1.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)   operating costs result in a small change in variable costs.

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

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

2.Which of the following types of firms is most likely to have a high degree of operating leverage?

A)   A fine clothing retailer.

B)   A firm providing residential house cleaning services.

C)   A firm that develops and sells complex software.

D)   A restaurant.

3.Which of the following financial statement effects is most likely associated with an increase in financial leverage?

A)   Increased liabilities.

B)   Increased operating expenses.

C)   Increased revenue.

D)   Increased equity.

4.Which of the following events would decrease financial leverage?

A)   Issuing common stock to purchase assets.

B)   Issuing debt to purchase assets.

C)   Purchasing goods on account.

D)   Paying dividends.

5.Financial leverage would NOT be increased if a firm financed its next project with:

A)   bonds with embedded call options.

B)   preferred stock.

C)   common stock.

D)   bonds maturing in 30 years.

6.NG Inc. is thinking about issuing new common stock. Given the following information, what would be NG’s cost of issuing new common stock?

§ Beta of common stock                           1.10

§ Risk-free rate                                        3.5%

§ Expected return on the stock market      8.0%

§ Marginal tax rate                                    40%

A)   9.60%.

B)   8.45%.

C)   7.95%.

D)   5.10%.

1.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)   operating costs result in a small change in variable costs.

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

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

The correct answer was C)

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.

2.Which of the following types of firms is most likely to have a high degree of operating leverage?

A)   A fine clothing retailer.

B)   A firm providing residential house cleaning services.

C)   A firm that develops and sells complex software.

D)   A restaurant.

The correct answer was C)

Firms that tend to have high operating leverage are those that invest up front to produce a product, but have low variable costs when it comes to distributing the product. A software development firm will have to spend a great deal of money up front to create the software, but the costs of distributing the software will be relatively low. Retailers, restaurants, or a firm providing residential house cleaning services are more likely to have a variable cost structure, which would imply low operating leverage.

3.Which of the following financial statement effects is most likely associated with an increase in financial leverage?

A)   Increased liabilities.

B)   Increased operating expenses.

C)   Increased revenue.

D)   Increased equity.

The correct answer was A)

A firm utilizes financial leverage by financing its assets through the use of debt.

4.Which of the following events would decrease financial leverage?

A)   Issuing common stock to purchase assets.

B)   Issuing debt to purchase assets.

C)   Purchasing goods on account.

D)   Paying dividends.

The correct answer was A)

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

5.Financial leverage would NOT be increased if a firm financed its next project with:

A)   bonds with embedded call options.

B)   preferred stock.

C)   common stock.

D)   bonds maturing in 30 years.

The correct answer was C)

Financial leverage is the result of financing assets with fixed income securities such as bonds or preferred stock. It does not matter whether the company is using short-term debt or long-term debt. Each of these alternatives has a required payment component that increases the risk of the firm beyond that arising solely from business risk.

6.NG Inc. is thinking about issuing new common stock. Given the following information, what would be NG’s cost of issuing new common stock?

§ Beta of common stock                           1.10

§ Risk-free rate                                        3.5%

§ Expected return on the stock market      8.0%

§ Marginal tax rate                                    40%

A)   9.60%.

B)   8.45%.

C)   7.95%.

D)   5.10%.

The correct answer was B)

The cost of common stock can be calculated using the Security Market Line:

r_ce = risk free rate + beta of stock*(market return - risk free rate)
r_ce = .035 + 1.1*(.08 - .035)
r_ce = 8.45%

There is no tax savings when issuing new common stock.