21
22) ACME, Inc. reported the following income statement for 2009:
Sales
$2,500,000
Variable Costs
900,000
Fixed Operating Costs
700,000
EBIT
900,000
Interest Expense
200,000
EBT
700,000
Taxes (30%)
210,000
Net Income
$490,000
Earnings Per Share
$4.90
If ACME’s sales next year increase by 20%, ACME’s EBIT will increase
A) 20%, showing no operating leverage.
B) 20%, showing no financial leverage.
C) over 35%, due to operating leverage.
D) over 35%, due to operating leverage and financial leverage.
Keywords: Operating Leverage, Financial Leverage, Earnings Per Share
Learning Obj.: L.O. 12.3
AACSB: Analytical Thinking
23) Amalgamated Mining, Inc. has very high operating leverage due to the capital intensive nature of the
steel business. The firm’s CEO is concerned about the variability in the firm’s EPS if sales should drop,
and decides to take action. Which of the following will reduce the variability in the firm’s EPS for a given
change in sales?
A) The CEO may increase the firm’s financial leverage and hence reduce the variability by using non–
shareholder money to support the business.
B) The CEO may decrease the firm’s financial leverage, thus lowering the firm’s total leverage.
C) The CEO may increase the firm‘s total leverage by raising money from the sale of common stock.
D) The CEO may issue more corporate bonds and use the proceeds to pay off short-term liabilities.
Keywords: Operating Leverage, Financial Leverage, Total Leverage
Learning Obj.: L.O. 12.3
AACSB: Reflective Thinking
22
24) Bristal Boats, Inc. reports sales of $4,000,000, variable costs of $500,000, fixed operating costs of
$1,250,000, and interest expense of $350,000. The corporation’s EBIT is $3,250,000 and its marginal tax rate
is 30%. If the corporation is able to increase its sales by 25%, then
A) its EBIT will increase by 25% and its EPS will increase by 25%.
B) its EBIT will increase by more than 25% and its EPS will increase by less than 25%.
C) its EBIT and EPS will both increase, but less than 25% due to fixed costs and taxes.
D) its EBIT will increase by more than 25% and its EPS will increase by more than the percentage increase
in EBIT.
Keywords: Financial Leverage, Combined Leverage, Operating Leverage
Learning Obj.: L.O. 12.3
AACSB: Analytical Thinking
25) A firm that uses large amounts of debt financing in an industry characterized by a high degree of
business risk would have ________ earnings per share fluctuations resulting from changes in levels of
sales.
A) no
B) constant
C) large
D) small
Keywords: Business Risk, Financial Leverage
Learning Obj.: L.O. 12.3
AACSB: Reflective Thinking
26) Financial leverage could mean financing some of a firm‘s assets with
A) preferred stock.
B) retained earnings.
C) private equity capital.
D) sales revenues.
Keywords: Financial Leverage, Bonds
Learning Obj.: L.O. 12.3
AACSB: Reflective Thinking
27) Financing a portion of a firm‘s assets with securities bearing a fixed rate of return in hopes of
increasing the return to stockholders refers to
A) business risk.
B) financial leverage.
C) operating leverage.
D) combined leverage.
Keywords: Financial Leverage
Learning Obj.: L.O. 12.3
AACSB: Reflective Thinking
23
28) Operating leverage refers to
A) financing a portion of the firm’s assets with securities bearing a fixed rate of return.
B) the additional chance of insolvency borne by the common shareholder.
C) the incurrence of fixed operating costs in the firm’s income stream.
D) a high degree of variable costs of production.
Keywords: Operating Leverage
Learning Obj.: L.O. 12.3
AACSB: Reflective Thinking
29) Financial leverage is distinct from operating leverage since it accounts for
A) use of debt and preferred stock.
B) variability in fixed operating costs.
C) variability in sales.
D) changes in EBIT.
