Foundations of Financial Management 11Th Canadian Edition By Stanley B. Block - Test Bank

Foundations of Financial Management 11Th Canadian Edition By Stanley B. Block – Test Bank

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Chapter 05

Operating and Financial Leverage

Multiple Choice Questions

The concept of operating leverage involves the use of __________ to magnify returns at high levels of operation.
A.fixed costs
B. variable costs
C. marginal costs
D. semi-variable costs

Accessibility: Keyboard Navigation
Blooms: Remember
Difficulty: Easy
Learning Objective: 05-02 Calculate break-even in units and in dollars.
Topic: 05-01 Leverage in a Business

In break-even analysis the contribution margin is defined as:
A.sales minus variable costs.
B. sales minus fixed costs.
C. variable costs minus fixed costs.
D. fixed costs minus variable costs.

Accessibility: Keyboard Navigation
Blooms: Remember
Difficulty: Easy
Learning Objective: 05-01 Define leverage as a method to magnify earnings available to the firm’s common shareholders.
Topic: 05-02 Break-Even Analysis

At the break-even point, a firm’s profits are:
A.greater than zero.
B. less than zero.
C. equal to zero.
D. not enough information to tell.

If a firm has a break-even point of 20,000 units and the contribution margin on the firm’s single product is $3.00 per unit and fixed costs are $60,000, what will the firm’s net income be at sales of 30,000 units?
A.$90,000
B. $30,000
C. $15,000
D. $45,000

If sales volume exceeds the break-even point, the firm will experience:
A.an operating loss.
B. an operating profit.
C. an increase in plant and equipment.
D. an increase in share price.

The break-even point can be calculated as:
A.variable costs divided by contribution margin.
B. total costs divided by contribution margin.
C. variable cost times contribution margin.
D. fixed cost divided by contribution margin.

A highly automated plant would generally have:
A.more variable costs than fixed costs.
B. more fixed costs than variable costs.
C. all fixed costs.
D. all variable costs.

Accessibility: Keyboard Navigation
Blooms: Remember
Difficulty: Medium
Learning Objective: 05-01 Define leverage as a method to magnify earnings available to the firm’s common shareholders.
Topic: 05-03 A More Conservative Approach

Which of the following is concerned with the change in operating profit as a result of a change in volume?
A.Financial leverage
B. Break-even point
C. Operating leverage
D. Combined leverage

The degree of operating leverage is computed as:
A.percent change in operating profit divided by percent change in net income.
B. percent change in volume divided by percent change in operating profit.
C. percent change in EPS divided by percent change in operating income.
D. percent change in operating income divided by percent change in volume.

Firm A employs a high degree of operating leverage; Firm B takes a more conservative approach. Which of the following comparative statements about firms A and B is true?
A.A has a lower break-even point than B, but A’s profit grows faster after the break-even.
B. A has a higher break-even point than B, but A’s profit grows slower after the break-even.
C. B has a lower break-even point than A, but A’s profit grows faster after the break-even.
D. B has a lower break-even point than A, and profit grows the same rate for both companies after the break-even point.

Firms with a high degree of operating leverage are:
A.easily capable of surviving large changes in sales volume.
B. usually trading off lower levels of risk for higher profits.
C. significantly affected by changes in interest rates.
D. trading off higher fixed costs for lower per-unit variable costs.

If EBIT equals $140,000 and interest equals $21,000, with a tax rate of 31%, what is the degree of financial leverage?
A.6.67x
B. 5.67x
C. 3.91x
D. 1.18x

Accessibility: Keyboard Navigation
Blooms: Apply
Difficulty: Medium
Learning Objective: 05-04 Define and calculate financial leverage and assess its opportunities and limitations.
Topic: 05-09 Financial Leverage

Financial leverage is concerned with the relation between:
A.changes in volume and changes in EPS.
B. changes in volume and changes in EBIT.
C. changes in EBIT and changes in EPS.
D. changes in EBIT and changes in operating income.

