Chapter 2 & 5 Terms

Question 1

What is Leverage?

Answer 1

• a relatively SMALL CHANGE IN THE TOP LINE (Sales) can produce a LARGER % CHANGE IN THE BOTTOM LINE(EBIT or EAT)
• INCREASED LEVERAGE = INCREASED RISK
• Increased risk potential for negative effects, but increased potential for higher returns

Question 2

Degree of Operating Leverage

Answer 2

degree to which we INVEST in FIXED COSTS & CAPITAL ASSETS

Question 3

Degree of Financial Leverage

Answer 3

degree to which we use DEBT or PAY INTEREST for FINANCING

Question 4

How are Debt & Leverage Related?

Answer 4

• HIGHER amount of DEBT = HIGHER FINANCIAL LEVERAGE
• LOWER amount of DEBT = LOWER FINANCIAL LEVERAGE
• if a firm employs NO DEBT = FINANCIAL LEVERAGE of 1

Question 5

Degree of Combined Leverage

Answer 5

give us the % INCREASE in EAT for a given % INCREASE in SALES

Question 6

When to Use the Degree of Combined Leverage

Answer 6

use the Degree of Combined Leverage if there are BOTH FIXED OPERATING COSTS & INTEREST CHARGES

Question 7

Fixed Costs vs Variable Costs

Answer 7

Fixed Costs

• the same at ALL LEVELS of sales or production
• Fixed Cost PER UNIT will DECREASE if sales or production INCREASES

Variable Costs

• Vary with the LEVEL of OUTPUT
• INCREASE in total, as output INCREASES
• Variable Cost PER UNIT are CONSTANT at all levels of sales or production
• Often are materials and labor

Question 8

Fixed vs Variable Cost Trade-Off

Answer 8

• Variable Costs = LESS RISKY

Only buy as much labour/materials as you need

• Fixed Costs = MORE RISKY

Can be PROFITABLE at HIGHER volumes

Question 9

The Cash Flow Statement

Answer 9

is the SUMMARY of cash flows (SOURCES & USES of cash)

Question 10

Operating Activities (Operating Accounts)

Answer 10

CHANGES in CURRENT ASSETS and CURRENT LIABILITIES are classified as OPERATING CASH FLOWS

Question 11

Investing Activities (Long-Term Assets)

Answer 11

CHANGES in CAPITAL ASSETS and INVESTMENTS are classified as INVESTING CASH FLOWS

• Property, plant and equipment
• Intangible assets
• Long term investments
• Loans receivable

Question 12

Financing Activities (Debt & Equity)

Answer 12

DIVIDENDS PAID and CHANGES in LOANS are classified as FINANCING CASH FLOWS

• Bank loans
• Bonds payable
• Dividends paid
• Issuing of Common or Preferred Shares

Question 13

Sources & Uses of Cash (Assets & Liabilities)

Answer 13

Assets

INCREASE in Asset = DECREASE in Cashflow (USE)

DECREASE in Asset = INCREASE in Cashflow = (SOURCE)

Liabilities

INCREASE in Liability = INCREASE in Cashflow = (SOURCE)

DECREASE in Liability = DECREASE in Cashflow = (USE)

Question 14

Income Tax Effects: Equity vs Debt Financing

Answer 14

Equity Financing

• Stock = Pay DIVIDENDS
• Dividends are paid out AFTER TAX
• Dividends are NOT TAX DEDUCTIBLE

Debt Financing

• Debt = Pay INTEREST
• Interest IS TAX DEDUCTIBLE
• Has a TAX SAVINGS Factor (Tax Shield)

After-Tax Cost of an Expense

Expense – Tax Savings