Keywords: Financial Leverage, Operating Leverage
Learning Obj.: L.O. 12.3
AACSB: Reflective Thinking
30) If a firm has no operating leverage and no financial leverage, then a 10% increase in sales will have
what effect on EPS?
A) EPS will remain the same.
B) EPS will increase by 10%.
C) EPS will decrease by 10%.
D) EPS will increase by less than 10%.
Keywords: Operating Leverage, Financial Leverage, Combined Leverage, EPS
Learning Obj.: L.O. 12.3
AACSB: Analytical Thinking
31) Operating leverage has to do with
A) borrowing money to finance a firm’s growth.
B) using preferred stock to increase sales volume.
C) the incurrence of fixed operating costs in the firm’s income stream.
D) financing with fixed cost sources of capital.
Keywords: Operating Leverage, Fixed Operating Costs
Learning Obj.: L.O. 12.3
AACSB: Reflective Thinking
24
32) Which of the following statements about operating leverage is true?
A) Operating leverage reduces a firm’s risk.
B) Operating leverage is the responsiveness of the firm‘s EBIT to fluctuations in sales.
C) Operating leverage involves the usage of fixed cost financial securities in the operation of a business.
D) Operating leverage is the responsiveness of the firm’s EPS to fluctuations in sales.
Keywords: Operating Leverage
Learning Obj.: L.O. 12.3
AACSB: Reflective Thinking
33) Financial leverage has to do with
A) the usage of fixed cost financial securities to finance a portion of a firm’s assets.
B) using common stock to finance a portion of a firm’s assets.
C) the incurrence of fixed operating costs in the firm’s income stream.
D) a high gross profit margin.
Keywords: Financial Leverage
Learning Obj.: L.O. 12.3
AACSB: Reflective Thinking
34) Which of the following statements about financial leverage is true?
A) Financial leverage is the responsiveness of the firm‘s EBIT to fluctuations in sales.
B) Financial leverage involves the incurrence of fixed operating costs in the firm’s income stream.
C) Financial leverage is the responsiveness of the firm’s EPS to fluctuations in EBIT.
D) Financial leverage reduces a firm’s risk.
Keywords: Financial Leverage
Learning Obj.: L.O. 12.3
AACSB: Reflective Thinking
35) Which of the following statements about combined (operating & financial) leverage is true?
A) If a firm employs both operating and financial leverage, any percent change in sales will produce a
larger percent change in earnings per share.
B) A firm that is in a capital-intensive industry should use a higher level of financial leverage than a firm
that employs low levels of operating leverage.
C) Usage of both operating and financial leverage reduces a firm’s risk.
D) High operating leverage and high financial leverage offset one another, meaning that if sales increase
by 10%, then EPS will also increase by 10%.
Keywords: Combined Leverage
Learning Obj.: L.O. 12.3
AACSB: Reflective Thinking
25
36) The following information pertains to the Classic Burger Restaurant chain:
Sales
$600,000
Variable costs
300,000
Total contribution margin
300,000
Fixed costs
100,000
EBIT
200,000
Interest expense
50,000
Earnings before taxes
150,000
Taxes (30%)
45,000
Net income
$105,000
a. If sales increase by 10%, what will be the new level of EPS if the firm has 100,000 shares outstanding?
b. What is the percentage increase in EPS? Explain the difference between the percentage increase in
sales and the percentage increase in EPS.
Sales
× 1.1 =
$660,000
Variable costs
× 1.1 =
330,000
Total contribution margin
330,000
Fixed costs
100,000
EBIT
230,000
Interest expense
50,000
Earnings before taxes
180,000
Taxes (30%)
54,000
Net income
$126,000
Earnings Per Share
$12.60
b. ($12.60 – $10.50)/$10.50 = .20 or 20%; A 10% increase in sales results in a 20% increase in EPS due to
leverage. Classic Burger uses both operating leverage (fixed cost of operations) and financial leverage
(debt financing reflected in interest expense).