Accessibility: Keyboard Navigation
Blooms: Remember
Difficulty: Medium
Learning Objective: 05-04 Define and calculate financial leverage and assess its opportunities and limitations.
Topic: 05-09 Financial Leverage

Heavy use of long-term debt may be beneficial in an inflationary economy because:
A.the debt may be repaid in more “expensive” dollars.
B. nominal interest rates exceed real interest rates.
C. inflation is associated with the peak of a business cycle.
D. the debt may be repaid in “cheaper” dollars.

A conservative financing plan involves:
A.heavy reliance on debt.
B. heavy reliance on equity.
C. high degree of financial leverage.
D. high degree of combined leverage.

Combined leverage is concerned with the relationship between:
A.changes in EBIT and changes in EPS.
B. changes in volume and changes in EPS.
C. changes in volume and changes in EBIT.
D. changes in EBIT and changes in net income.

Accessibility: Keyboard Navigation
Blooms: Remember
Difficulty: Easy
Learning Objective: 05-06 Define and calculate combined leverage.
Topic: 05-16 Degree of Combined Leverage

A firm would be indifferent between financing plans when:
A.debt is equal to equity.
B. return on assets equals return on equity.
C. the cost of borrowed funds equals the return on equity.
D. the cost of borrowed funds equals the return on assets.

Accessibility: Keyboard Navigation
Blooms: Understand
Difficulty: Medium
Learning Objective: 05-05 Calculate the indifference point between financing plans using EBIT/EPS analysis.
Topic: 05-12 The Indifference Point

If the business cycle were just beginning its upswing, which firm would you anticipate would be likely to show the best growth in EPS over the next year? Firm A has high combined leverage and Firm B has low combined leverage.
A.Firm A
B. Firm B
C. Indifferent between the two.
D. It depends on how much financial leverage each firm has.

Accessibility: Keyboard Navigation
Blooms: Remember
Difficulty: Medium
Learning Objective: 05-06 Define and calculate combined leverage.
Topic: 05-16 Degree of Combined Leverage

If fixed costs rise while other variables stay constant:
A.the break-even point decreases.
B. degree of operating leverage decreases.
C. total profit increases.
D. total profit decreases.

Under which of the following conditions could the overuse of financial leverage be detrimental to the firm?
A.Stable industry.
B. Cyclical demand for the firm’s products.
C. Upswing of business cycle.
D. Low interest cost compared to return on assets.

Cash break-even analysis:
A.is helpful in analyzing the short-term outlook of the firm, particularly when it is in trouble financially.
B. is important when analyzing long-term profitability.
C. includes amortization expense as a fixed cost when calculating the degree of financial leverage.
D. includes the amount of liabilities.

The degree of operating leverage may be defined as:
A.the change in operating income divided by the change in unit volume.
B. Q (P + VC) divided by Q (P + VC) – FC.
C. S + TVC divided by S + TVC – FC.
D. S – TVC divided by S – TVC – FC.

Accessibility: Keyboard Navigation
Blooms: Remember
Difficulty: Hard
Learning Objective: 05-01 Define leverage as a method to magnify earnings available to the firm’s common shareholders.
Topic: 05-06 Degree of Operating Leverage

Conservatively leveraged Firm C and highly leveraged Firm H operate at the same level of earnings before interest and taxes where the return on assets is greater than the cost of debt.
A.Firm C will have a higher return on equity than H.
B. Firm H will have a higher return on equity than C.
C. The return on equity will not be affected by financial leverage.
D. The return on equity will be the same at an equal level of earnings.

Accessibility: Keyboard Navigation
Blooms: Understand
Difficulty: Medium
Learning Objective: 05-01 Define leverage as a method to magnify earnings available to the firm’s common shareholders.
Topic: 05-03 A More Conservative Approach

Which of the following is not true about leverage?
A.Operating leverage influences the top half of the income statement, determining EBIT.
B. Financial leverage deals with the bottom half of the income statement, determining EPS.
C. Combined leverage utilizes the entire income statement, showing the impact of change in volume on EBIT.
D. Combined leverage utilizes the percentage change in EPS and percentage change in sales.

