Question 1

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 refers to the use of debt or other fixed-cost financing to amplify returns on investment. This is typically more under the control of management since they can make decisions on when and how to use debt to finance operations. Operating leverage, on the other hand, refers to the fixed costs involved in producing goods or services, and is often dictated by the nature of the product or production process.

Question 2

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

Accepted Answer

Break-even analysis assumes that the production and sales mix of a multiproduct firm remains constant, allowing for accurate calculation of the break-even point. However, in reality, the production and sales mix of a multiproduct firm may vary, making break-even analysis more complex.

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 includes both the potential for greater returns for shareholders through the use of financial leverage, as well as the increased possibility of insolvency if debt obligations cannot be met.

Question 4

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

Accepted Answer

Operating leverage measures how much a company's operating income (EBIT) changes in response to changes in sales volumes.

Question 5

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 6

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 borrowed capital, which increase the financial leverage of a firm.

Question 7

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

Accepted Answer

Operating leverage refers to the degree to which a company's fixed costs are involved in its operations. This means that as revenue increases, the contribution margin (revenue minus variable costs) increases by a larger percentage, leading to higher profits. However, the opposite is also true, if revenue decreases, the contribution margin decreases by a larger percentage, resulting in lower profits. This variability in profits ultimately affects the earnings per share of the company. Therefore, operating leverage does contribute to the variability of a firm's earnings per share.

Question 8

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

This is because fixed-charge securities require the firm to make fixed payments (such as interest or dividends) regardless of its earnings. This increases the financial risk for the firm, as it must generate enough earnings to cover these fixed payments and still have sufficient funds for other expenses and investments.

Question 9

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 10

Ames Drilling Corp.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 larger increase in EPS compared to sales and EBIT suggests high financial leverage, meaning the company has a significant amount of debt, which amplifies the effect of changes in EBIT on EPS.

Question 11

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 a company to use more debt, not less, as it may need to borrow to finance its operations or investments.

Question 12

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 13

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

Accepted Answer

An increase in financial leverage leads to an increase in debt, which results in a decrease in net income available to common shareholders (after paying interest on debt). However, as the number of outstanding shares remains the same, the decrease in net income is spread over the same number of shares, leading to an increase in EPS. Therefore, an increase in financial leverage will increase the absolute value of EPS, everything else equal.

Question 14

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 and using the money to pay off a loan does not increase financial leverage. Financial leverage refers to the use of debt to finance operations and investments, which increases the risk and potential returns for shareholders. Selling stock does not involve taking on debt and does not increase financial leverage.

Question 15

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

Accepted Answer

Operating leverage is indeed measured as the responsiveness of a firm's earnings before interest and taxes (EBIT) to changes in sales.

Question 16

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 sells bonds, it is increasing its debt and therefore increasing its financial leverage. If the proceeds from the bond sale are used to buy back common stock, it reduces the number of shares outstanding but does not decrease the company's debt. As a result, the company's financial leverage will increase.

Question 17

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

Accepted Answer

Operating leverage refers to the proportion of fixed costs in a company's cost structure, not the financing of earnings per share with debt.

Question 18

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 19

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

Operating leverage is primarily determined by a firm's fixed versus variable costs in its production process, which is not easily adjustable in the short term, whereas financial leverage, determined by the firm's use of debt, can often be more directly managed or adjusted by the firm's management through decisions on borrowing and capital structure.

Question 20

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.

Quiz 12: Determining the Financing Mix