Deck 5: Operating and Financial Leverage

Question 1

A firm would be indifferent between financing plans when:

A) debt is equal to equity.
B) return on assets equals return on equity.
C) the cost of borrowed funds equals the return on equity.
D) the cost of borrowed funds equals the return on assets.

Answer 1

D

Question 2

A conservative financing plan involves:

A) heavy reliance on debt.
B) heavy reliance on equity.
C) high degree of financial leverage.
D) high degree of combined leverage.

Answer 2

B

Question 3

A highly automated plant would generally have:

A) more variable costs than fixed costs.
B) more fixed costs than variable costs.
C) all fixed costs.
D) all variable costs.

Answer 3

B

Question 4

The break-even point can be calculated as:

A) variable costs divided by contribution margin.
B) total costs divided by contribution margin.
C) variable cost times contribution margin.
D) fixed cost divided by contribution margin.

Question 5

If sales volume exceeds the break-even point,the firm will experience:

A) an operating loss.
B) an operating profit.
C) an increase in plant and equipment.
D) an increase in share price.

Question 6

Firm A employs a high degree of operating leverage; Firm B takes a more conservative approach.Which of the following comparative statements about firms A and B is true?

A) A has a lower break-even point than B,but A's profit grows faster after the break-even.
B) A has a higher break-even point than B,but A's profit grows slower after the break-even.
C) B has a lower break-even point than A,but A's profit grows faster after the break-even.
D) B has a lower break-even point than A,and profit grows the same rate for both companies after the break-even point.

Question 7

The concept of operating leverage involves the use of __________ to magnify returns at high levels of operation.

A) fixed costs
B) variable costs
C) marginal costs
D) semi-variable costs

Question 8

Under which of the following conditions could the overuse of financial leverage be detrimental to the firm?

A) Stable industry.
B) Cyclical demand for the firm's products.
C) Upswing of business cycle.
D) Low interest cost compared to return on assets.

Question 9

In break-even analysis the contribution margin is defined as:

A) sales minus variable costs.
B) sales minus fixed costs.
C) variable costs minus fixed costs.
D) fixed costs minus variable costs.

Question 10

If the business cycle were just beginning its upswing,which firm would you anticipate would be likely to show the best growth in EPS over the next year? Firm A has high combined leverage and Firm B has low combined leverage.

A) Firm A
B) Firm B
C) Indifferent between the two.
D) It depends on how much financial leverage each firm has.

Question 11

Which of the following is concerned with the change in operating profit as a result of a change in volume?

A) Financial leverage
B) Break-even point
C) Operating leverage
D) Combined leverage

Question 12

Financial leverage is concerned with the relation between:

A) changes in volume and changes in EPS.
B) changes in volume and changes in EBIT.
C) changes in EBIT and changes in EPS.
D) changes in EBIT and changes in operating income.

Question 13

At the break-even point,a firm's profits are:

A) greater than zero.
B) less than zero.
C) equal to zero.
D) not enough information to tell.

Question 14

If fixed costs rise while other variables stay constant:

A) the break-even point decreases.
B) degree of operating leverage decreases.
C) total profit increases.
D) total profit decreases.

Question 15

The degree of operating leverage is computed as:

A) percent change in operating profit divided by percent change in net income.
B) percent change in volume divided by percent change in operating profit.
C) percent change in EPS divided by percent change in operating income.
D) percent change in operating income divided by percent change in volume.

Question 16

Firms with a high degree of operating leverage are:

A) easily capable of surviving large changes in sales volume.
B) usually trading off lower levels of risk for higher profits.
C) significantly affected by changes in interest rates.
D) trading off higher fixed costs for lower per-unit variable costs.

Question 17

Combined leverage is concerned with the relationship between:

A) changes in EBIT and changes in EPS.
B) changes in volume and changes in EPS.
C) changes in volume and changes in EBIT.
D) changes in EBIT and changes in net income.

Question 18

If a firm has a break-even point of 20,000 units and the contribution margin on the firm's single product is $3.00 per unit and fixed costs are $60,000,what will the firm's net income be at sales of 30,000 units?

A) $90,000
B) $30,000
C) $15,000
D) $45,000

Question 19

Heavy use of long-term debt may be beneficial in an inflationary economy because:

A) the debt may be repaid in more "expensive" dollars.
B) nominal interest rates exceed real interest rates.
C) inflation is associated with the peak of a business cycle.
D) the debt may be repaid in "cheaper" dollars.