Accessibility: Keyboard Navigation
Blooms: Remember
Difficulty: Medium
Learning Objective: 05-06 Define and calculate combined leverage.
Topic: 05-16 Degree of Combined Leverage

When a firm employs no debt:
A.it has a financial leverage of one.
B. it has a financial leverage of zero.
C. its operating leverage is equal to its financial leverage.
D. it will not be profitable.

Accessibility: Keyboard Navigation
Blooms: Understand
Difficulty: Easy
Learning Objective: 05-04 Define and calculate financial leverage and assess its opportunities and limitations.
Topic: 05-11 Degree of Financial Leverage

If the price per unit decreases because of competition but the cost structure remains the same:
A.the break-even point increases.
B. the break-even point decreases.
C. the degree of financial leverage declines.
D. the degree of combined leverage declines.

Accessibility: Keyboard Navigation
Blooms: Understand
Difficulty: Medium
Learning Objective: 05-04 Define and calculate financial leverage and assess its opportunities and limitations.
Topic: 05-11 Degree of Financial Leverage

Which of the following is true about the concept of leverage?
A.At the break-even point, operating leverage is equal to zero.
B. Combined leverage measures the impact of operating and financial leverage on EBIT.
C. Financial leverage measures the impact of fixed costs on earnings.
D. Combined leverage measures the impact of operating and financial leverage on EPS.

Accessibility: Keyboard Navigation
Blooms: Understand
Difficulty: Medium
Learning Objective: 05-06 Define and calculate combined leverage.
Topic: 05-15 Combining Operating and Financial Leverage

A firm’s indifference point between debt and equity financing plans would occur when the:
A.amount of debt used is equal to the amount of equity.
B. cost of borrowing is low.
C. cost of borrowed funds equals return on equity.
D. current level of EBIT generates the same EPS under both plans.

Accessibility: Keyboard Navigation
Blooms: Remember
Difficulty: Medium
Learning Objective: 05-05 Calculate the indifference point between financing plans using EBIT/EPS analysis.
Topic: 05-12 The Indifference Point

Sales (75,000 units)	$750,000
Variable costs	225,000
Contribution margin	525,000
Fixed manufacturing costs	187,500
Operating income	337,500
Interest	75,000
Earnings before taxes	262,500
Taxes (at 31%)	81,375
Net income	$181,125
Shares outstanding	15,000

The Degree of Operating Leverage is:
A.1.43x.
B. 1.56x.
C. 3.33x.
D. 2.22x.

The Degree of Financial Leverage is:
A.1.29x.
B. 4.50x.
C. 3.50x.
D. 1.32x.

The Degree of Combined Leverage is:
A.2.1x.
B. 1.9x.
C. 2.9x.
D. 2.0x.

Accessibility: Keyboard Navigation
Blooms: Apply
Difficulty: Medium
Learning Objective: 05-06 Define and calculate combined leverage.
Topic: 05-16 Degree of Combined Leverage

Sales (30,000 units)	$150,000
Variable costs	100,800
Contribution margin	49,200
Fixed manufacturing costs	24,000
Operating income	25,200
Interest	18,000
Earnings before taxes	7,200
Taxes (at 31%)	2,160
Net income	$5,040
Shares outstanding	600

This firm’s break-even point is:
A.4,800 units.
B. 14,634 units.
C. 7,142 units.
D. 18,000 units.

The Degree of Operating Leverage (DOL) is:
A.1.58x.
B. 1.95x.
C. 3.50x.
D. 1.40x.

The Degree of Financial Leverage (DFL) is:
A.3.50x.
B. 1.40x.
C. 1.95x.
D. 1.58x.

The Degree of Combined Leverage (DCL) is:
A.3.08x.
B. 5.45x.
C. 2.73x.
D. 6.83x.

Accessibility: Keyboard Navigation
Blooms: Apply
Difficulty: Medium
Learning Objective: 05-06 Define and calculate combined leverage.
Topic: 05-15 Combining Operating and Financial Leverage
Topic: 05-16 Degree of Combined Leverage

Which of the following questions does break-even analysis not attempt to address?
A.How much do changes in volume affect costs and profits?
B. At what point does the firm break even?
C. What is the most efficient level of capital assets to employ?
D. Percentage change in earnings per share.

