kim226

Which of the following best describes a firm with low operating leverage? A large change in:

A) earnings before interest and taxes result in a small change in net income.

B) sales result in a small change in net income.

C) the number of units a firm produces and sells result in a similar change in the firm’s earnings before interest and taxes.

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Operating leverage is the result of a greater proportion of fixed costs compared to variable costs in a firm’s capital structure and is characterized by the sensitivity in operating income (earnings before interest and taxes) to change in sales. A firm that has equal changes in sales and operating income would have low operating leverage (the least it can be is one). Note that the relationship between operating income and net income is impacted by the degree of financial leverage, and the relationship between sales and net income is impacted by the degree of total leverage.

kim226

Which of the following events would decrease financial leverage?

A) Issuing common stock to purchase assets.

B) Paying dividends.

C) Issuing debt to purchase assets.

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Acquiring assets by issuing stock decreases the degree of financial leverage since total assets are increased but total liabilities remain the same.

kim226

FCO, Inc. (FCO) is comparing EBIT forecasts to help determine the impact its capital structure has on net income.

	Expected EBIT	EBIT + 10%
EBIT	$80,000	$88,000
Interest expense	15,000	15,000
EBT	65,000	73,000
Taxes	26,000	29,200
Net income	39,000	43,800

Liabilities	200,000
Shareholder equity	250,000
Return on equity	15.60%

FCO’s degree of financial leverage is closest to:

A) 0.80.

B) 0.60.

C) 1.25.

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The degree of financial leverage (DFL) is interpreted as the ratio of the percentage change in net income to the percentage change in EBIT. FCO can compare two EBIT forecasts to determine how net income is being driven by financial leverage.

kim226

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

A) firm earnings.

B) the value of the firm.

C) earnings per share.

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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.

kim226

Financial leverage magnifies:

A) earnings per share variability.

B) taxes.

C) operating income variability.

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Financial leverage results in the existence of required interest payments and, hence, increased earnings per share variability. Higher debt ratios, given a fixed asset base, result in a greater earnings per share variability. Operating income is based on the products and assets of the firm and not on the firm’s financing and, hence, has no impact on financial leverage. Greater financial leverage is likely to reduce taxes due to the tax deductibility of interest payments.

kim226

Which of the following is a key determinant of operating leverage?

A) The competitive nature of the business.

B) Level and cost of debt.

C) The tradeoff between fixed and variable costs.

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Operating leverage can be defined as the trade off between variable and fixed costs.

kim226

Which of the following statements regarding the impact of financial leverage on a company’s net income and return on equity (ROE) is most accurate?

A) Using financial leverage increases the volatility of ROE for a level of volatility in operating income.

B) If a firm has a positive operating profit margin, using financial leverage will always increase ROE.

C) Increasing financial leverage increases both risk and potential return of existing bondholders.

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If a firm is financed with 100% equity, there is a direct relationship between changes in the firm’s ROE and changes in operating income. Adding financial leverage (debt) to the firm’s capital structure will cause ROE to become much more volatile and ROE will change more rapidly for a given change in operating income. The increased volatility in ROE reflects an increase in both risk and potential return for equity holders. Note that financial leverage results in increased default risk, but since existing bond holders are compensated by coupon interest and return of principal, their potential return is unchanged. Although financial leverage will generally increase ROE if a firm has a positive operating margin (EBIT/Sales), if the operating margin were small, the added interest expense could turn the firm’s net profit margin negative, which would in turn make ROE negative.

kim226

Munn Industrial Components currently finances its operations with 100% equity, but is considering changing its target capital structure to 70% equity and 30% debt. Munn has a large asset base, a 20% operating profit margin, and the average interest rate on debt is expected to be 6.0%. If Munn makes the change to its capital structure and EBIT is unchanged, what is most likely the impact on Munn’s net income and return on equity (ROE) respectively?

Impact on Net Income

Impact on Return on Equity

A) No Change Increase

B) Decrease Increase

C) Decrease Decrease

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You should be able to figure out this question with logic (without having to use calculations). The interest expense associated with using debt represents a fixed cost that reduces net income. However, the lower net income value is spread over a smaller base of equity capital, serving to increase the ROE.

kim226

Which of the following firms is likely to have a higher debt ratio?

A) Bath & Books, which produces toiletries and other consumer staples that are in demand regardless of economic conditions.

B) Critter Care, which has a low debt rating due to the prior financial mismanagement by the chief executive officer.

C) Egg Harbor Furs, which serves as a wholesaler of fine furs and garments.

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Bath & Books appears to have relatively little business risk, especially in relation to Egg Harbor Furs, which is likely to be a much more cyclical business. Creditors will be less willing to lend funds to Critter Care whose managers have shown poor money management skills in the past.

kim226

Wanton’s San Y’isidro Co. manufactures custom door knobs for international clients. Average Revenue is $35 per unit, variable costs are $15 per unit, and total costs are $200,000. If sales are 10,000 units, what is the firm's breakeven sales quantity?

A) 2,500 units.

B) 1,750 units.

C) 3,000 units.

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For this problem you need 2 equations. Break-even quantity = Fixed Costs / (Price - Variable cost) Q = FC / (P - V) Fixed Costs = Total Costs - Variable Costs FC = TC - VC = 200,000 - 150,000 = 50,000
Q = 50,000 / (35 - 15) = 2,500