LOS a: Define and explain leverage, business risk, sales risk, operating risk, and financial risk, and classify a risk, given a description.

Q1. All else equal, a firm's business risk is higher when:

A)   fixed costs are the highest portion of its expense.

B)   the firm has low operating leverage.

C)   variable costs are the highest portion of its expense.

Q2. Which of the following statements about business risk and financial risk is least accurate?

A)   Business risk is the riskiness of the company's assets if it uses no debt.

B)   The greater a company's business risk, the higher its optimal debt ratio.

C)   Factors that affect business risk are demand, sales price, and input price variability.

Q3. Variability in a firm’s operating income is most closely related to its:

A)   internal risk.

B)   business risk.

C)   financial risk.

Q4. Which of the following factors is least likely to affect business risk?

A)   Demand variability.

B)   Operating leverage.

C)   Interest rate variability.

Q5. Hughes Continental is assessing its business risk. Which of the following factors would least likely be considered in the analysis?

A)   Debt-equity ratio.

B)   Input price variability.

C)   Unit sales levels.

Q6. Financial risk is borne by:

A)   common shareholders.

B)   creditors.

C)   managers.

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Q7. During a period of expansion in the economy compared to firms with lower operating expense levels, the earnings growth for firms with high operating leverage will be:

A)   lower.

B)   not enough information.

C)   higher.

Q8. The two major types of risk affecting a firm are:

A)   financial risk and cash flow risk.

B)   business risk and financial risk.

C)   business risk and collection risk.

Q9. The uncertainty in return on assets due to the nature of a firm’s operations is known as:

A)   business risk.

B)   financial leverage.

C)   tax efficiency.

Q10. As financial leverage increases, what will be the impact on the expected rate of return and financial risk?

A)   Both will rise.

B)   Both will fall.

C)   One will rise while the other falls.

Q11. Additional debt should be used in the firm’s capital structure if it increases:

A)   the value of the firm.

B)   firm earnings.

C)   earnings per share.

LOS a: Define and explain leverage, business risk, sales risk, operating risk, and financial risk, and classify a risk, given a description. fficeffice" />

Q1. All else equal, a firm's business risk is higher when:

A)   fixed costs are the highest portion of its expense.

B)   the firm has low operating leverage.

C)   variable costs are the highest portion of its expense.

Correct answer is A)

The higher the percentage of a firm's costs that are fixed, the higher the operating leverage, and the greater the firm's business risk and the more susceptible it is to business cycle fluctuations.

Q2. Which of the following statements about business risk and financial risk is least accurate?

A)   Business risk is the riskiness of the company's assets if it uses no debt.

B)   The greater a company's business risk, the higher its optimal debt ratio.

C)   Factors that affect business risk are demand, sales price, and input price variability.

Correct answer is B)         

The greater a company’s business risk, the lower its optimal debt ratio.

Q3. Variability in a firm’s operating income is most closely related to its:

A)   internal risk.

B)   business risk.

C)   financial risk.

Correct answer is B)         

Business risk is the uncertainty regarding the operating income of a company. Financial risk refers to the uncertainty caused by the fixed cost associated with borrowed money.

Q4. Which of the following factors is least likely to affect business risk?

A)   Demand variability.

B)   Operating leverage.

C)   Interest rate variability.

Correct answer is C)

Business risk can be defined as the uncertainty inherent in a firm’s return on assets (ROA). While changes in interest rates may impact the demand or input prices, there is a more direct impact on business risk with the other three choices.

Q5. Hughes Continental is assessing its business risk. Which of the following factors would least likely be considered in the analysis?

A)   Debt-equity ratio.

B)   Input price variability.

C)   Unit sales levels.

Correct answer is A)

The main factors affecting business risk are demand variability, sales price variability, input price variability, ability to adjust output prices, and operating leverage. Debt levels affect financial risk, not business (operating) risk.

Q6. Financial risk is borne by:

A)   common shareholders.

B)   creditors.

C)   managers.

Correct answer is A)

Common shareholders are the residual owners of the company. As such, they experience the benefits of above-normal gains in good times and the pain of losses when the business is in a slow period. Financial leverage magnifies the variability of earnings per share due to the existence of the required interest payments.

Q7. During a period of expansion in the economy compared to firms with lower operating expense levels, the earnings growth for firms with high operating leverage will be:

A)   lower.

B)   not enough information.

C)   higher.

Correct answer is C)

If a high percentage of a firm's total costs are fixed, the firm is said to have high operating leverage. High operating leverage, other things held constant, means that a relatively small change in sales will result in a large change in operating income. Therefore, during an expansionary phase in the economy a highly leveraged firm will have higher earnings growth than a lesser leveraged firm. The opposite will happen during an economic contraction.

Q8. The two major types of risk affecting a firm are:

A)   financial risk and cash flow risk.

B)   business risk and financial risk.

C)   business risk and collection risk.

Correct answer is B)         

Business risk is the uncertainty regarding the operating income of a company. Financial risk refers to the uncertainty caused by the fixed cost associated with borrowed money.

Q9. The uncertainty in return on assets due to the nature of a firm’s operations is known as:

A)   business risk.

B)   financial leverage.

C)   tax efficiency.

Correct answer is A)

Business risk is a function of the firm's revenue and expenses, resulting in operating income, or earnings before interest and taxes (EBIT). The main factors affecting business risk are demand variability, sales price variability, input price variability, ability to adjust output prices, and operating leverage. Tax efficiency is tied to mutual fund investing, while financial leverage requires the existence of debt.

Q10. As financial leverage increases, what will be the impact on the expected rate of return and financial risk?

A)   Both will rise.

B)   Both will fall.

C)   One will rise while the other falls.

Correct answer is A)

A higher breakeven point resulting from increased interest costs associated with debt financing increases the risk of the company. Since the risk is tied to firm financing, it is referred to as financial risk. Given the positive risk-return relationship, the expected return of the company’s common stock also rises.

Q11. Additional debt should be used in the firm’s capital structure if it increases:

A)   the value of the firm.

B)   firm earnings.

C)   earnings per share.

Correct answer is A)

The key to finding the optimal capital structure is identifying the level of debt that will maximize firm value. Earnings and earnings per share are not critical in and of themselves when assessing firm value, because they do not consider risk.

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