If a firm has fixed costs of $30,000, a price of $4.00, and a break-even point of 15,000 units, the variable cost per unit is:
A.$5.00.
B. $2.00.
C. $0.50.
D. $4.00.

If a firm has fixed costs of $20,000, variable cost per unit of $0.50, and a break-even point of 5,000 units, the price is:
A.$2.50.
B. $5.00.
C. $4.00.
D. $4.50.

If a firm has a price of $4.00, variable cost per unit of $2.50, and a break-even point of 20,000 units, fixed costs are equal to:
A.$13,333.
B. $10,000.
C. $30,000.
D. $50,000.

Financial leverage primarily affects the _________ while operating leverage primarily affects the __________.
A.left-hand side of the balance sheet; the right-hand side of the balance sheet
B. right-hand side of the balance sheet; the upper part of the income statement
C. lower part of the income statement; the right-hand side of the balance sheet
D. the upper part of the income statement; the left-hand side of the balance sheet

Accessibility: Keyboard Navigation
Blooms: Remember
Difficulty: Medium
Learning Objective: 05-02 Calculate break-even in units and in dollars.
Topic: 05-01 Leverage in a Business

Operating leverage primarily affects the __________ while financial leverage primarily affects the __________.
A.left-hand side of the balance sheet; the lower part of the income statement
B. right-hand side of the balance sheet; the upper part of the income statement
C. the lower part of the income statement; the right-hand part of the balance sheet
D. the upper part of the income statement; the left-hand side of the balance sheet

Accessibility: Keyboard Navigation
Blooms: Remember
Difficulty: Medium
Learning Objective: 05-02 Calculate break-even in units and in dollars.
Topic: 05-01 Leverage in a Business

Financial leverage is determined to a large extent by the firm’s:
A.working capital choice.
B. capital budgeting choice.
C. capital structure choice.
D. dividend policy choice.

A weakness of break-even analysis is that it assumes:
A.revenue and costs are a linear (constant) function of volume.
B. prices and costs increase when the economy is strong and confidence is high.
C. cost of goods sold goes up as revenue increase.
D. there is no weakness.

Financial leverage deals with:
A.the relationship of fixed and variable costs.
B. the relationship of debt and equity in the capital structure.
C. the entire income statement.
D. the entire balance sheet.

Accessibility: Keyboard Navigation
Blooms: Remember
Difficulty: Easy
Learning Objective: 05-04 Define and calculate financial leverage and assess its opportunities and limitations.
Topic: 05-09 Financial Leverage

A high DOL means:
A.there are high labour costs.
B. there is high debt.
C. there is a large amount of equity.
D. there are high fixed costs.

In break-even analysis the contribution margin is defined as:
A.sales minus variable costs.
B. sales minus fixed costs.
C. fixed costs minus variable costs.
D. fixed costs minus amortization.

If the contribution margin on the firm’s single product is $2.00 per unit and fixed costs are $60,000, what will the firm’s net income be at sales of 30,000 units?
A.$90,000
B. $30,000
C. $15,000
D. $0

If sales volume is less than the break-even point, the firm will experience:
A.an operating loss.
B. an operating profit.
C. an increase in plant and equipment.
D. an increase in share price.

A plant relying mostly on manual labour would generally have:
A.more variable than fixed costs.
B. more fixed than variable costs.
C. all fixed costs.
D. all variable costs.

Accessibility: Keyboard Navigation
Blooms: Remember
Difficulty: Medium
Learning Objective: 05-03 Define and calculate operating leverage and assess its opportunities and limitations.
Topic: 05-08 Operating Leverage

If EBIT equals $280,000 and interest equals $20,000, with a tax rate of 31%, what is the degree of financial leverage?
A.14.00x
B. 9.66x
C. 3.91x
D. 1.08x

Heavy use of long-term debt may be detrimental in a deflationary economy because:
A.the debt may be repaid in more “expensive” dollars.
B. nominal interest rates exceed real interest rates.
C. inflation is associated with the peak of a business cycle.
D. the debt may be repaid in “cheaper” dollars.

