WEB APPENDIX 14A—DEGREE OF LEVERAGE
1. A company currently sells 75,000 units annually. At this sales level, its EBIT is $4 million, and its degree of total
leverage is 2.0. The firm’s debt consists of $15 million in bonds with a 9.5% coupon. The company is considering a new
production method which will entail an increase in fixed costs but a decrease in variable costs, and will result in a degree
of operating leverage of 1.600. The president, who is concerned about the stand-alone risk of the firm, wants to keep the
degree of total leverage at 2.0. If EBIT remains at $4 million, what dollar amount of bonds must be retired to accomplish
this?
a.
$5,640,625
b.
$5,937,500
c.
$6,250,000
d.
$6,578,947
e.
$6,907,895
d
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CHALLENGING
14A Degree of Leverage
2. Your firm’s EPS last year was $1.00. You expect sales to increase by 15% during the coming year. If your firm has a
degree of operating leverage equal to 1.25 and a degree of financial leverage equal to 3.50, then what is its expected EPS?
a.
$1.57
b.
$1.66
c.
$1.74
d.
$1.83
e.
$1.92
b
% ΔSales
DOL
DFL
1
MODERATE
14A Degree of Leverage
FOFM.BRIG.16.14.14A – Degree of Leverage
United States – BUSPROG.FOFM.BRIG.16.03 – Analytic skills
United States – OH – DISC.FOFM.BRIG.16.10 – Capital structure
Change in EPS
Bloom’s: Application
Multiple Choice: Problem
3. Which of the following statements is CORRECT?
a.
An increase in fixed costs, (holding sales and variable costs constant) will reduce the company’s degree of
operating leverage.
b.
An increase in interest expense will reduce the company’s degree of financial leverage.
c.
If the company has no debt outstanding, then its degree of total leverage equals its degree of operating
leverage.
d.
If a firm’s degree of operating leverage increases, its degree of financial leverage must also have increased.
e.
If the company has no debt outstanding, then its degree of total leverage equals its degree of financial
leverage.
c
1
MODERATE
DFL
Bloom’s: Evaluation
Multiple Choice: Problem
WEB APPENDIX 14A—DEGREE OF LEVERAGE
14A Degree of Leverage
4. The Quick Company expects its sales to increase by 50% in the coming year. The firm’s current EPS is $3.25. Its
degree of operating leverage is 1.6, while its degree of financial leverage is 2.1. What is the firm’s projected EPS for the
coming year using the DTL approach?
a.
$7.47
b.
$7.86
c.
$8.27
d.
$8.71
e.
$9.15
d
DFL
1
MODERATE
14A Degree of Leverage
5. Alvarez Technologies has sales of $3,000,000. The company’s fixed operating costs total $500,000 and its variable
costs equal 60% of sales, so the company’s current operating income is $700,000. The company’s interest expense is
$500,000. What is the company’s degree of total leverage (DTL)?
a.
4.8870
b.
5.1443
c.
5.4150
d.
5.7000
WEB APPENDIX 14A—DEGREE OF LEVERAGE
e.
6.0000
e
1
CHALLENGING
14A Degree of Leverage
FOFM.BRIG.16.14.14A – Degree of Leverage
United States – BUSPROG.FOFM.BRIG.16.03 – Analytic skills
United States – OH – DISC.FOFM.BRIG.16.10 – Capital structure
DTL
Bloom’s: Application
Multiple Choice: Problem
6. Which of the following statements is CORRECT?
a.
The degree of operating leverage (DOL) depends on a company’s fixed costs, variable costs, and sales. The
DOL formula assumes (1) that fixed costs are constant and (2) that variable costs are a constant proportion of
sales.
b.
The degree of total leverage (DTL) is equal to the DOL plus the degree of financial leverage (DFL).
c.
Arithmetically, financial leverage and operating leverage offset one another so as to keep the degree of total
leverage constant. Therefore, the formula shows that the greater the degree of financial leverage, the smaller
the degree of operating leverage.
d.
For a given change in sales, the corresponding percentage change in net income could be more or less than the
percentage change in operating income.
e.
