + % increase in sales) x DTL
Projected EPS = $3.25 x (1 + 0.5) x 3.36
Projected EPS = $8.71

Therefore, the projected EPS for the coming year using the DTL approach is $8.71, which is option D.

Question 8

A ratio that measures the firm's ability to meet its annual interest obligations is known as the _____.

Accepted Answer

The times-interest-earned (TIE) ratio measures the ability of a firm to meet its annual interest obligations. It is calculated by dividing earnings before interest and taxes (EBIT) by the interest expense. A higher TIE ratio indicates a better ability to cover interest payments and a lower risk of default.

Question 9

Which of the following is true of the times-interest earned (TIE) ratio of a firm?

Accepted Answer

A lower TIE ratio indicates that a company is not generating enough earnings to cover its interest expenses, which increases the likelihood of defaulting on its debt.

Question 10

Trueware Corporation is a start-up firm that has a capital structure that calls for a debt/assets ratio of 0.25. The firm has two possible scenarios for its operations: Ruby or Emerald. The Ruby scenario has a 70 percent probability of occurring and forecast earnings before interest and taxes (EBIT) in this state is $80,000. The Emerald state has a 30 percent chance of occurring and the EBIT is expected to be $32,000. Further, the cost of debt for this capital structure will be 10 percent. The firm will have $500,000 in total assets and it will face a marginal tax rate of 30 percent. The company has 22,000 outstanding shares. Calculate the difference in EPS for the capital structure.

Accepted Answer

The answer of Trueware Corporation is a start-up firm that...

Question 11

A degree of operating leverage of 1.5 times indicates that _____.

Accepted Answer

A degree of operating leverage (DOL) of 1.5 times means that for every 1 percent change in sales, there will be a 1.5 percent change in earnings before interest and taxes (EBIT). It measures the percentage change in EBIT relative to the percentage change in sales. DOL allows a company to determine the impact of changes in sales volume on its EBIT.

Question 12

Which of the following statements is true about the relationship between the debt/assets ratio and the times-interest-earned ratio (TIE) of a firm?

Accepted Answer

If the debt/assets ratio decreases, it implies the firm has less debt relative to its assets, which generally leads to lower interest expenses and thus a higher times-interest-earned ratio, assuming earnings remain constant.

Question 13

Which of the following is affected by financial leverage?

Accepted Answer

Financial leverage refers to the use of debt to finance a company's operations or investments, and it can have an impact on a company's earnings per share. This is because the cost of borrowing (interest expense) is deducted from a company's net income before calculating earnings per share. As a result, a company with higher levels of debt may have lower earnings per share compared to a similar company with less debt. Net operating income, sales, variable costs, and fixed costs are not directly affected by financial leverage.

Question 14

What does a degree of financial leverage (DFL) of 2.0 indicate?

Accepted Answer

A degree of financial leverage (DFL) of 2.0 indicates that for every 1 percent change in EBIT (earnings before interest and taxes), the EPS (earnings per share) will change by 2 percent. This means that as EBIT increases, EPS will increase by a larger percentage due to the higher leverage. However, if EBIT decreases, EPS will decrease by a larger percentage due to the higher leverage.

Question 15

Given the following information, calculate the current price per share (P0) for Olson Corporation. The data all pertain to the year that just ended. Round the answer to two decimal places. Net income $27,475
Beta 1.5
RRF 5%
RM 9%
Dividend payout ratio 40%
Growth rate in earnings and dividends 7%
Common stock shares outstanding 10,000 shares

Accepted Answer

The answer of Given the following information, calculate the current...

Question 16

The percentage change in earnings per share (EPS) that results from a given percentage change in sales is known as the _____.

Accepted Answer

The degree of total leverage measures the sensitivity of EPS to changes in sales, combining both operating and financial leverage effects.

Question 17

When will a firm's degree of operating leverage be at its highest level?

Accepted Answer

The degree of operating leverage is highest when EBIT (Earnings Before Interest and Taxes) is zero because at this point, any change in sales will have the maximum percentage impact on EBIT.

Question 18

What is the formula for calculating the times-interest earned (TIE) ratio?

Accepted Answer

Times-interest earned (TIE) ratio is calculated as earnings before interest and taxes (EBIT) divided by interest charges. Therefore, the formula for calculating TIE ratio is TIE ratio = EBIT ÷ Interest charges, which is option D. Options A, B, C, and E are not correct formulas for calculating the TIE ratio.

Question 19

For every 1 percent decrease in sales of a firm, the EBIT decreases by 3.2 percent. What does this statement indicate?

Accepted Answer

The statement describes the degree of operating leverage (DOL), which measures the sensitivity of a firm's EBIT to changes in sales. The fact that a 1 percent decrease in sales leads to a 3.2 percent decrease in EBIT indicates a DOL of 3.2.

Question 20

Which of the following is true of the degree of financial leverage of a firm?

Accepted Answer

The answer of Which of the following is true of...

Quiz 12: Capital Structure