If fixed costs decreases while other variables stay constant:
A.the break-even point increases.
B. degree of operating leverage increases.
C. total profit decrease.
D. total profit increases.

If the price per unit increases but the cost structure remains the same:
A.the break-even point rises.
B. the degree of combined leverage increases.
C. the degree of financial leverage increases.
D. the break-even point falls.

Sales (100,000 units)	$1,000,000
Variable costs	300,000
Contribution margin	700,000
Fixed manufacturing costs	250,000
Operating income	450,000
Interest	60,000
Earnings before taxes	390,000
Taxes (at 31%)	120,000
Net income	$269,100
Shares outstanding	10,000

The Degree of Operating Leverage is:
A.1.79x.
B. 1.56x.
C. 2.22x.
D. 2.33x.

The Degree of Financial Leverage is:
A.1.56x.
B. 1.79x.
C. 7.50x.
D. 1.15x.

The Degree of Combined Leverage is:
A.2.79x.
B. 1.90x.
C. 1.79x.
D. 3.46x.

Lever Products (LP) is considering the elimination of a press machine. The new press machine should reduce depreciation expenses by $80,000 annually. If LP’s total fixed costs were $420,000 last year, what would LP’s new break-even point in units if the contribution margin is 3.75 per unit?
A.68,000 units
B. 90,667 units
C. 100,800 units
D. 50,667 units

If a firm has a 30% change in operating income, and its Degree of Operating Leverage is 3.63, what was its percentage change in unit volume, all other things considered?
A.36.5%
B. 12.52%
C. 8.26%
D. 360%

Accessibility: Keyboard Navigation
Blooms: Apply
Difficulty: Hard
Learning Objective: 05-01 Define leverage as a method to magnify earnings available to the firm’s common shareholders.
Topic: 05-06 Degree of Operating Leverage

Sales volumes lower than the break-even point result in a firm having ___________________.
A.operating losses
B. operating profits
C. break even cash flows
D. a gain of potential leverage and bank financing

ECG has a contribution margin of $196,000. If ECG earned $87,000 before taxes in the year, what is the firm’s Degree of Combined Leverage?
A.2.26x
B. 1.27x
C. 0.44x
D. 1.29x

Accessibility: Keyboard Navigation
Blooms: Apply
Difficulty: Easy
Learning Objective: 05-06 Define and calculate combined leverage.
Topic: 05-15 Combining Operating and Financial Leverage

True / False Questions

Operating Leverage is the use of fixed costs to magnify returns at high levels of operation.
TRUE

Accessibility: Keyboard Navigation
Blooms: Remember
Difficulty: Easy
Learning Objective: 05-02 Calculate break-even in units and in dollars.
Topic: 05-01 Leverage in a Business

Operating Leverage works best when volume is increasing.
TRUE

Accessibility: Keyboard Navigation
Blooms: Remember
Difficulty: Easy
Learning Objective: 05-02 Calculate break-even in units and in dollars.
Topic: 05-01 Leverage in a Business

Linear break-even analysis assumes that costs are linear functions of volume.
TRUE

The closer a firm is to its break-even point, the lower the degree of operating leverage will be.
FALSE

The degree of operating leverage is a number indicating the relationship between the percentage changes in sales to the percentage change in earnings per share.
FALSE

Operating leverage is concerned with the use of capital assets in the business.
TRUE

Operating leverage determines how income from operations is to be divided between debt holders and shareholders.
FALSE

Financial leverage is concerned with the use of debt in the business.
TRUE

The degree of financial leverage measures the percentage change in EPS for every 1 percent move in EBIT.
TRUE

Financial leverage primarily affects the left-hand side of the balance sheet.
FALSE

If a firm has a DFL of 2.0, EPS will change 2% for every 1% change in volume.
FALSE

