i75 cpa operating and fin leverage Flashcards
Calder Company has a degree of operating leverage of 4 after experiencing a 24% increase in earnings before interest and taxes as a result of earning additional revenue. What percentage of additional revenue did Calder Company earn in order to experience a 24% increase in EBIT?
A. 20%
B. 96%
C. 4%
D. 6%
D is the correct answer
Explanation
Formula for calculating operating leverage:
OP = Percent change in EBIT / Percent change in sales
*From the information given:
Degree of Op leverage = 4
% increase in EBIT = 24%
degree of operating leverage of 4 = 24/X
X= 24/4
X = 6 % increase in sales
If a company’s EBIT increases by 15% and its Degree of Financial leverage is 2, by what percentage will its EPS change?
Your answer
A. 15% increase
B. 30% increase
C. 15% decrease
D. 30% decrease
Correct Answer
B. 30% increase
Explanation
The percentage change in EPS is the Degree of Financial Leverage times the percentage change in EBIT. In this case, 2 times 15% increase in EBIT equals 30% increase in EPS.
Formula for calculating financial leverage = Percent change in EPS / Percent chg in EBIT
The Degree of Operating Leverage (DOL) is used to measure what aspect of a company?
A. Sensitivity of EPS to changes in sales
B. Sensitivity of EBIT to changes in sales
C. Sensitivity of net income to changes in debt
D. Sensitivity of dividends to changes in interest rates
B. Sensitivity of EBIT to changes in sales
Explanation
High sensitivity to changes in sales. The Degree of Operating Leverage (DOL) quantifies how a change in sales will affect a company’s EBIT. It is calculated by dividing the percentage change in EBIT by the percentage change in sales. A higher DOL means that a small change in sales can lead to a significant change in EBIT, indicating higher operating risk.
As for the wrong choices:
Lower sensitivity to changes in sales: Incorrect: High operating leverage actually results in higher sensitivity to changes in sales. With a higher proportion of fixed costs, even small changes in sales can have a significant impact on operating income.
High interest expense. Incorrect- Interest expenses are typically associated with financial leverage, not operating leverage. Operating leverage deals with the relationship between fixed and variable costs, not the costs of borrowing.
High dividend yield. Incorrect: Dividend yield is not related to operating leverage. High operating leverage concerns the ratio of fixed to variable costs and its impact on operating income as sales change, whereas dividend yield pertains to the relationship between annual dividends and the stock’s current price.
Which of the following statements is true about the relationship between operating leverage and financial leverage?
A. Operating leverage is focused on sales, while financial leverage is focused on the capital structure
B. Operating leverage deals with the relationship between fixed and variable costs, while financial leverage deals with variable costs only
C. Operating and financial leverage are identical concepts
D. Operating leverage is concerned with dividend policy, while financial leverage is concerned with interest expenses
Correct Answer
A. Operating leverage is focused on sales, while financial leverage is focused on the capital structure
Explanation
Operating leverage deals with the relationship between fixed and variable costs in a company’s operating structure and how changes in sales affect operating income (EBIT). Financial leverage, on the other hand, is concerned with the capital structure, particularly how a company uses debt and equity to finance its operations and investments. It reflects the company’s ability to meet financial obligations and can magnify both gains and losses.
hat type of companies might typically prefer low financial leverage?
Incorrect
Your answer
A. All of these
B. Real estate firms
C. Cyclical companies
D. Utility companies
Correct Answer
C.
Cyclical companies
Explanation
Cyclical companies, whose revenues can be highly variable, might prefer low financial leverage to minimize risks during downturns. Cyclical companies, whose revenues can fluctuate greatly, might prefer low financial leverage to minimize risks during downturns. High financial leverage (i.e., a high level of debt) in such a situation might lead to difficulties in meeting interest obligations during economic downturns. Therefore, to minimize risk, cyclical companies often prefer a capital structure with lower levels of debt, or low financial leverage. On the other hand, industries like utilities, which often have more stable cash flows, might be more comfortable taking on higher levels of debt.
MCQ-03695
Kator Co. is a manufacturer of industrial components. One of their products that is used as
a sub-component in auto manufacturing is KB-96. This product has the following financial
structure per unit.
