Question 1

Bell Brothers has $3,000,000 in sales. Its fixed costs are estimated to be $200,000, and its variable costs are equal to 50 percent of sales. The company has $1,000,000 in debt outstanding with a before-tax cost of 10 percent. If Bell Brothers' sales increase by 20 percent, by what percent should its earnings per share (EPS) change?

Accepted Answer

The answer of Bell Brothers has $3,000,000 in sales. Its...

Question 2

Everything else equal, in which of the following situations will a firm's degree of operating leverage (DOL) increase? Assume the firm currently generates a positive net operating income.

Accepted Answer

The degree of operating leverage (DOL) increases as a firm's sales move closer to its operating breakeven point because the proportion of fixed costs in the total cost structure becomes more significant relative to variable costs, amplifying the effect of sales volume changes on operating income.

Question 3

Following are the results of the capital structure analysis SoCal Irrigation just completed:    
$$\begin{array} { c c c } 
\begin{array} { c } 
\text { Proportion } \
\text { of Debt }
\end{array} & \begin{array} { c } 
\text { Stock Price } \
\text { (per share) }
\end{array} & \begin{array} { c } 
\text { Earnings per } \
\text { Share (EPS) }
\end{array} \
\hline 20 \% & \$ 44.50 & \$ 1.20 \
40 & 45.15 & 1.26 \
60 & 45.20 & 1.22 \
80 & 44.95 & 1.18
\end{array}$$
According to this information, what is SoCal's optimal capital structure?

Accepted Answer

The answer of Following are the results of the capital...

Question 4

Top-Shelf Construction discovered that for every 1 percent decrease in its sales, its earnings before interest and taxes (EBIT) decrease by 3.2 percent. Based on this information, we know that Top-Shelf Construction has a:

Accepted Answer

The degree of operating leverage (DOL) measures how a percentage change in sales affects the earnings before interest and taxes (EBIT), which is exactly what is described in the scenario.

Question 5

A firm's assets are finance with 60 percent debt and 40 percent common equity. As a result, we know that the firm must have:

Accepted Answer

A firm's financial leverage is measured by the degree of financial leverage (DFL), which is the ratio of percentage change in earnings per share (EPS) to percentage change in earnings before interest and taxes (EBIT). A higher DFL indicates higher financial leverage, meaning that the firm is more reliant on debt financing. Since the firm's assets are financed with 60% debt and 40% equity, it has a higher DFL, which must be greater than 1.0. The other options are not necessarily related to the firm's capital structure.

Question 6

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 answer of The degree of leverage concept is designed...

Question 7

Quick Launch Rocket Company, expects its sales to increase by 50 percent in the coming year. The firm's current earnings per share (EPS) is $3.25. Its degree of operating leverage is 1.6 and its degree of financial leverage is 2.1. What is the firm's projected EPS for the coming year?

Accepted Answer

First, we calculate the total degree of leverage: 
Degree of Leverage = Degree of Operating Leverage x Degree of Financial Leverage = 1.6 x 2.1 = 3.36

Next, we calculate the expected percentage increase in EPS: 
Expected % Increase in EPS = Degree of Leverage x Expected % Increase in Sales = 3.36 x 50% = 168%

Finally, we calculate the projected EPS: 
Projected EPS = Current EPS x (1 + Expected % Increase in EPS) = $3.25 x (1 + 1.68) = $3.25 x 2.68 = $8.71

Therefore, the projected EPS for the coming year is $8.71. The correct answer is D.

Question 8

Trueware Corporation is a start-up firm with a capital structure that includes 25 percent debt. Trueware has no preferred stock. The firm has two possible scenarios for its operations: Ruby or Emerald. The Ruby scenario has a 70 percent probability of occurring and the forecast earnings before interest and taxes (EBIT) in this scenario is $80,000. The Emerald scenario has a 30 percent chance of occurring and the EBIT is expected to be $32,000. Further, the firm's cost of debt is 10 percent. The firm has $500,000 in total assets and its marginal tax rate is 30 percent. The company has 22,000 shares of common stock outstanding. Calculate the difference in earnings per share (EPS) for the capital structure

Accepted Answer

The expected EBIT is calculated as (0.7 * $80,000) + (0.3 * $32,000) = $65,600. Interest expense is 10% of $125,000 (25% of $500,000), which is $12,500. Taxable income is $65,600 - $12,500 = $53,100. After-tax income is $53,100 * (1 - 0.3) = $37,170. EPS is $37,170 / 22,000 = $1.69. The difference in EPS between scenarios is calculated by comparing the EPS in each scenario, leading to a difference of $1.53.

Question 9

Suppose that a firm has a degree of financial leverage (DFL) that is greater than 1.0; that is, DFL > 1. If the firm's sales decrease by 1 percent, its ______ will decrease by more than 1 percent.

Accepted Answer

A degree of financial leverage greater than 1 indicates that the firm has a higher proportion of debt financing than equity financing. This means that the firm is paying fixed financing costs in the form of interest expenses. When sales decrease, the firm's earnings before interest and taxes (EBIT) will also decrease. As the firm has fixed financing costs, the decrease in EBIT will result in a larger decrease in earnings after taxes and, therefore, EPS will decrease by more than 1 percent.

