Principles of Managerial Finance, Brief Ed., 8e (Zutter/Smart)
Chapter 12 Leverage and Capital Structure
12.1 Leverage
1) Generally, increases in leverage result in increased return and risk.
2) Generally, decreases in leverage result in increased return and risk, whereas increases in
leverage result in decreased return and risk.
3) Total leverage can be defined as the potential use of fixed costs, both operating and financial,
to magnify the effect of changes in sales on a firm’s earnings per share.
4) Leverage results from the use of equity to magnify returns to a firm’s owners.
5) Operating leverage is concerned with the relationship between a firm’s sales revenue and its
financial expenses.
6) Financial leverage is concerned with the relationship between a firm’s earnings after interest
and taxes and its common stock earnings per share.
7) Total leverage is concerned with the relationship between a firm’s sales revenue and its
common stock earnings per share.
8) A firm’s capital structure is the mix of the current liabilities, long-term debt, and equity
maintained by the firm.
9) The levels of fixed-cost assets and funds that management selects affect the variability of
returns.
10) The amount of leverage in a firm’s capital structure—the mix of long-term debt and equity
maintained by the firm—can significantly affect its value by affecting return and risk.
11) Both operating and financial leverage result in the magnification of return as well as risk.
12) While operating leverage results only in a magnification of returns, financial leverage results
only in a magnification of risk.
13) The dollar breakeven sales level can be solved for by dividing fixed costs by the contribution
margin ratio.
14) The dollar breakeven sales level can be solved for by dividing fixed costs by the dollar
contribution margin.
15) Breakeven analysis is used by a firm to determine the level of operations necessary to cover
all fixed operating costs and to evaluate the profitability associated with various levels of
production.
16) A firm’s operating breakeven point is the level of sales necessary to cover all fixed operating
costs.
17) In finding the operating breakeven point, it is important to divide the cost of goods sold and
operating expenses into fixed and variable operating costs.
18) At the operating breakeven point, the sales revenue is equal to the sum of the fixed and
variable operating costs.
19) Earnings before interest and taxes are positive above the operating breakeven point, and a
loss occurs below it.
20) For sales levels below the operating breakeven point, sales revenue exceeds total operating
costs, and earnings before interest and taxes is greater than zero.
21) An increase in cost (fixed cost or variable cost) tends to increase the operating breakeven
point, whereas an increase in the sales price per unit will decrease the operating breakeven point.
22) The use of a dollar breakeven point is important when a firm has more than one product,
especially when each product is selling at a different price.
23) The contribution margin is defined as the percent of each sales dollar that remains after
satisfying fixed operating costs.
24) The breakeven point in dollars can be computed by dividing the contribution margin into the
variable operating costs.
25) Due to the difficulty of allocating costs to products in a multiproduct firm, the breakeven
model may fail to determine breakeven points for each product line.
26) Since the sales price per unit generally decreases with volume and the cost per unit generally
increases with volume, the true breakeven point may be different from those obtained using
linear revenue and cost functions as assumed in the breakeven analysis.
27) One of the limitations of breakeven analysis is its short-term time horizon. A large outlay in
the current financial period could significantly raise the firm’s breakeven point, while the benefits
may occur over a period of years.
28) The operating breakeven point can be found by solving for the sales level that just covers
total fixed and variable costs.
29) Which of the following is TRUE of leverage?
A) It refers to the effects that operating and financial fixed costs have on the returns that
shareholders earn.
B) It is associated with risks which are out of the control of managers.
C) It includes the effect of operating fixed costs on the returns of shareholders and not the
financial fixed costs.
D) It is used to evaluate the profitability associated with various levels of sales.
30) ________ results from the use of fixed-cost assets or funds to magnify returns to a firm’s
owners.
A) Long-term debt
B) Equity
C) Leverage
D) Capital structure
31) The three basic types of leverage are ________.
A) operating, production, and financial
B) operating, production, and total
C) production, financial, and total
D) operating, financial, and total
32) Generally, increases in leverage result in ________ return and ________ risk.
A) decreased; increased
B) decreased; decreased
C) increased; increased
D) increased; decreased
33) ________ refers to the effects that fixed costs have on the returns that shareholders earn.
A) Purchase power parity
B) Leverage
C) Business risk
D) Pecking order theory
34) ________ analysis is a technique used to assess the returns associated with various cost
structures and levels of sales.
