Study Unit 1.4: Leverage

Question 1

Operating Leverage

Answer 1

arises from the use of a high level of plant and machinery in the production process, revealed through charges for depreciation, property taxes,etc.

Question 2

Finance Leverage

Answer 2

arises from the use of high level of debt in the firm’s financing structure, revealed through amounts paid out of interest

Question 3

Degree of Operating Leverage (DOL single period)

Answer 3

Contribution Margin / Operating income or EBIT

*Requires financial information based on variable costing as it isolates the use of fixed costs

Question 4

Degree of Operating Leverage (DOL multiple period)

Answer 4

% change in operating or EBIT / % change in Sales

Question 5

Degree of Financial Leverage (DOF single period)

Answer 5

EBIT / EBT

Isolates the effects of interest as the only true fixed financing cost

Question 6

Degree of Financial Leverage (DOF multiple period)

Answer 6

% change in net income / % change in EBIT

Question 7

Identify five factors that influence a company’s capital structure

Answer 7

• Companies with relatively stable sales vs. companies with highly cyclical industries
• First with assets that are suitable as security for loans
• Levels of operating risk
• Growth rates
• Effective tax rate
• Amount of debt vs. amount of equity
• Rating agency assessments
• Market conditions
• Financial flexibility