Reading 35: measures of leverage

Question 1

Business risk is the combination of:
operating risk and financial risk.
sales risk and financial risk.
operating risk and sales risk.

Answer 1

Business risk refers to the risk associated with a firm’s operating income and is the result of uncertainty about a firm’s revenues and the expenditures necessary to produce those revenues. Business risk is the combination of sales risk (the uncertainty associated with the price and quantity of goods and services sold) and operating risk (the leverage created by the use of fixed costs in the firm’s operations). (LOS 35.a)

Question 2

Which of the following is a key determinant of operating leverage?
Level and cost of debt.
The competitive nature of the business.
The trade-off between fixed and variable costs.

Answer 2

The extent to which costs are fixed determines operating leverage. (LOS 35.b)

Question 3

Which of the following statements about capital structure and leverage is most accurate?
Financial leverage is directly related to operating leverage.
Increasing the corporate tax rate will not affect capital structure decisions.
A firm with low operating leverage has a small proportion of its total costs in fixed costs.

Answer 3

If fixed costs are a small percentage of total costs, operating leverage is low. Operating leverage is separate from financial leverage, which depends on the amount of debt in the capital structure. Increasing the tax rate would make the after-tax cost of debt cheaper. (LOS 35.b)

Question 4

Jayco, Inc., sells blue ink for $4 a bottle. The ink’s variable cost per bottle is $2. Ink has fixed operating costs of $4,000 and fixed financing costs of $6,000. What is Jayco’s breakeven quantity of sales, in units?
2,000.
3,000.
5,000.

Answer 4

Qbe=4000+6000/4.00-2.00=5000 units

Question 5

Jayco, Inc., sells blue ink for $4 a bottle. The ink’s variable cost per bottle is $2. Ink has fixed operating costs of $4,000 and fixed financing costs of $6,000. What is Jayco’s operating breakeven quantity of sales, in units?
2,000.
3,000.
5,000.

Answer 5

Qbe=4000/4.00-2.00=2000

Question 6

If Jayco’s sales increase by 10%, Jayco’s EBIT increases by 15%. If Jayco’s EBIT increases by 10%, Jayco’s EPS increases by 12%. Jayco’s degree of operating leverage (DOL) and degree of total leverage (DTL) are closest to:
1.2 DOL and 1.5 DTL.
1.2 DOL and 2.7 DTL.
1.5 DOL and 1.8 DTL.

Answer 6

DOL=15%/10%=1.5

DFL=12%/10%=1.2

DTL= DOL x DFL = 1.5 x 1.2 = 1.8

Question 7

Jayco, Inc., sells 10,000 units at a price of $5 per unit. Jayco’s fixed costs are $8,000, interest expense is $2,000, variable costs are $3 per unit, and EBIT is $12,000.

Jayco’s degree of operating leverage (DOL) and degree of financial leverage (DFL) are closest to:
2.50 DOL and 1.00 DFL.
1.67 DOL and 2.00 DFL.
1.67 DOL and 1.20 DFL.

Answer 7

DOL=Q(P-V)/[Q(P-V)-F]

= 10000(5-3)/[10000(5-3)-8000 = 1.67

DFL=EBIT/EBIT-1

= 12000/12000-2000 = 1.2

Question 8

Jayco, Inc., sells 10,000 units at a price of $5 per unit. Jayco’s fixed costs are $8,000, interest expense is $2,000, variable costs are $3 per unit, and EBIT is $12,000.

Jayco’s degree of total leverage (DTL) is closest to:
2.00.
1.75.
1.50.

Answer 8

DTL= Q(P-V)/[Q(P-V)-F-I]

= 10000(5-3)/[10000(5-3)-8000-2000]

DFL= 1.67 x 1.62 =2.0