Selling Price $150
Direct materials $20
Direct labor 15
Variable manufacturing overhead 12
Fixed manufacturing overhead 30
Shipping and handling 3
Fixed selling and administrative 10
Total costs $90
During the next year, KB-96 sales are expected to be 10,000 units. All of the costs will remain the same except for fixed manufacturing overhead, which will increase by 20 percent and material, which will increase by 10 percent. The selling price per unit for next year will be $160. Based on these data, the contribution margin from KB-96 for next year will be:
A. $620,000
B. $750,000
C. $1,080,000
D. $1,100,000
THIS YEAR
Sale price = $160
minus
- Direct materials = 20 * 1.1 = 22
- Direct Labor = 15
- Variable mfg OH = 12
- Shipping and handling (variable) = 3
Total variable costs = $52
Contribution margin per unit –> 160 - 52 = $108
Total contribution margin = 108 x 10,000 units = $1,080,000
MCQ-05781
Wren Co. manufactures and sells two products with selling prices and variable costs as follows:
A B
Selling price $18.00 $22.00
Variable costs 12.00 14.00
Wren’s total annual fixed costs are $38,400. Wren sells four units of A for every unit of B. If operating income last year was $28,800, what was the number of units Wren sold?
A. 5,486
B. 6,000
C. 9,600
D. 10,500
Choice “D” is correct. Wren will have sold a total of 10,500 units to achieve a $28,800 operating profit assuming the fact pattern described above. The question requires the candidate to recall the basic contribution margin formula and apply some algebra. The fact pattern describes that the operating income is $28,800 and the fixed costs are
$38,400. The contribution margin is; therefore, the total of the two $67,200.
The basic formula to compute units sold is:
CM per unit x Units = $67,200
First, compute the contribution margin:
Product A CM —-> 18 - 12 = $6
Product B CM —–> 22 - 14 = $8
Second, quantify the selling pattern and the relationship between the products. Wren sells 4 units of Product A for every unit of Product B, so expressing Product A in terms of Product B
Product A = 4 x Product B
Third, determine the number of units of Product B that were sold:
$6 contribution margin x (4B) + $8 contribution margin x B = $67,200
24B + 8B = 67,200
32B = 67,200
B = 2100
Fourth, determine the number of Product A and the total number of products sold:
A = 4 x B = 4 * 2100 = 8,400
Total units = 2,100 + 8,400 or 10,500
MCQ-04257
Delphi Company has developed a new product that will be marketed for the first time during
the next fiscal year. Although the Marketing Department estimates that 35,000 units could
be sold at $36 per unit, Delphi’s management has allocated only enough manufacturing
capacity to produce a maximum of 25,000 units of the new product annually. The fixed costs associated with the new product are budgeted at $450,000 for the year, which includes $60,000 for depreciation on new manufacturing equipment. Data associated with each unit of product are presented below. Delphi is subject to a 40 percent income tax rate.
Variable Costs Direct material 7 Direct labor 3.50 Manufacturing overhead 4.00 Total variable manufacturing cost 14.50 Selling expenses 1.50 Total variable cost = $16
The maximum after-tax profit that can be earned by Delphi Company from sales of the new
product during the next fiscal year is:
A. $30,000
B. $50,000
C. $110,000
D. $66,000
Contribution margin = 36-16 = $20
Max amt of units 25,000 * $20 = total pretax contribution margin of $500,000
CM $500,000 - Fixed costs $450,000 = $50,000 pretax net
$50,000 * (1-taxrate) = $50,000 * (1-.4) = $50,000 * .6 = $30,000
Selected information concerning the operations of a company for the year ended December
31 is as follows:
Units produced 20,000
Units sold 18,000
Direct materials used $80,000
Direct labor incurred $40,000
Fixed factory overhead $50,000
Variable factory overhead $24,000
Fixed selling and administrative expenses $60,000
Variable selling and administrative expenses $9,000
Work-in-process inventories at the beginning and end of the year were zero. What was the company’s finished goods inventory cost at December 31 under the variable (direct) costing method?
A. $23,900
B. $19,400
C. $17,000
D. $14,400
Choice “D” is correct. The ending finished goods inventory computed using direct
costing is calculated by allocating the total costs capitalized in inventory under direct
costing (variable costs) to ending inventory as follows:
DM $80,000 + DL $40,000 + VFO $24,000 = $144,000
NOTE: Under the variable (direct) costing method, do NOT use variable sg&a in calculations. Only use mfc. costs.
$144,000 / 20,000 units = $7.20 per unit
NOW FIGURE OUT THE ENDING INVENTORY AMT.
20,000 produced inventory - 18,000 units sold = 2000 ending inventory
(NOTE: 0 WIP at beg. and end of year)
Ending inv in dollars = $7.20 * 2,000
Ending inventory in $’s = $14,400
