Corporate Finance【Reading 38】Sample 2012, percentage, business, higher

kim226

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

A) the firm has low operating leverage.

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

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

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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.

kim226

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.

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

kim226

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

A) internal risk.

B) business risk.

C) financial 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.

kim226

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

A) Demand variability.

B) Interest rate variability.

C) Operating leverage.

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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.

kim226

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.

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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.

kim226

Financial risk is borne by:

A) common shareholders.

B) creditors.

C) managers.

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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.

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.

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

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

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.