Question 1

Financial leverage is concerned with the relationship between a firm's earnings after interest and taxes and its common stock earnings per share.

Accepted Answer

A) True 
 B)False  False

Question 2

Total leverage is concerned with the relationship between a firm's sales revenue and its common stock earnings per share.

Accepted Answer

A) True 
 B)False  True

Question 3

The operating breakeven point can be found by solving for the sales level that just covers total fixed and variable costs.

Accepted Answer

A) True 
 B)False  True

Question 4

Generally, increases in leverage result in increased return and risk.

Accepted Answer

A) True 
 B)False

Question 5

The asymmetric information explanation of capital structure suggests that firms will issue new debt only when the managers believe the firm's stock is overvalued; as a result, issuing new debt is considered a negative signal that will result in a decline in share price.

Accepted Answer

A) True 
 B)False

Question 6

A corporation has $5,000,000 of 10 percent bonds and $3,000,000 of 12 percent preferred stock outstanding. The firm's financial breakeven (assuming a 40 percent tax rate) is ________.

Accepted Answer

A)   $860,000
B)   $716,000
C)   $1,100,000
D)   $1,400,000

Question 7

Poor capital structure decisions can result in a high cost of capital, thereby making some unacceptable investments acceptable.

Accepted Answer

A) True 
 B)False

Question 8

Total leverage exists whenever the percentage change in earnings per share (EPS) resulting from a given percentage change in sales is greater than the percentage change in sales.

Accepted Answer

A) True 
 B)False

Question 9

The steeper the slope of the EBIT-EPS capital structure line, the lower is the financial risk.

Accepted Answer

A) True 
 B)False

Question 10

According to the traditional approach to capital structure, the value of a firm will be maximized when ________.

Accepted Answer

A)   the financial leverage is maximized
B)   the cost of debt is minimized
C)   the weighted average cost of capital is minimized
D)   the dividend payout is maximized

Question 11

Despite the extensive research conducted in recent years in the area of capital structure theory, it is not yet possible to provide financial managers with a specified methodology for use in determining a firm's optimal capital structure.

Accepted Answer

A) True 
 B)False

Question 12

Breakeven analysis is used by a firm to determine the level of operations necessary to cover all fixed operating costs and to evaluate the profitability associated with various levels of production.

Accepted Answer

A) True 
 B)False

Question 13

The degree of operating leverage depends on the base level of sales used as a point of reference. The closer the base sales level used is to the operating breakeven point, the greater the operating leverage.

Accepted Answer

A) True 
 B)False

Question 14

Carol's Dolls has fixed operating costs of $25,000. Its sale price is $55 per doll, and its variable operating cost is $30 per doll. It sells 3,000 dolls per month. The firm's earnings before interest and taxes is ________.

Accepted Answer

A)   $37,500
B)   $55,000
C)   $75,000
D)   $50,000

Question 15

One function of breakeven analysis is to ________.

Accepted Answer

A)   determine the profit attributable to each stockholder
B)   evaluate the effect of leverage on a firm's risks and returns
C)   evaluate the profitability of various sales levels
D)   determine the amount of financing needed by the firm

Question 16

If a firm's fixed financial costs decrease, the firm's operating breakeven point will ________.

Accepted Answer

A)   decrease
B)   increase
C)   remain unchanged
D)   change based on the sale price per unit

Question 17

Due to its secondary position relative to equity, suppliers of debt capital face greater risk and therefore must be compensated with higher expected returns than suppliers of equity capital.

Accepted Answer

A) True 
 B)False

Question 18

Business risk is the risk to a firm of being unable to cover operating costs.

Accepted Answer

A) True 
 B)False

Question 19

The effect of financial leverage is such that an increase in a firm's earnings before interest and taxes (EBIT) results in a more than proportional increase in the firm's earnings per share (EPS), while a decrease in the firm's EBIT results in a less than proportional decrease in EPS.

Accepted Answer

A) True 
 B)False

Question 20

A firm has fixed operating costs of $525,000. The sales price per unit is $35 and its variable costs per unit is $22.50. The firm's operating breakeven point in units is ________.

Accepted Answer

A)   $23,330
B)   $32,000
C)   $42,000
D)   $52,000

Exam 13: Leverage and Capital Structure

Financial leverage is concerned with the relationship between a firm's earnings after interest and taxes and its common stock earnings per share.

Total leverage is concerned with the relationship between a firm's sales revenue and its common stock earnings per share.

The operating breakeven point can be found by solving for the sales level that just covers total fixed and variable costs.

Generally, increases in leverage result in increased return and risk.

The asymmetric information explanation of capital structure suggests that firms will issue new debt only when the managers believe the firm's stock is overvalued; as a result, issuing new debt is considered a negative signal that will result in a decline in share price.

A corporation has $5,000,000 of 10 percent bonds and $3,000,000 of 12 percent preferred stock outstanding. The firm's financial breakeven (assuming a 40 percent tax rate) is ________.

Poor capital structure decisions can result in a high cost of capital, thereby making some unacceptable investments acceptable.

Total leverage exists whenever the percentage change in earnings per share (EPS) resulting from a given percentage change in sales is greater than the percentage change in sales.

The steeper the slope of the EBIT-EPS capital structure line, the lower is the financial risk.

According to the traditional approach to capital structure, the value of a firm will be maximized when ________.

Despite the extensive research conducted in recent years in the area of capital structure theory, it is not yet possible to provide financial managers with a specified methodology for use in determining a firm's optimal capital structure.

Breakeven analysis is used by a firm to determine the level of operations necessary to cover all fixed operating costs and to evaluate the profitability associated with various levels of production.

The degree of operating leverage depends on the base level of sales used as a point of reference. The closer the base sales level used is to the operating breakeven point, the greater the operating leverage.

Carol's Dolls has fixed operating costs of $25,000. Its sale price is $55 per doll, and its variable operating cost is $30 per doll. It sells 3,000 dolls per month. The firm's earnings before interest and taxes is ________.

One function of breakeven analysis is to ________.

If a firm's fixed financial costs decrease, the firm's operating breakeven point will ________.

Due to its secondary position relative to equity, suppliers of debt capital face greater risk and therefore must be compensated with higher expected returns than suppliers of equity capital.

Business risk is the risk to a firm of being unable to cover operating costs.

The effect of financial leverage is such that an increase in a firm's earnings before interest and taxes (EBIT) results in a more than proportional increase in the firm's earnings per share (EPS), while a decrease in the firm's EBIT results in a less than proportional decrease in EPS.

A firm has fixed operating costs of $525,000. The sales price per unit is $35 and its variable costs per unit is $22.50. The firm's operating breakeven point in units is ________.