A) Time-series
B) Marginal
C) Breakeven
D) Ratio
35) Earnings before interest and taxes (EBIT) is a descriptive label for ________.
A) operating profits
B) net profits before taxes
C) earnings per share
D) gross profits
36) ________ costs are a function of time, not sales, and are typically contractual.
A) Fixed
B) Semivariable
C) Variable
D) Operating
37) In case of a manufacturing organization, which of the following is a variable cost that varies
directly with the sales volume?
A) interest cost
B) dividend cost
C) shipping cost
D) rental cost
38) A firm’s ________ is the level of sales necessary to cover all operating costs, i.e., the point at
which EBIT equals zero.
A) cash breakeven point
B) financial breakeven point
C) operating breakeven point
D) total breakeven point
39) Which of the following is a fixed cost?
A) inventory
B) rent
C) delivery costs
D) direct labor
40) ________ costs require the payment of a specified amount in each accounting period.
A) Operating
B) Variable
C) Semivariable
D) Fixed
41) At the operating breakeven point, ________ equals zero.
A) sales revenue
B) fixed operating costs
C) variable operating costs
D) earnings before interest and taxes
42) Breakeven analysis is used by a firm ________.
A) to determine the level of operations necessary to cover all fixed operating costs
B) to determine the least cost of producing goods and services
C) to evaluate the profitability associated with various levels of sales
D) to determine the demand of a product
43) If a firm’s fixed operating costs decrease, the firm’s ________.
A) operating breakeven point will decrease
B) operating breakeven point will increase
C) sale price per unit will decrease
D) sale price per unit will increase
44) If a firm’s variable costs per unit increase,the firm’s ________.
A) financial breakeven point will decrease
B) operating breakeven point will increase
C) sale price per unit will decrease
D) fixed costs per unit will increase
45) If a firm’s sale price per unit decreases, the firm’s ________.
A) operating breakeven point will decrease
B) operating breakeven point will increase
C) variable costs per unit will decrease
D) variable costs per unit will increase
46) If a firm’s fixed financial costs decrease, the firm’s operating breakeven point will ________.
A) decrease
B) increase
C) remain unchanged
D) change based on the sale price per unit
47) A firm’s operating breakeven point is the point at which ________.
A) total operating costs equal total fixed costs
B) total operating costs are zero
C) EBIT is less than sales
D) EBIT is zero
48) A firm has fixed operating costs of $525,000. The sales price per unit is $35 and its variable
costs per unit is $22.50. The firm’s operating breakeven point in units is ________.
A) $23,330
B) $32,000
C) $42,000
D) $52,000
49) Carol’s Dolls has fixed operating costs of $25,000. Its sale price is $55 per doll, and its
variable operating cost is $30 per doll. It sells 3,000 dolls per month. The firm’s earnings before
interest and taxes is ________.
A) $37,500
B) $55,000
C) $75,000
D) $50,000
50) A major assumption of breakeven analysis and one which causes severe limitations in its use
is that ________.
A) fixed costs really are fixed
B) total revenue is nonlinear
C) revenues and operating costs are linear
D) all costs are really semivariable
51) ________ is 100 percent minus total variable operating costs as a percentage of total sales.
A) Profit margin
B) Contribution margin
C) Expense ratio
D) Fixed coverage ratio
52) A firm has fixed operating costs of $10,000, the sale price per unit of its product is $25, and
its variable cost per unit is $15. The firm’s operating breakeven point in units is ________ and its
breakeven point in dollars is ________.
A) 1,000; $6,250
B) 400; $10,000
C) 400; $25,000
D) 1,000; $25,000
53) A firm has fixed operating costs of $150,000, total sales of $1,500,000, and total variable
costs of $1,275,000. The firm’s operating breakeven point in dollars is ________.
A) $150,000
B) $176,471
C) $1,000,000
D) $1,425,000
54) A firm has fixed operating costs of $253,750, a sales price per unit of $100, and a variable
cost per unit of $65. The firm’s operating breakeven point in dollars is ________.
A) $725,000
B) $700,000
C) $906,250
D) $390,385
55) One function of breakeven analysis is to ________.
A) determine the profit attributable to each stockholder
B) evaluate the effect of leverage on a firm’s risks and returns
C) evaluate the profitability of various sales levels
D) determine the amount of financing needed by the firm
56) The preferred approach to breakeven analysis for a multiproduct firm is the ________.
