kim226

Given the following information on the annual operating results for ArtFrames, a producer of quality metal picture frames, what is the degree of operating leverage (DOL) and the degree of financial leverage (DFL)?

• Sales of $3.5 million
• Variable Costs at 45% of sales
• Fixed Costs of $1.05 million
• Debt interest payments on $750,000 issued with an annual 9.0% coupon (current yield is 7.0%)

Which of the following choices is closest to the correct answer? ArtFrame’s DOL and DFL are:

DOL

DFL

A) 3.00 1.50

B) 2.20 1.08

C) 2.20 1.50

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The calculations are as follows:
First, calculate the operating results:

ArtFrames Annual Operating Results
Sales	$3,500,000
Variable Costs1	1,575,000
	1,925,000
Fixed Costs	1,050,000
Earnings before interest and taxes (EBIT)	875,000
Interest Expense2	67,500
	807,500
1Variable costs = 0.45 × 3,500,000
2Interest Expense = 0.09 × 750,000

Second,calculate DOL:

DOL = (Sales – Variable Costs) / (Sales – Variable Costs – Fixed Costs)
= (3,500,000 – 1,575,000) / (3,500,000 – 1,575,000 – 1,050,000) = 2.20

Third, calculate DFL:

DFL = EBIT / (EBIT – I) = 875,000 / 807,500 = 1.08

kim226

Stromburg Corporation's 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 permit sales to increase to $100,000,000. What is Stromburg's degree of operating leverage at the new projected sales level?

A) 4.20.

B) 3.50.

C) 3.75.

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Sales = $100,000,000
VC of 25% of sales = 25,000,000
FC of 40,000,000 + 15,000,000 = 55,000,000
DOL= [100,000,000 – 25,000,000] / [100,000,000 – 25,000,000 – 55,000,000] = 3.75

kim226

The following information reflects the projected operating results for Opstalan, a catalog printer.

• Sales of $5.0 million.
• Variable Costs at 40% of sales.
• Fixed Costs of $1.0 million.
• Debt interest payments on $1.5 million issued with an annual 7.0% coupon (current yield is 8.0%).
• Tax Rate of 0.0%.

Opstalan’s degree of total leverage (DTL) is closest to:

A) 2.58.

B) 1.59.

C) 1.41.

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First, calculate the operating results:

Opstalan Annual Operating Results
Sales	$5,000,000
Variable Costs1	2,000,000
	3,000,000
Fixed Costs	1,000,000
EBIT	2,000,000
Interest Expense2	105,000
	1,895,000

1Variable costs = 0.40 × 5,000,000
2Interest Expense = 0.07 × 1,500,000

Second, calculate DOL = (Sales − Variable Costs) / (Sales − Variable Costs − Fixed Costs) = 3,000,000 / 2,000,000 = 1.50
Third, calculate DFL = EBIT / (EBIT − I) = 2,000,000 / 1,895,000 = 1.06.
Finally, calculate DTL = DOL × DFL = 1.50 × 1.06 = 1.59.

kim226

Which of the following statements about leverage is most accurate?

A) An increase in fixed costs (holding sales and variable costs constant) will reduce the company's degree of operating leverage.

B) A decrease in interest expense will increase the company's degree of total leverage.

C) If the company has no debt outstanding, then its degree of total leverage equals its degree of operating leverage.

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If debt = 0 then DFL = 1 because DFL = EBIT/(EBIT - I)
If debt = 0 then I = 0 and DFL = EBIT/(EBIT - 0) = EBIT/EBIT = 1
DTL = (DOL)(DFL)
If DFL = 1 then DTL = (DOL)(1) which complies to DTL = DOL
A decrease in interest expense will decrease DFL, which will decrease DTL. An increase in fixed costs will increase the company’s DOL.

kim226

The management of Strings & All, Inc., a small, highly leveraged, electric guitar manufacturer, wants to reduce the company’s degree of total leverage (DTL) to 2.0. Currently, the company’s expected operating performance is as follows:

• Sales of $500,000.

• Variable Costs at 60% of sales.

• Fixed Costs of $120,000.

• Fixed-Interest Debt with annual interest payments of $25,000.

All else constant, to obtain a DTL of 2.0, management must:

A) reduce variable expenses by 30%.

B) increase variable expenses by 30%.

C) reduce variable expenses by 38.5%.

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To obtain this result, we need to calculate the current variable costs, determine the variable costs that will result in a DTL ratio of 2.00, and calculate the percentage change.
Step 1: Calculate current variable costs (VC): VC = 0.6 × 500,000 = 300,000
Step 2: Calculate Variable costs needed to decrease the DTL to 2.0:

Rearranging the formula for DTL:
(Sales − Variable Costs) / (Sales − Variable Costs − Fixed Costs − Interest Expense)
results in:  
Variable Costs (VC) = Sales − (2 × Fixed Costs) − (2 × Interest Expense)

= 500,000 − (2 × 120,000) − (2 × 25,000) = 210,000

Step 3: Calculate percentage change:
DVC = (300,000 − 210,000) / 300,000 = 0.30, or 30%.

kim226

If a 10% increase in sales causes EPS to increase from $1.00 to $1.50, and if the firm uses no debt, then what is its degree of operating leverage?

A) 5.0.

B) 4.7.

C) 4.2.

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Upon first glance, it appears there is not enough information to complete the problem. However when one realizes DTL = (DOL)(DFL) it is possible to complete this problem.
DTL = %∆EPS/%∆Sales = 5
DFL =  EBIT/(EBIT-I) = 1.
(DOL)(1) =5
DOL= 5.

kim226

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.

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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.

kim226

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

A) higher.

B) lower.

C) unaffected.

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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.

kim226

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

A) financial leverage.

B) tax efficiency.

C) business risk.

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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.

kim226

The two major types of risk affecting a firm are:

A) business risk and financial risk.

B) financial risk and cash flow risk.

C) business risk and collection risk.

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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.