Question 20

If EBIT equals $140,000 and interest equals $21,000,with a tax rate of 31%,what is the degree of financial leverage?

A) 6.67x
B) 5.67x
C) 3.91x
D) 1.18x

Question 21

If a firm has fixed costs of $30,000,a price of $4.00,and a break-even point of 15,000 units,the variable cost per unit is:

A) $5.00.
B) $2.00.
C) $0.50.
D) $4.00.

Question 22

Which of the following is not true about leverage?

A) Operating leverage influences the top half of the income statement,determining EBIT.
B) Financial leverage deals with the bottom half of the income statement,determining EPS.
C) Combined leverage utilizes the entire income statement,showing the impact of change in volume on EBIT.
D) Combined leverage utilizes the percentage change in EPS and percentage change in sales.

Question 23

$$\begin{array} { l r } \text { Sales } ( 30,000 \text { units } ) & \$ 150,000 \\\text { Variable costs } & \underline { 100,800 } \\\text { Contribution margin } & 49,200 \\\text { Fixed manufacturing costs } & \underline { 24,000 } \\\text { Operating Income } & 25,200 \\\text { Interest } & \underline { 18,000 } \\\text { Earnings Before Taxes } & 7,200 \\\text { Taxes } ( 30 \% ) & \underline { 2,160 } \\\text { Net Income } & \underline { \$ 5,040 } \\\text { Shares Outstanding } & 600\end{array}$$

-This firm's break-even point is:

A) 4,800 units.
B) 14,634 units.
C) 7,142 units.
D) 18,000 units.

Question 24

Which of the following is true about the concept of leverage?

A) At the break-even point,operating leverage is equal to zero.
B) Combined leverage measures the impact of operating and financial leverage on EBIT.
C) Financial leverage measures the impact of fixed costs on earnings.
D) Combined leverage measures the impact of operating and financial leverage on EPS.

Question 25

$\begin{array}{lr}\text { Sales }(75,000 \text { units }) & \$ 750,000 \\\text { Variable costs } & \underline{225,000} \\\text { Contribution margin } & 525,000 \\\text { Fixed manufacturing costs } & \underline{187,500}\\\text { Operating income } & 337,500 \\\text { Interest } & \mathbf{7 5 , 0 0 0} \\\text { Earnings before taxes } & 262,500 \\\text { Taxes (at } 31 \% \text { ) } & 81.375\\\text { Net income }&\$181,125\\\text { Shares outstanding }&15,000\end{array}$

-The Degree of Financial Leverage is:

A) 1.29x.
B) 4.50x.
C) 3.50x.
D) 1.32x.

Question 26

Cash break-even analysis:

A) is helpful in analyzing the short-term outlook of the firm,particularly when it is in trouble financially.
B) is important when analyzing long-term profitability.
C) includes amortization expense as a fixed cost when calculating the degree of financial leverage.
D) includes the amount of liabilities.

Question 27

$\begin{array}{lr}\text { Sales }(75,000 \text { units }) & \$ 750,000 \\\text { Variable costs } & \underline{225,000} \\\text { Contribution margin } & 525,000 \\\text { Fixed manufacturing costs } & \underline{187,500}\\\text { Operating income } & 337,500 \\\text { Interest } & \mathbf{7 5 , 0 0 0} \\\text { Earnings before taxes } & 262,500 \\\text { Taxes (at } 31 \% \text { ) } & 81.375\\\text { Net income }&\$181,125\\\text { Shares outstanding }&15,000\end{array}$

-The Degree of Combined Leverage is:

A) 2.1x.
B) 1.9x.
C) 2.9x.
D) 2.0x.

Question 28

$$\begin{array} { l r } \text { Sales } ( 30,000 \text { units } ) & \$ 150,000 \\\text { Variable costs } & \underline { 100,800 } \\\text { Contribution margin } & 49,200 \\\text { Fixed manufacturing costs } & \underline { 24,000 } \\\text { Operating Income } & 25,200 \\\text { Interest } & \underline { 18,000 } \\\text { Earnings Before Taxes } & 7,200 \\\text { Taxes } ( 30 \% ) & \underline { 2,160 } \\\text { Net Income } & \underline { \$ 5,040 } \\\text { Shares Outstanding } & 600\end{array}$$

-The Degree of Financial Leverage (DFL)is:

A) 3.50x.
B) 1.40x.
C) 1.95x.
D) 1.58x.

