B3-2

Question 1

A firm that designs its cost structure to include a higher degree of operating fixed costs than variable costs by electing to pay salaries instead of commissions, is magnifying the impact of each additional sales dollar using the concept of:

a.

Financial leverage.

b.

Combined leverage.

c.

Operating leverage.

d.

Fixed leverage.

Answer 1

Choice “c” is correct. Operating leverage is defined as the degree to which a firm uses fixed operating costs, as opposed to variable operating costs. A firm that has high operating leverage has high fixed operating costs and relatively low variable operating costs and uses this cost structure to magnify the financial results of each additional dollar in sales.

Choice “d” is incorrect. The term “fixed leverage” does not have an accepted definition. This is a distracter.

Choice “a” is incorrect. Financial leverage is defined as the degree to which a firm uses debt to finance the firm, not purely operating fixed costs. When making financing decisions, a firm can choose to issue debt or equity. When debt is issued, the firm generally must pay fixed interest costs.

Choice “b” is incorrect. Combined (total) leverage results from the use of both fixed operating costs and fixed financing costs to magnify returns to the firm’s owners.

Question 2

Sylvan Corporation has the following capital structure:

Debenture bonds

$10,000,000

Preferred equity

1,000,000

Common equity

39,000,000

The financial leverage of Sylvan Corp. would increase as a result of:

a.

Financing its future investments with a higher percentage of equity funds.

b.

Financing its future investments with a higher percentage of bonds.

c.

Issuing common stock and using the proceeds to retire debenture bonds.

d.

Issuing common stock and using the proceeds to retire preferred stock.

Answer 2

Choice “b” is correct. Financial leverage increases when the debt to equity ratio increases. Using a higher percentage of debt (bonds) for future investments would increase financial leverage.

Choice “d” is incorrect. This results in no change in total equity and, consequently, no change in financial leverage.

Choice “c” is incorrect. This would result in increased equity and decreased debt, which would decrease financial leverage.

Choice “a” is incorrect. This would increase equity, decrease the debt to equity ratio and decrease financial leverage.