Diff: 2 Page Ref: 414, 416, 418
Keywords: Operating Leverage, Financial Leverage, Combined Leverage, EPS
Learning Obj.: L.O. 12.3
AACSB: Analytical Thinking
37) How do operating and financial leverage interact to affect the volatility of a firm’s earnings per share?
Keywords: Financial Leverage, Combined Leverage, Operating Leverage
Learning Obj.: L.O. 12.3
AACSB: Reflective Thinking
26
38) Welker Products sells small kitchen gadgets for $15 each. The gadgets have a variable cost of $4 per
unit, and Welker Products’ fixed operating costs are $220,000 per year. Welker Products’ capital structure
includes 55% debt and 45% equity. Annual interest expense is $25,000, and the corporate tax rate is 35%.
a. Calculate the break-even point in units.
b. If Welker Products sells 25,000 units, calculate the firm‘s EBIT and net income.
c. If sales increase ten percent from 25,000 units to 30,000 units, estimate the firm’s expected EBIT and
net income.
d. Does Welker Products use operating leverage and/or financial leverage? Explain.
Keywords: Break-even, Operating Leverage, Financial Leverage, Combined Leverage
Learning Obj.: L.O. 12.3
AACSB: Analytical Thinking
Learning Objective 12.4
1) Raising funds internally is effectively increasing the investment of the firm’s existing common
shareholders.
Keywords: Internal Financing, Shareholders
Learning Obj.: L.O. 12.4
AACSB: Reflective Thinking
2) Capital structure is equal to financial structure minus current liabilities.
Keywords: Capital Structure, Financial Structure
Learning Obj.: L.O. 12.4
AACSB: Reflective Thinking
27
3) The optimal capital structure occurs when operating leverage equals financial leverage.
Keywords: Optimal Capital Structure
Learning Obj.: L.O. 12.4
AACSB: Reflective Thinking
4) Higher bankruptcy costs will result in optimal capital structures using more long-term debt financing.
Keywords: Bankruptcy Costs, Optimal Capital Structure
Learning Obj.: L.O. 12.4
AACSB: Analytical Thinking
5) Financial structure includes long- and short-term sources of funds.
Keywords: Financial Structure
Learning Obj.: L.O. 12.4
AACSB: Reflective Thinking
6) According to the moderate view of capital structure theory, the cost of common equity is constant
regardless of the debt financing level.
Keywords: Capital Structure Theory
Learning Obj.: L.O. 12.4
AACSB: Reflective Thinking
7) The objective of capital structure management is to maximize the market value of the firm‘s common
stock.
Keywords: Capital Structure Management
Learning Obj.: L.O. 12.4
AACSB: Reflective Thinking
8) The independence hypothesis suggests that the total market value of the firm’s outstanding securities is
unaffected by its capital structure.
Keywords: Independence Hypothesis, Capital Structure
Learning Obj.: L.O. 12.4
AACSB: Reflective Thinking
9) The moderate view of capital structure theory allows for the tax-deductibility of interest expense.
Keywords: Capital Structure Theory, Tax-deductible Interest
Learning Obj.: L.O. 12.4
AACSB: Reflective Thinking
28
10) Other things the same, the use of debt financing reduces the firm’s total tax bill resulting in a higher
total market value.
Keywords: Debt Financing, Interest Tax Shield
Learning Obj.: L.O. 12.4
AACSB: Reflective Thinking
11) The tax shield on interest is calculated by multiplying the interest rate paid on debt by the principal
amount of the debt and the firm’s marginal tax rate.
Keywords: Interest Tax Shield
Learning Obj.: L.O. 12.4
AACSB: Reflective Thinking
12) A firm‘s cost of capital is not affected by the composition of the right-hand side of the firm‘s balance
sheet, but rather is determined by the firm’s mix of assets.