Question 29

Which of the following questions does break-even analysis not attempt to address?

A) How much do changes in volume affect costs and profits?
B) At what point does the firm break even?
C) What is the most efficient level of capital assets to employ?
D) Percentage change in earnings per share.

Question 30

Operating leverage primarily affects the __________ while financial leverage primarily affects the __________.

A) left-hand side of the balance sheet; the lower part of the income statement
B) right-hand side of the balance sheet; the upper part of the income statement
C) the lower part of the income statement; the right-hand part of the balance sheet
D) the upper part of the income statement; the left-hand side of the balance sheet

Question 31

$$\begin{array} { l r } \text { Sales } ( 30,000 \text { units } ) & \$ 150,000 \\\text { Variable costs } & \underline { 100,800 } \\\text { Contribution margin } & 49,200 \\\text { Fixed manufacturing costs } & \underline { 24,000 } \\\text { Operating Income } & 25,200 \\\text { Interest } & \underline { 18,000 } \\\text { Earnings Before Taxes } & 7,200 \\\text { Taxes } ( 30 \% ) & \underline { 2,160 } \\\text { Net Income } & \underline { \$ 5,040 } \\\text { Shares Outstanding } & 600\end{array}$$

-The Degree of Operating Leverage (DOL)is:

A) 1.58x.
B) 1.95x.
C) 3.50x.
D) 1.40x.

Question 32

$\begin{array}{lr}\text { Sales }(75,000 \text { units }) & \$ 750,000 \\\text { Variable costs } & \underline{225,000} \\\text { Contribution margin } & 525,000 \\\text { Fixed manufacturing costs } & \underline{187,500}\\\text { Operating income } & 337,500 \\\text { Interest } & \mathbf{7 5 , 0 0 0} \\\text { Earnings before taxes } & 262,500 \\\text { Taxes (at } 31 \% \text { ) } & 81.375\\\text { Net income }&\$181,125\\\text { Shares outstanding }&15,000\end{array}$

-The Degree of Operating Leverage is:

A) 1.43x.
B) 1.56x.
C) 3.33x.
D) 2.22x.

Question 33

A firm's indifference point between debt and equity financing plans would occur when the:

A) amount of debt used is equal to the amount of equity.
B) cost of borrowing is low.
C) cost of borrowed funds equals return on equity.
D) current level of EBIT generates the same EPS under both plans.

Question 34

If the price per unit decreases because of competition but the cost structure remains the same:

A) the break-even point increases.
B) the break-even point decreases.
C) the degree of financial leverage declines.
D) the degree of combined leverage declines.

Question 35

The degree of operating leverage may be defined as:

A) the change in operating income divided by the change in unit volume.
B) Q (P + VC)divided by Q (P + VC)- FC.
C) S + TVC divided by S + TVC - FC.
D) S - TVC divided by S - TVC - FC.

Question 36

When a firm employs no debt:

A) it has a financial leverage of one.
B) it has a financial leverage of zero.
C) its operating leverage is equal to its financial leverage.
D) it will not be profitable.

Question 37

$$\begin{array} { l r } \text { Sales } ( 30,000 \text { units } ) & \$ 150,000 \\\text { Variable costs } & \underline { 100,800 } \\\text { Contribution margin } & 49,200 \\\text { Fixed manufacturing costs } & \underline { 24,000 } \\\text { Operating Income } & 25,200 \\\text { Interest } & \underline { 18,000 } \\\text { Earnings Before Taxes } & 7,200 \\\text { Taxes } ( 30 \% ) & \underline { 2,160 } \\\text { Net Income } & \underline { \$ 5,040 } \\\text { Shares Outstanding } & 600\end{array}$$

-The Degree of Combined Leverage (DCL)is:

A) 3.08x.
B) 5.45x.
C) 2.73x.
D) 6.83x.

Question 38

Financial leverage primarily affects the _________ while operating leverage primarily affects the __________.