Operating income is not the same thing as EBIT.
FALSE

Accessibility: Keyboard Navigation
Blooms: Remember
Difficulty: Easy
Learning Objective: 05-02 Calculate break-even in units and in dollars.
Topic: 05-01 Leverage in a Business

Operating leverage influences the bottom half of the income statement while financial leverage deals with the top half.
FALSE

Accessibility: Keyboard Navigation
Blooms: Remember
Difficulty: Medium
Learning Objective: 05-02 Calculate break-even in units and in dollars.
Topic: 05-01 Leverage in a Business

The degree of combined leverage is the sum of the degree of operating leverage and the degree of financial leverage.
FALSE

Accessibility: Keyboard Navigation
Blooms: Remember
Difficulty: Medium
Learning Objective: 05-06 Define and calculate combined leverage.
Topic: 05-15 Combining Operating and Financial Leverage

Firms with cyclical sales should employ a high degree of leverage.
FALSE

If economic conditions were expected to be favourable, an investor would likely prefer a firm with a low degree of leverage.
FALSE

The contribution margin is equal to price per unit minus total costs per unit.
FALSE

As the contribution margin rises, the break-even point goes down.
TRUE

Managers who are risk averse and uncertain about the future would most likely minimize combined leverage.
TRUE

Cash break-even analysis eliminates the amortization expense and other non-cash charges from capital costs.
TRUE

The analysis of operating leverage assumes that relationships between revenues and costs are constant.
TRUE

Linear break-even analysis and operating leverage are only valid within a relevant range of production.
TRUE

Operating leverage primarily affects the left hand side of the balance sheet while financial leverage affects the right hand side of the balance sheet.
TRUE

Accessibility: Keyboard Navigation
Blooms: Remember
Difficulty: Medium
Learning Objective: 05-06 Define and calculate combined leverage.
Topic: 05-15 Combining Operating and Financial Leverage

The degree of financial leverage is not influenced by the interest rate on debt, only the amount borrowed.
FALSE

Use of financial leverage must consider risk, not just maximizing profit.
TRUE

Accessibility: Keyboard Navigation
Blooms: Remember
Difficulty: Medium
Learning Objective: 05-02 Calculate break-even in units and in dollars.
Topic: 05-01 Leverage in a Business

A lower price for the firm’s product will reduce the firm’s break-even point.
FALSE

Operating leverage will change when a firm alters the mix of capital resources and labour that it uses.
TRUE

A firm with a high degree of combined leverage will, other things being equal, experience higher earnings in the expansionary part of the business cycle.
TRUE

Accessibility: Keyboard Navigation
Blooms: Remember
Difficulty: Hard
Learning Objective: 05-06 Define and calculate combined leverage.
Topic: 05-16 Degree of Combined Leverage

A firm with a high degree of financial leverage could face financial difficulty even though it is in a stable industry.
TRUE

Accessibility: Keyboard Navigation
Blooms: Remember
Difficulty: Hard
Learning Objective: 05-04 Define and calculate financial leverage and assess its opportunities and limitations.
Topic: 05-09 Financial Leverage

Management should tailor the use of leverage to meet its own risk-taking desires.
TRUE

For firms in industries that offer some degree of stability, are in a positive stage of growth, and are operating in favourable economic conditions, the use of debt is not needed or recommended.
FALSE

The interwoven boundaries of banks and different trading companies in Japan make it easier to acquire credit in Japan than in Canada.
TRUE

Accessibility: Keyboard Navigation
Blooms: Understand
Difficulty: Medium
Learning Objective: 05-06 Define and calculate combined leverage.
Topic: 05-17 A Word of Caution

For Japanese firms that have high levels of operating and financial leverage, maintaining sales volume is of critical importance even at the cost of price cuts.
TRUE

Accessibility: Keyboard Navigation
Blooms: Understand
Difficulty: Hard
Learning Objective: 05-06 Define and calculate combined leverage.
Topic: 05-17 A Word of Caution

