1.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)   roughly the same.

C)   higher.

D)   not enough information.

2.Financial risk is borne by:

A)   creditors.

B)   common shareholders.

C)   managers.

D)   preferred shareholders.

3.Hughes Continental is assessing its business risk. Which of the following factors would NOT be considered in the analysis?

A)   Unit sales levels.

B)   Unit sales trends.

C)   Input price variability.

D)   Debt-equity ratio.

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

A)   Interest rate variability.

B)   Demand variability.

C)   Input price variability.

D)   Operating leverage.

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

A)   firm earnings.

B)   dividend yield

C)   the value of the firm.

D)   earnings per share.

1.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)   roughly the same.

C)   higher.

D)   not enough information.

The correct answer was 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.

2.Financial risk is borne by:

A)   creditors.

B)   common shareholders.

C)   managers.

D)   preferred shareholders.

The correct answer was B)

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.

3.Hughes Continental is assessing its business risk. Which of the following factors would NOT be considered in the analysis?

A)   Unit sales levels.

B)   Unit sales trends.

C)   Input price variability.

D)   Debt-equity ratio.

The correct answer was D)

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.

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

A)   Interest rate variability.

B)   Demand variability.

C)   Input price variability.

D)   Operating leverage.

The correct answer was A)

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.

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

A)   firm earnings.

B)   dividend yield

C)   the value of the firm.

D)   earnings per share.

The correct answer was C)

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. Dividend yields do not necessarily increase firm value due to the related increase in taxable income, reduced firm liquidity, and other factors.