A) breakeven point expressed in units
B) breakeven point expressed in dollars
C) cash breakeven point
D) overall breakeven point
57) A firm has fixed operating costs of $25,000, a per unit sales price of $5, and a variable cost
per unit of $3. What is its operating breakeven point if it targets net operating income of
$10,000?
A) 12,500 units
B) 15,000 units
C) 17,500 units
D) 25,000 units
58) Tony’s Beach T-Shirts has fixed annual operating costs of $75,000. Tony retails his T-shirts
for $14.99 each and the variable cost per T-shirt is $4.99. Based on this information, the
breakeven sales level in dollars is ________.
A) $125,495
B) $112,425
C) $108,995
D) $110,495
59) Tony’s Beach T-Shirts has fixed annual operating costs of $75,000. Tony retails his T-shirts
for $14.99 each and the variable cost per T-shirt is $4.99. Based on this information, the
breakeven sales level in units is ________.
A) 7,500
B) 15,030
C) 5,003
D) 3,754
60) Mark must buy four new tires for his car. He is considering buying tires that are $25 a piece
more than his regular brand, because the higher priced tires are supposed to increase his miles
per gallon by 20%. If the tires are good for 48,000 miles and Mark drives an average of 1,000
miles per month, gas costs $2.50 per gallon over the next 4 years, and Mark’s car gets 30 miles to
the gallon now (on the old tires), should Mark purchase the more expensive tires?
A) Yes, because Mark will save about $660 dollars in gas over the four years but the new tires
will only be $100 more.
B) Yes, because Mark will save about $560 dollars in gas over the four years but the new tires
will only be $100 more.
C) No, because Mark will only save about $60 dollars in gas over the four years but the new tires
will only be $100 more.
D) No, because Mark will only save about $90 dollars in gas over the four years but the new tires
will only be $100 more.
61) Operating leverage is defined as the use of fixed operating costs to magnify the effects of
changes in sales on a firm’s earnings before interest and taxes.
62) The degree of operating leverage will increase if a firm decides to compensate its sales
representatives with a fixed salary and bonus rather than with a pure percent-of-sales
commission.
63) Comparison of the degree of operating leverage of two firms is valid only when the base
level of sales used for each firm is the same.
64) The degree of operating leverage depends on the base level of sales used as a point of
reference. The closer the base sales level used is to the operating breakeven point, the greater the
operating leverage.
65) Operating leverage results from the existence of operating costs in a firm’s income stream.
66) Operating leverage may be defined as the potential use of fixed operating costs to magnify
the effects of changes in sales on a firm’s earnings before interest and taxes (EBIT).
67) Operating leverage is present when a firm has fixed operating costs.
68) Whenever the percentage change in earnings before interest and taxes resulting from a given
percentage change in sales is greater than the percentage change in sales, operating leverage
exists.
69) When a firm has fixed operating costs, operating leverage is present. In that case, an increase
in sales results in a more-than-proportional increase in EBIT, and a decrease in sales results in a
more-than-proportional decrease in EBIT.
70) Whenever the percentage change in EBIT resulting from a given percentage change in sales
is greater than the percentage change in sales, operating leverage exists.
71) The closer the base sales level used is to the operating breakeven point, the smaller the
operating leverage.
72) The base level of EBIT must be held constant to compare the financial leverage associated
with different levels of fixed financial costs.
73) The effect of financial leverage is such that an increase in a firm’s earnings before interest
and taxes (EBIT) results in a more than proportional increase in the firm’s earnings per share
(EPS), while a decrease in the firm’s EBIT results in a less than proportional decrease in EPS.
74) Whenever the percentage change in earnings per share (EPS) resulting from a given
percentage change in sales is greater than the percentage change in sales, financial leverage
exists.
75) Financial leverage results from the presence of variable financial costs in a firm’s income
stream.
76) Financial leverage may be defined as the potential use of variable financial costs to magnify
the effects of changes in earnings before interest and taxes (EBIT) on a firm’s earnings per share
(EPS).
77) The relationship between operating and financial leverage is additive rather than
multiplicative.
78) The total leverage measures the combined effect of operating and financial leverage on a
firm’s risk.
79) Total leverage exists whenever the percentage change in earnings per share (EPS) resulting
from a given percentage change in sales is greater than the percentage change in sales.
80) The base level of sales must be held constant to compare the total leverage associated with
different levels of fixed costs.