Exam 18: Financial and Operating Leverage: Analysis and Calculation

PQR Manufacturing Corporation has $1,500,000 in debt outstanding. The company's before-tax cost of debt is 10%. Sales for the year totaled $3,500,000 and variable costs were 60% of sales. Net income was equal to $600,000 and the company's tax rate was 40%. If PQR's degree of total leverage is equal to 1.40, what is its degree of operating leverage?

Using the Security Market Line concept in capital budgeting, which of the following statements is CORRECT?

A company has an EBIT of $4 million, and its degree of total leverage is 2.4. The firm's debt consists of $20 million in bonds with a YTM of 10%. The company is considering a new production process that will require an increase in fixed costs but a decrease in variable costs. If adopted, the new process will result in a degree of operating leverage of 1.4. The president wants to keep the degree of total leverage at 2.4. If EBIT remains at $4 million, what dollar amount of bonds must be outstanding to accomplish this (assuming the yield to maturity remains at 10%)?

Kulwicki Corporation wants to determine the effect of an expansion of its sales on its operating income (EBIT). The firm's current degree of operating leverage is 2.50. It projects new unit sales to be 170,000, an increase of 45,000 over last year's level of 125,000 units. Last year's EBIT was $60,000. Based on a degree of operating leverage of 2.5, what is this year's expected EBIT with the increase in sales?

You need a down payment of $19,000 in order to purchase your first home 4 years from today. You currently have $14,014 to invest. In order to achieve your goal, what nominal interest rate, compounded continuously, must you earn on this investment?

Which of the following statements is most CORRECT?

A 4-year, zero coupon Treasury bond sells at a price of $762.8952. A 3-year, zero coupon Treasury bond sells at a price of $827.8491. Assuming the expectations theory is correct, what does the market believe the price of 1-year, zero coupon bonds will be in 3 years?

You just purchased a 12-year, $1,000 face value, zero coupon bond with a yield to maturity of 9%. If your tax rate is 25%, how much in taxes will you have to pay at the end of the first year of holding the bond?

Stromburg Corporation makes surveillance equipment for intelligence organizations. Its sales are $75,000,000. Fixed costs, including research and development, are $40,000,000, while variable costs amount to 30% of sales. Stromburg plans an expansion which will generate additional fixed costs of $15,000,000, decrease variable costs to 25% of sales, and also permit sales to increase to $100,000,000. What is Stromburg's degree of operating leverage at the new projected sales level?

If you receive $15,000 today and can invest it at a 5% annual rate compounded continuously, what will be your ending value after 20 years?

Which of the following methods involves calculating an average beta for comparable firms and using that beta to determine a project's beta?

U.S. Delay Corporation, a subsidiary of the Postal Service, must decide whether to issue zero coupon bonds or quarterly payment bonds to fund construction of new facilities. The $1,000 par value quarterly payment bonds would sell at $795.54, have a 10% coupon rate, and mature in 10 years. At what price would the zero coupon bonds with a maturity of 10 years have to sell to earn the same effective annual rate as the quarterly payment bonds?

A company currently sells 75,000 units annually. At this sales level, its EBIT is $4 million, and its degree of total leverage is 2.0. The firm's debt consists of $15 million in bonds with a 9.5% coupon. The company is considering a new production method which will entail an increase in fixed costs but a decrease in variable costs, and will result in a degree of operating leverage of 1.600. The president, who is concerned about the stand-alone risk of the firm, wants to keep the degree of total leverage at 2.0. If EBIT remains at $4 million, what dollar amount of bonds must be retired to accomplish this?

Assume that the State of Florida sold tax-exempt, zero coupon bonds with a $1,000 maturity value 5 years ago. The bonds had a 25-year maturity when they were issued, and the interest rate built into the issue was a nominal 8%, compounded semiannually. The bonds are now callable at a premium of 4% over the accrued value. What effective annual rate of return would an investor who bought the bonds when they were issued and who still owns them earn if they were called today?

Which of the following statements is most CORRECT?

Chapter 7 of the Bankruptcy Act is designed to do all of the following EXCEPT:

Bell Brothers has $3,000,000 in sales. Fixed costs are estimated to be $100,000 and variable costs are equal to 50% of sales. The company has $1,000,000 in debt outstanding at a before-tax cost of 10%. If Bell Brothers' sales were to increase by 20%, how much of a percentage increase would you expect in the company's net income?

Stock X and the "market" have had the following rates of returns over the past four years. Year Stock X Market 1 12.00\% 14.00\% 2 5.00\% 2.00\% 3 11.00\% 14.00\% 4 -7.00\% -3.00\%

S. Claus & Co. is planning a zero coupon bond issue that has a par value of $1,000 and matures in 2 years. The bonds will be sold today at a price of $826.45. If the firm's marginal tax rate is 40%, what is the annual after-tax cost of debt to the company on this issue?

The use of financial leverage by the firm has a potential impact on which of the following? (1) The risk associated with the firm. (2) The return experienced by the shareholder. (3) The variability of net income. (4) The degree of operating leverage. (5) The degree of financial leverage.