Question 10

The degree of financial leverage (DFL) is defined as the percentage change in ______ that results from a particular percentage change in _____.

Accepted Answer

The degree of financial leverage (DFL) is defined as the percentage change in EPS that results from a particular percentage change in EBIT.

Question 11

According to the following information, what is the firm's optimal capital structure?    $\begin{array}{ccc}
\text { Proportion } & \text { Earnings Per } & \text { Weighted Average Cost } \
\text { of Debt } & \text { Share (EPS) } & \text { of Capital (WACC) } \
\hline 30 \% & \$ 2.50 & 13.2 \% \
40 & 3.80 & 12.7 \
50 & 4.75 & 12.4 \
60 & 5.25 & 12.8
\end{array}$

Accepted Answer

The optimal capital structure is the one that maximizes Earnings Per Share (EPS) while minimizing the Weighted Average Cost of Capital (WACC). In this case, at 50% debt, the firm has the highest EPS of $4.75 and a relatively low WACC of 12.4%, indicating that 50% is the optimal proportion of debt.

Question 12

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

Accepted Answer

The degree of operating leverage (DOL) measures the percentage change in EBIT associated with a given percentage change in sales. It shows the sensitivity of a company's operating income to changes in sales volume.

Question 13

A degree of operating leverage (DOL) equal to 1.5 times indicates that for every 1 percent change in _____.

Accepted Answer

A degree of operating leverage (DOL) indicates the percentage change in earnings before interest and taxes (EBIT) for a 1 percent change in sales. Therefore, a DOL of 1.5 times means that for every 1 percent change in sales, there will be a 1.5 percent change in EBIT. Choice A and E are incorrect because they refer to a percentage change in earnings per share (EPS), which is not directly related to the DOL. Choice B is incorrect because it refers to a percentage change in interest, which is also not directly related to the DOL. Choice D is incorrect because it suggests a change in EPS for a change in EBIT, which is not the definition of the DOL.

Question 14

Which of the following statements concerning a firm's degree of financial leverage (DFL) is correct? Assume everything else is equal.

Accepted Answer

A higher degree of financial leverage means that the company has more fixed financial costs in the form of interest payments, which increases its financial risk. Therefore, option B is the correct choice. Option A is incorrect because issuing additional common stock will not affect the level of fixed financial costs and therefore has no impact on the DFL. Option C is incorrect because a lower DFL means that the company has fewer fixed financial costs and therefore has a lower financial risk. Option D is incorrect because issuing additional long-term debt will increase the fixed financial costs and therefore increase the DFL. Option E is incorrect because a negative DFL is possible if the company's operating income is negative.

Question 15

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, the firm's EPS will change by 2 percent. This means that the firm has a high level of financial leverage, relying heavily on debt financing, and any changes in operating profits will have a magnified impact on its earnings per share (EPS).

Question 16

Which of the following statements concerning a firm's degree of financial leverage (DFL) is correct?

Accepted Answer

The Degree of Financial Leverage (DFL) measures the sensitivity of a firm's earnings per share (EPS) to fluctuations in its operating income, based on the structure of its capital (debt and equity). A higher DFL indicates that a firm has a higher proportion of debt in its capital structure, which increases financial risk because the firm must meet fixed interest payments regardless of its operating performance.

Question 17

A firm expects to have a 15 percent increase in sales this year. If its degree of operating leverage is 1.2 and its degree of financial leverage is 3.5, what will be the percentage change in earnings per share (EPS) this year?

Accepted Answer

The degree of operating leverage (DOL) measures the sensitivity of earnings before interest and taxes (EBIT) to changes in sales. The degree of financial leverage (DFL) measures the sensitivity of EPS to changes in EBIT. The formula for calculating the percentage change in EPS is:% Change in EPS = % Change in Sales * DOL * DFLIn this case, the firm expects to have a 15 percent increase in sales, the DOL is 1.2, and the DFL is 3.5. Therefore, the percentage change in EPS is:% Change in EPS = 15% * 1.2 * 3.5 = 63.0%Therefore, the correct answer is C) 63.0%.

Question 18

Assume that a firm's degree of financial leverage (DFL) is 1.2. If sales this year increase by 20 percent, the firm expects a 60 percent increase in earnings per share (EPS). What is the firm's degree of operating leverage of the firm?

Accepted Answer

The degree of operating leverage (DOL) can be calculated using the formula: DOL = (Percentage change in EPS / Percentage change in sales) / DFL. Here, DOL = (60% / 20%) / 1.2 = 2.5.

Question 19

The percentage change in earnings per share (EPS) that results from a given percentage change in sales is known as the firm's degree of_____ leverage.

Accepted Answer

The answer of The percentage change in earnings per share...

Question 20

Olson Corporation has a beta coefficient of 1.5 at a debt/assets ratio equal to 40 percent. The risk-free rate of return, rRF, is 5 percent and the market return, rM, is 9 percent. Based on the capital asset pricing model (CAPM), what is Olson's required rate of return on its common equity?

Accepted Answer

The answer of Olson Corporation has a beta coefficient of...

Quiz 12: Capital Structure