M2-Capital Structure: Part 2

Question 1

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. (true or false)

Answer 1

true

Question 2

Financial leverage is defined as the degree to which a firm uses debt to finance the firm, not purely operating fixed costs. When making financial decisions, a firm can choose to issue debt or equity. When debt is issued, the firm generally must pay fixed interest costs. (true or false)

Answer 2

true

Question 3

Combined (total) leverage results from the use of both fixed operating costs and fixed financing costs to magnify returns to the firm’s owners. (true or false)

Answer 3

true

Question 4

Financial leverage increases when the debt-to-equity ratio increases. Using a higher percentage of debt (bonds) for future investments would increase financial leverage. (true or false)

Answer 4

true

Question 5

A shortcut computation for operating leverage is the ratio of fixed costs to variable costs. (true or false)

Answer 5

true

If total cost is $100,000 and variable cost is 40% of total costs (or $40,000), then fixed costs must be 60% (or $60,000). Operating leverage is then calculated as follows:
60,000/40,000= 1.5

Question 6

When fixed costs are high relative to variable costs and total costs, the company’s operating leverage is high. What this implies is that the company must generate enough in sales in order to meet its fixed obligations. This equates to higher risk and could cause the company to fail if sales are not high enough. (true or false)

Answer 6

true