A) left-hand side of the balance sheet; the right-hand side of the balance sheet
B) right-hand side of the balance sheet; the upper part of the income statement
C) lower part of the income statement; the right-hand side of the balance sheet
D) the upper part of the income statement; the left-hand side of the balance sheet

Question 39

If a firm has fixed costs of $20,000,variable cost per unit of $0.50,and a break-even point of 5,000 units,the price is:

A) $2.50.
B) $5.00.
C) $4.00.
D) $4.50.

Question 40

If a firm has a price of $4.00,variable cost per unit of $2.50,and a break-even point of 20,000 units,fixed costs are equal to:

A) $13,333.
B) $10,000.
C) $30,000.
D) $50,000.

Question 41

$$\begin{array} { l r } \text { Sales } ( 100,000 \text { units) } & \$ 1,000,000 \\\text { Variable costs } & \underline { 300,000 } \\\text { Contribution margin } & 700,000 \\\text { Fixed manufacturing costs } & \underline { 250,000 } \\\text { Operating income } & 450,000 \\\text { Interest } & \underline { 60,000 } \\\text { Earnings before taxes } & 390,000 \\\text { Taxes (at } 31 \% \text { ) } & \underline { 120,900 } \\\text { Net Income } & \underline { \$ 269,100 } \\\text { Shares outstanding } & 10,000\end{array}$$

-If the price per unit increases but the cost structure remains the same:

A) the break-even point rises.
B) the degree of combined leverage increases.
C) the degree of financial leverage increases.
D) the break-even point falls.

Question 42

In break-even analysis the contribution margin is defined as:

A) sales minus variable costs.
B) sales minus fixed costs.
C) fixed costs minus variable costs.
D) fixed costs minus amortization.

Question 43

$$\begin{array} { l r } \text { Sales } ( 100,000 \text { units) } & \$ 1,000,000 \\\text { Variable costs } & \underline { 300,000 } \\\text { Contribution margin } & 700,000 \\\text { Fixed manufacturing costs } & \underline { 250,000 } \\\text { Operating income } & 450,000 \\\text { Interest } & \underline { 60,000 } \\\text { Earnings before taxes } & 390,000 \\\text { Taxes (at } 31 \% \text { ) } & \underline { 120,900 } \\\text { Net Income } & \underline { \$ 269,100 } \\\text { Shares outstanding } & 10,000\end{array}$$

-The Degree of Operating Leverage is:

A) 1.79x.
B) 1.56x.
C) 2.22x.
D) 2.33x.

Question 44

Sales volumes lower than the break-even point result in a firm having ___________________.

A) operating losses
B) operating profits
C) break even cash flows
D) a gain of potential leverage and bank financing

Question 45

Lever Products (LP)is considering the elimination of a press machine.The new press machine should reduce depreciation expenses by $80,000 annually.If LP's total fixed costs were $420,000 last year,what would LP's new break-even point in units if the contribution margin is 3.75 per unit?

A) 68,000 units
B) 90,667 units
C) 100,800 units
D) 50,667 units

Question 46

$$\begin{array} { l r } \text { Sales } ( 100,000 \text { units) } & \$ 1,000,000 \\\text { Variable costs } & \underline { 300,000 } \\\text { Contribution margin } & 700,000 \\\text { Fixed manufacturing costs } & \underline { 250,000 } \\\text { Operating income } & 450,000 \\\text { Interest } & \underline { 60,000 } \\\text { Earnings before taxes } & 390,000 \\\text { Taxes (at } 31 \% \text { ) } & \underline { 120,900 } \\\text { Net Income } & \underline { \$ 269,100 } \\\text { Shares outstanding } & 10,000\end{array}$$

-The Degree of Combined Leverage is:

A) 2.79x.
B) 1.90x.
C) 1.79x.
D) 3.46x.

Question 47

A weakness of break-even analysis is that it assumes:

A) revenue and costs are a linear (constant)function of volume.
B) prices and costs increase when the economy is strong and confidence is high.
C) cost of goods sold goes up as revenue increase.
D) there is no weakness.

Question 48

If a firm has a 30% change in operating income,and its Degree of Operating Leverage is 3.63,what was its percentage change in unit volume,all other things considered?