Keywords: Capital Structure
Learning Obj.: L.O. 12.4
AACSB: Reflective Thinking
13) Financial structure is another term for capital structure.
Keywords: Capital Structure, Financial Structure
Learning Obj.: L.O. 12.4
AACSB: Reflective Thinking
14) Financial structure is equal to non-interest bearing liabilities, such as accounts payable and accruals,
plus capital structure, which includes short- and long-term debt, preferred stock, and common equity.
Keywords: Capital Structure, Financial Structure
Learning Obj.: L.O. 12.4
AACSB: Reflective Thinking
15) Two key components of a prudent capital structure are the debt maturity composition and the debt to
equity composition.
Keywords: Capital Structure, Debt Maturity Composition, Debt-Equity Composition
Learning Obj.: L.O. 12.4
AACSB: Reflective Thinking
29
16) Borrowing funds using short-term debt, such as commercial paper, and using the proceeds to invest
in long-term investments, creates a refinancing risk that can force firms to sell assets at distressed prices if
financing becomes unavailable.
Keywords: Debt Maturity Composition, Capital Structure
Learning Obj.: L.O. 12.4
AACSB: Reflective Thinking
17) Corporations that are heavily committed to investments in fixed assets that are expected to produce
cash flow over many years generally favor long-term debt to the extent that they borrow.
Keywords: Debt Maturity Composition, Capital Structure
Learning Obj.: L.O. 12.4
AACSB: Reflective Thinking
18) A saucer-shaped or U-shaped weighted average cost of capital curve results from the tax deductibility
of interest, which results in the downward slope, followed by the recognition of potential financial
distress costs, that cause the upward slope as the amount of debt ratio increases.
Keywords: U-Shaped WACC Curve, Interest Deductibility, Financial Distress Costs
Learning Obj.: L.O. 12.4
AACSB: Reflective Thinking
19) A corporation‘s debt capacity is the maximum proportion of debt that the corporation can include in
its capital structure and still maintain its lowest composite cost of capital.
Keywords: Debt Capacity, Optimal Range of Financial Leverage
Learning Obj.: L.O. 12.4
AACSB: Reflective Thinking
20) The independence hypothesis allows for bankruptcy and agency costs.
Keywords: Independence Hypothesis, Bankruptcy Costs, Agency Costs
Learning Obj.: L.O. 12.4
AACSB: Reflective Thinking
21) The independence hypothesis suggests that the cost of equity decreases as financial leverage
increases.
Keywords: Independence Hypothesis, Cost of Equity, Financial Leverage
Learning Obj.: L.O. 12.4
AACSB: Reflective Thinking
30
22) If we ignore bankruptcy and agency costs then the optimal capital structure for a firm under the
moderate view would be 100% debt.
Keywords: Optimal Capital Structure, Capital Structure Theory, Bankruptcy Costs, Agency Costs
Learning Obj.: L.O. 12.4
AACSB: Reflective Thinking
23) The implicit cost of debt takes into consideration the change in the cost of common equity brought on
by using additional debt.
Keywords: Implicit Cost of Debt
Learning Obj.: L.O. 12.4
AACSB: Reflective Thinking
24) The control hypothesis suggests that shareholders prefer an increase in the firm‘s debt in order to
reduce the agency costs associated with excessive free cash flow.
Keywords: Control Hypothesis, Agency Costs
Learning Obj.: L.O. 12.4
AACSB: Reflective Thinking
25) Capital structure is the mix of the long-term sources of funds used by the firm.
Keywords: Capital Structure
Learning Obj.: L.O. 12.4
AACSB: Reflective Thinking
26) The optimal capital structure is the funds mix that will
A) minimize the use of debt.
B) achieve an equal proportion of debt, preferred stock, and common equity.
C) minimize the firm’s composite cost of capital.
D) maximize total leverage.
Keywords: Optimal Capital Structure
Learning Obj.: L.O. 12.4
AACSB: Reflective Thinking