Greater leverage can be used by firms in periods of strong economic growth?
TRUE

Accessibility: Keyboard Navigation
Blooms: Understand
Difficulty: Easy
Learning Objective: 05-05 Calculate the indifference point between financing plans using EBIT/EPS analysis.
Topic: 05-13 Valuation Basics with Financial Leverage

Raw materials used in the manufacturing process are generally classified as fixed costs. In contrast, property taxes are classified as variable costs.
FALSE

Accessibility: Keyboard Navigation
Blooms: Remember
Difficulty: Easy
Learning Objective: 05-02 Calculate break-even in units and in dollars.
Topic: 05-01 Leverage in a Business

Break even in dollars is calculated by dividing sales by the contribution margin in percentage terms.
FALSE

Leverage is a strategic choice made by management based on assessment of risk and potential positive cash flows and the availability of financing
TRUE

The combined leverage is the result of the reduction in earnings from fixed costs and from amortization expense.
FALSE

Accessibility: Keyboard Navigation
Blooms: Remember
Difficulty: Easy
Learning Objective: 05-06 Define and calculate combined leverage.
Topic: 05-16 Degree of Combined Leverage

Nonlinear break-even analysis is the use of break-even analysis based on the assumption that cost and revenue relationships to quantity sold may vary at different levels of sales.
TRUE

Short Answer Questions

From the following income statement for 20X5, calculate:
A) Degree of financial leverage
B) Degree of operating leverage
C) Degree of combined leverage

Income Statement for the year ended 12/31/20X5
Sales	$440,000
Variable cost	240,000
Contribution margin	200,000
Fixed costs	96,000
EBIT	104,000
Interest	19,200
EBT	84,800
Taxes @35%	29,680
Net Income	$55,120
Shares outstanding	16,00
EPS	$5.52

A) DFL = EBIT/EBT = $104,000/$84,800 = 1.23X
B) DOL = CM/EBiT = $200,000/$104,00 = 1.92X
C) DCL = CM/EBT = $200,000/$84,800 = 2.36X = 1.23 ´92

Accessibility: Keyboard Navigation
Blooms: Apply
Difficulty: Medium
Learning Objective: 05-01 Define leverage as a method to magnify earnings available to the firm’s common shareholders.
Learning Objective: 05-04 Define and calculate financial leverage and assess its opportunities and limitations.
Learning Objective: 05-06 Define and calculate combined leverage.
Topic: 05-06 Degree of Operating Leverage
Topic: 05-09 Financial Leverage
Topic: 05-15 Combining Operating and Financial Leverage

Heister Corporation produces class rings to sell to college and high school students. These rings sell for $75 each, and cost $35 each to produce. Heister has fixed costs of $50,000.
A) Calculate Heister’s break-even point.
B) How much profit (loss) will Heister have if it sells 1,000 rings? 8,000 rings?
C) Heister’s president, J. R. D’Angelo, expects an annual profit of $100,000. How many rings must be sold to attain this profit?
A) BE = FC/P-VC = $50,000/($75-$35) = 1.250 rings
B) Profit or loss = PQ – VC (Q) – FC

= $75(1,000) – $35(1,000) – $50,000
= $75,000 – $35,000 – $50,000
Loss = $(10,000)
= $75(8,000) – $50,000 – $35(8,000)
= $65,000 – $50,000 – $280,000
profit = $270,000

C) Profit
= PQ – VC (Q) – FC
= Q(P – VC) – FC
Q(P – VC) = Profit + FC
Q = (Profit + FC)/(P – VC) = ($100,000 + $50,000)/($75 – $35) = 3,750 rings

102. A new restaurant is ready to open for business. It is estimated that the food cost (variable cost) will be 40% of sales, while fixed cost will be $450,000. The first year’s sales estimates are $1,250,000. The cost to start up this restaurant will be $2,000,000. Two financing alternatives are being considered: (a) 50% equity financing and 50% debt at 12%, or (b) all equity financing. Common stock can be sold at $5 per share.

A) Compute break-even point.
B) Compute DOL.
C) Compute DFL and DCL for both financing plans.
D) Include an explanation of what your computations mean.