A) 36.5%
B) 12.52%
C) 8.26%
D) 360%

Question 49

$$\begin{array} { l r } \text { Sales } ( 100,000 \text { units) } & \$ 1,000,000 \\\text { Variable costs } & \underline { 300,000 } \\\text { Contribution margin } & 700,000 \\\text { Fixed manufacturing costs } & \underline { 250,000 } \\\text { Operating income } & 450,000 \\\text { Interest } & \underline { 60,000 } \\\text { Earnings before taxes } & 390,000 \\\text { Taxes (at } 31 \% \text { ) } & \underline { 120,900 } \\\text { Net Income } & \underline { \$ 269,100 } \\\text { Shares outstanding } & 10,000\end{array}$$

-The Degree of Financial Leverage is:

A) 1.56x.
B) 1.79x.
C) 7.50x.
D) 1.15x.

Question 50

Operating Leverage is the use of fixed costs to magnify returns at high levels of operation.

Question 51

If the contribution margin on the firm's single product is $2.00 per unit and fixed costs are $60,000,what will the firm's net income be at sales of 30,000 units?

A) $90,000
B) $30,000
C) $15,000
D) $0

Question 52

If fixed costs decreases while other variables stay constant:

A) the break-even point increases.
B) degree of operating leverage increases.
C) total profit decrease.
D) total profit increases.

Question 53

ECG has a contribution margin of $196,000.If ECG earned $87,000 before taxes in the year,what is the firm's Degree of Combined Leverage?

A) 2.26x
B) 1.27x
C) 0.44x
D) 1.29x

Question 54

If EBIT equals $280,000 and interest equals $20,000,with a tax rate of 31%,what is the degree of financial leverage?

A) 14.00x
B) 9.66x
C) 3.91x
D) 1.88x

Question 55

Heavy use of long-term debt may be detrimental in a deflationary economy because:

A) the debt may be repaid in more "expensive" dollars.
B) nominal interest rates exceed real interest rates.
C) inflation is associated with the peak of a business cycle.
D) the debt may be repaid in "cheaper" dollars.

Question 56

A plant relying mostly on manual labour would generally have:

A) more variable than fixed costs.
B) more fixed than variable costs.
C) all fixed costs.
D) all variable costs.

Question 57

Financial leverage deals with:

A) the relationship of fixed and variable costs.
B) the relationship of debt and equity in the capital structure.
C) the entire income statement.
D) the entire balance sheet.

Question 58

If sales volume is less than the break-even point,the firm will experience:

A) an operating loss.
B) an operating profit.
C) an increase in plant and equipment.
D) an increase in share price.

Question 59

Financial leverage is determined to a large extent by the firm's:

A) working capital choice.
B) capital budgeting choice.
C) capital structure choice.
D) dividend policy choice.

Question 60

A high DOL means:

A) there are high labour costs.
B) there is high debt.
C) there is a large amount of equity.
D) there are high fixed costs.

Question 61

Financial leverage is concerned with the use of debt in the business.

Question 62

The contribution margin is equal to price per unit minus total costs per unit.

Question 63

Linear break-even analysis assumes that costs are linear functions of volume.

Question 64

The analysis of operating leverage assumes that relationships between revenues and costs are constant.

Question 65

The closer a firm is to its break-even point,the lower the degree of operating leverage will be.

Question 66

As the contribution margin rises,the break-even point goes down.

Question 67

The degree of financial leverage measures the percentage change in EPS for every 1 percent move in EBIT.

Question 68

If economic conditions were expected to be favourable,an investor would likely prefer a firm with a low degree of leverage.

Question 69

Firms with cyclical sales should employ a high degree of leverage.

Question 70

Managers who are risk averse and uncertain about the future would most likely minimize combined leverage.

Question 71

Operating Leverage works best when volume is increasing.

Question 72

The degree of combined leverage is the sum of the degree of operating leverage and the degree of financial leverage.

Question 73

Operating income is not the same thing as EBIT.

Question 74

Financial leverage primarily affects the left-hand side of the balance sheet.

Question 75

Operating leverage influences the bottom half of the income statement while financial leverage deals with the top half.

Question 76

The degree of operating leverage is a number indicating the relationship between the percentage changes in sales to the percentage change in earnings per share.

Question 77

If a firm has a DFL of 2.0,EPS will change 2% for every 1% change in volume.

Question 78

Operating leverage is concerned with the use of capital assets in the business.

Question 79

Operating leverage determines how income from operations is to be divided between debt holders and shareholders.

Question 80

Cash break-even analysis eliminates the amortization expense and other non-cash charges from capital costs.