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

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

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

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

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

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

Jayco, Inc. sells 10,000 units at a price of $5 per unit. Jayco's fixed costs are $8,000, interest expense is $2,000, variable costs are $3 per unit, and earnings before interest and taxes (EBIT) is $12,000. What is Jayco’s degree of financial leverage (DFL) and total leverage (DTL)?

DFL

DTL

A) 1.33 1.75

B) 1.33 2.00

C) 1.20 2.00

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DOL = [Q(P − V)] / [Q(P − V) − F] = [10,000(5 − 3)] / [10,000(5 − 3) − 8,000] = 1.67
DFL = EBIT / (EBIT − I) = 12,000 / (12,000 − 2,000) = 1.2
DTL = DOL × DFL = 1.67 × 1.2 = 2.0

kim226

All else equal, which of the following statements about operating leverage is least accurate?

A) Lower operating leverage generally results in a higher expected rate of return.

B) Operating leverage reflects the tradeoff between variable costs and fixed costs.

C) Firms with high operating leverage experience greater variance in operating income.

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Operating leverage is the trade off between fixed and variable costs. Higher operating leverage typically is indicative of a firm with higher levels of risk (greater income variance). Given the positive risk/return relationship, higher operating leverage firms are expected to have a higher rate of return. And, lower operating leverage firms are expected to have a lower rate of return.

kim226

A firm expects to produce 200,000 units of flour that can be sold for $3.00 per bag. The variable costs per unit are $2.00, the fixed costs are $75,000, and interest expense is $25,000. The degree of operating leverage (DOL) and the degree of total leverage (DTL) is closest to:

DOL

DTL

A) 1.6 2.0

B) 1.3 1.3

C) 1.6 1.3

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DOL = Q(P – V) / [Q(P – V) – F]
DOL = 200,000 (3 – 2) / [200,000(3 – 2) – 75,000] = 1.6
DTL = [Q(P - V) / Q(P - V) - F - I]
DTL = 200,000 (3 - 2) / [200,000 (3 - 2) - 75,000 - 25,000] = 2

kim226

Which of the following statements regarding leverage is most accurate?

A) A firm with high business risk is more likely to increase its use of financial leverage than a firm with low business risk.

B) A firm with low operating leverage has a small proportion of its total costs in fixed costs.

C) High levels of financial leverage increase business risk while high levels of operating leverage will decrease business risk.

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A firm with high operating leverage has a high percentage of its total costs in fixed costs.