Question 1

Operating leverage contributes ultimately to the variability of a firm's earnings per share.

Accepted Answer

Operating leverage is the degree to which a firm uses fixed costs versus variable costs in its operations. When a firm has a high level of fixed costs, small changes in sales volume can result in larger changes in earnings per share. Therefore, operating leverage contributes to the variability of a firm's earnings per share.

Question 2

Dakota Oil,Inc.reported that its sales and EBIT increased by 10%,but its EPS increased by 30%.The much larger change in earnings per share could be the result of

Accepted Answer

The much larger increase in EPS compared to sales and EBIT suggests that Dakota Oil has high financial leverage, meaning it has a significant amount of debt financing. This results in a higher proportion of earnings available to common shareholders due to the effects of financial leverage. High operating leverage (choice A) would have affected both sales and earnings similarly, while credit sale collections (choice C) and fixed costs of production (choice D) would not have had such a substantial impact on EPS.

Question 3

Financial risk applies to both the additional variability in earnings available to common shareholders and the additional chance of insolvency caused by the use of financial leverage.

Accepted Answer

Financial risk refers to the risk of loss that arises from the use of debt financing, which can lead to variability in earnings available to common shareholders and increased chance of insolvency. Therefore, both statements are true.

Question 4

Operating leverage is the responsiveness of a firm's EBIT to changes in sales revenues.

Accepted Answer

Operating leverage measures how sensitive a company's operating income (EBIT) is to changes in revenue. It is calculated by dividing the company’s fixed costs by its variable costs. The higher the proportion of fixed costs in a company's cost structure, the higher its operating leverage.

Question 5

A company that sells common stock and uses the money to pay off a loan is increasing its use of financial leverage.

Accepted Answer

Selling common stock does not increase the company's financial leverage as it does not create any debt. Financial leverage refers to the use of debt to finance a company's operations or investments. By taking a loan and using the proceeds to pay it off, the company would be reducing its financial leverage rather than increasing it.

Question 6

Break-even analysis assumes that a multiproduct firm maintains a constant production and sales mix.

Accepted Answer

Break-even analysis assumes that a multiproduct firm maintains a constant production and sales mix, meaning that the relative proportions of different products sold remain constant. This assumption is necessary for the calculation of the overall break-even point, which is the point at which total revenues equal total costs.

Question 7

Operating leverage is measured as the responsiveness of the firm's earnings before interest and taxes relative to fluctuations in sales.

Accepted Answer

This is the definition of operating leverage.

Question 8

A CEO concerned about variability of earnings per share may try to offset high operating leverage with a capital structure that is mostly debt in order to take advantage of the interest tax shield.

Accepted Answer

A CEO concerned about the variability of earnings per share (EPS) would likely prefer a capital structure with less debt to avoid the fixed interest payments that increase financial leverage and potentially the variability of EPS. High operating leverage already increases earnings variability; adding high financial leverage (mostly debt) would exacerbate this variability, not offset it.

Question 9

The more fixed-charge securities (such as bonds and preferred stock)the firm employs in its financial structure,the greater its financial leverage.

Accepted Answer

Fixed-charge securities such as bonds and preferred stock represent debt and have set interest or dividend payments, thus increasing the financial leverage of the firm.

Question 10

Because fixed costs do not vary with a firm's revenues,firm's with high levels of fixed cost enjoy lower levels of operating risk because their costs are more certain,making budgeting easier.

Accepted Answer

Firms with high levels of fixed costs actually face higher levels of operating risk because their break-even point is higher, making them more sensitive to fluctuations in sales volume.

Question 11

Which of the following transactions will lower a company's financial leverage?

Accepted Answer

The answer of Which of the following transactions will lower...

Question 12

The presence of debt and/or preferred stock in a firm's financial structure means the firm is using financial leverage.

Accepted Answer

Debt and preferred stock are forms of financial leverage as they allow the firm to raise funds without diluting existing ownership. Financial leverage can increase returns to shareholders, but also increases the risk of financial distress if the firm is unable to meet its debt obligations.

Question 13

If a company sells bonds and uses the proceeds to buy back common stock,the company's financial leverage with increase.

Accepted Answer

When a company buys back its own stock, it reduces the amount of equity on its balance sheet and increases its debt-to-equity ratio, which is a measure of financial leverage. Selling bonds to fund the stock buyback will increase the amount of debt the company has, further increasing its financial leverage.

Question 14

All of the following are likely to result in the use of less debt in a company's capital structure EXCEPT

Accepted Answer

Insufficient internal funds would likely lead to a company using more debt in its capital structure, not less, as it seeks external financing to support its operations or growth initiatives. Options A, B, and D are factors that would lead a company to use less debt to avoid financial risk, maintain creditworthiness, or when the tax benefits of debt are reduced, respectively.

Question 15

Because financial markets can be extremely volatile,with bond and stock prices changing significantly from day to day,a firm's management has much greater control over the firm's operating leverage than over its financial leverage.

Accepted Answer

The statement is incorrect. While financial markets can be volatile, a firm's management has more control over its financial leverage, which relates to its debt and capital structure decisions, than over its operating leverage, which relates to the fixed and variable costs of running the business. A firm's operating leverage is largely determined by factors such as its industry and competitive environment, while its financial leverage is a result of its financing decisions.

Question 16

If a firm's production process requires high operating leverage (use of fixed costs),then the firm should finance its assets with debt,so that the cost of capital will be reduced and financing costs will remain fixed.

Accepted Answer

High operating leverage means a firm has high fixed costs relative to its variable costs, making its earnings more sensitive to changes in sales volume. Financing with debt adds fixed financial obligations (interest payments), increasing the firm's financial leverage and risk. This doesn't necessarily reduce the cost of capital and can make the firm's earnings more volatile.

Question 17

A company that sells preferred stock and uses the money to pay off a loan is decreasing its amount of financial leverage.

Accepted Answer

The answer of A company that sells preferred stock and...

Question 18

Financial leverage is typically more under the control of management than is operating leverage because the nature of the product often dictates the type of production process needed.

Accepted Answer

Financial leverage is determined by the amount of debt that a company uses in its capital structure, which management has control over. On the other hand, operating leverage is determined by the level of fixed costs in the production process, which is often influenced by the nature of the product and is not as directly controlled by management.

Question 19

An increase in financial leverage will increase the absolute value of EPS,everything else equal.

Accepted Answer

An increase in financial leverage increases the use of debt financing, which can lead to a lower cost of capital and higher profits. This, in turn, increases the absolute value of EPS. However, it also increases the risk of the company's financial position, which investors may take into consideration when valuing the stock.

Question 20

Operating leverage means financing a portion of a firm's earnings per share with debt.

Accepted Answer

Operating leverage refers to the extent to which a firm relies on fixed costs to generate earnings before interest and taxes (EBIT). It has nothing to do with financing a portion of earnings per share with debt.

Quiz 12: Determining the Financing Mix