A) Break-even point in sales Sales = Variable Cost + Fixed Cost
Sales = 0.40 Sales + $450,000
60 Sales = $450,000
Sales = $750,000
B) DOL = (S – TVC/S – TVC – FC) = (1,250,000 – 0.40($1,250,000))/($1,250,000 – 0.40($1,250,000) – $450,000)
DOL = $750,000/$300,000 = 2.50x
C) PLAN A

PLAN B

D) Subjective.

Blooms: Apply
Difficulty: Medium
Learning Objective: 05-01 Define leverage as a method to magnify earnings available to the firm’s common shareholders.
Learning Objective: 05-04 Define and calculate financial leverage and assess its opportunities and limitations.
Learning Objective: 05-06 Define and calculate combined leverage.
Topic: 05-06 Degree of Operating Leverage
Topic: 05-09 Financial Leverage
Topic: 05-15 Combining Operating and Financial Leverage

Jim Wilson is considering the possibility of opening his own machine shop. He expects first-year sales to be $600,000, and he feels that his variable costs will be approximately 50% of sales. His fixed costs in the first year will be $250,000.
Jim is considering two ways of financing the firm: (a) 60% equity financing and 40% debt at 14%, or (b) 100% equity financing. He can sell common stock to his relatives for $10 per share. Either way, he will need to raise $800,000.

A) Compute his break-even point in dollars.
B) Calculate the Degree of Operating Leverage at the expected first-year sales volume.
C) Calculate the Degree of Financial Leverage and the Degree of Combined Leverage under each of the possible financing plans.
D) Explain the implications of your answers if the machine shop business is highly cyclical.

Break-even point	Sales =	Fixed Cost + Variable Cost
	=	$250,000 + 0.5 (Sales)
	0.5 (Sales) =	$250,000
	Sales =	$500,000

B)

C) 60% Equity/40% Debt

100% Equity

D) The leveraged plan is highly risky if the machine shop business is very cyclical.

Blooms: Apply
Difficulty: Hard
Learning Objective: 05-01 Define leverage as a method to magnify earnings available to the firm’s common shareholders.
Learning Objective: 05-04 Define and calculate financial leverage and assess its opportunities and limitations.
Learning Objective: 05-06 Define and calculate combined leverage.
Topic: 05-06 Degree of Operating Leverage
Topic: 05-09 Financial Leverage
Topic: 05-15 Combining Operating and Financial Leverage

Doug Robinson is considering the possibility of opening his own manufacturing facility. He expects first-year sales to be $800,000, and he feels that his variable costs will be approximately 40% of sales. His fixed costs in the first year will be $200,000.
Doug is considering two ways of financing the firm: (a) 40% equity financing and 60% debt at 10%, or (b) 100% equity financing. He can sell common stock to his relatives for $10 per share. Either way, he will need to raise $1,000,000. Compute his break-even point in dollars.

Break-even point Sales = Fixed Cost + Variable Cost
= $200,000 + 0.4 (Sales)
0.4 (Sales) = $200,000
Sales = $500,000

Calculate the Degree of Operating Leverage at the expected first-year sales volume.

Degree of Operating Leverage

Calculate the Degree of Financial Leverage and the Degree of Combined Leverage under each of the possible financing plans.

40% Equity/60% Debt

DCL = DOL ´ DFL = 1.71 ´ 1.27 = 2.17x

100% Equity

DCL = DOL ´ DFL = 1.71 ´ 1.0 = 1.71x

Explain the implications of your answers if the machine shop business is highly cyclical.

As the amount of leverage is not high for this scenario, the leveraged plan is not very risky.

Accessibility: Keyboard Navigation
Blooms: Analyze
Difficulty: Hard
Learning Objective: 05-01 Define leverage as a method to magnify earnings available to the firm’s common shareholders.
Learning Objective: 05-04 Define and calculate financial leverage and assess its opportunities and limitations.
Learning Objective: 05-06 Define and calculate combined leverage.
Topic: 05-06 Degree of Operating Leverage
Topic: 05-09 Financial Leverage
Topic: 05-15 Combining Operating and Financial Leverage

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