The degree of total leverage (DTL) is equal to the DFL divided by the degree of operating leverage (DOL).
a
1
MODERATE
14A Degree of Leverage
FOFM.BRIG.16.14.14A – Degree of Leverage
United States – BUSPROG.FOFM.BRIG.16.03 – Analytic skills
United States – OH – DISC.FOFM.BRIG.16.10 – Capital structure
Operating and fin. leverage
Bloom’s: Comprehension
Multiple Choice: Conceptual
7. Assume that a firm currently has EBIT of $2,000,000, a degree of total leverage of 7.5, and a degree of financial
leverage of 1.875. If sales decline by 20% next year, then what will be the firm’s expected EBIT in one year?
WEB APPENDIX 14A—DEGREE OF LEVERAGE
a.
$361,000
b.
$380,000
c.
$400,000
d.
$420,000
e.
$441,000
c
1
CHALLENGING
14A Degree of Leverage
FOFM.BRIG.16.14.14A – Degree of Leverage
United States – BUSPROG.FOFM.BRIG.16.03 – Analytic skills
United States – OH – DISC.FOFM.BRIG.16.10 – Capital structure
Expected EBIT
Multiple Choice: Problem
8. The degree of operating leverage has which of the following characteristics?
a.
The closer the firm is operating to the breakeven quantity, the smaller the DOL.
b.
A change in quantity demanded will produce the same percentage change in EBIT as an identical change in
price per unit of output, other things held constant.
c.
The DOL is not a fixed number for a given firm, but will depend upon the time zero values of the economic
variable Q (Quantity), P (Price), and V (Volume).
d.
The DOL relates the change in net income to the change in operating income.
e.
If the firm has no debt, the DOL will equal 1.
c
1
CHALLENGING
14A Degree of Leverage
FOFM.BRIG.16.14.14A – Degree of Leverage
9. Maxvill Motors has annual sales of $15,000. Its variable costs equal 60% of its sales and its fixed costs equal $1,000. If
the company’s sales increase 10%, what will be the percentage increase in the company’s earnings before interest and
taxes (EBIT)?
a.
12.00%
b.
12.60%
c.
13.23%
d.
13.89%
e.
14.59%
a
Sales
% ΔSales
% ΔEBIT = 12.00%
1
MODERATE
14A Degree of Leverage
FOFM.BRIG.16.14.14A – Degree of Leverage
United States – BUSPROG.FOFM.BRIG.16.03 – Analytic skills
United States – OH – DISC.FOFM.BRIG.16.10 – Capital structure
Bloom’s: Evaluation
Multiple Choice: Problem
10. Coats Corp. generates $10,000,000 in sales. Its variable costs equal 85% of sales and its fixed costs are $500,000.
Therefore, the company’s operating income (EBIT) equals $1,000,000. The company estimates that if its sales were to
United States – BUSPROG.FOFM.BRIG.16.03 – Analytic skills
United States – OH – DISC.FOFM.BRIG.16.10 – Capital structure
Multiple Choice: Conceptual
WEB APPENDIX 14A—DEGREE OF LEVERAGE
increase 10%, its net income and EPS would increase 17.5%. What is the company’s interest expense?
a.
$122,482
b.
$128,929
c.
$135,714
d.
$142,857
e.
$150,000
d
Sales
EBIT
DTL
1.75
$1,500,000
1.75I
1
CHALLENGING
14A Degree of Leverage
11. PQR Manufacturing Corporation has $1,500,000 in debt outstanding. The company’s before-tax cost of debt is 10%.
Sales for the year totaled $3,500,000 and variable costs were 60% of sales. Net income was equal to $600,000 and the
company’s tax rate was 40%. If PQR’s degree of total leverage is equal to 1.40, what is its degree of operating leverage?
a.
1.0987
b.
1.1565
c.
1.2174
d.
1.2783
e.
1.3422
c
12. Kulwicki Corporation wants to determine the effect of an expansion of its sales on its operating income (EBIT). The
firm’s current degree of operating leverage is 2.50. It projects new unit sales to be 170,000, an increase of 45,000 over last
year’s level of 125,000 units. Last year’s EBIT was $60,000. Based on a degree of operating leverage of 2.5, what is this
year’s expected EBIT with the increase in sales?
a.
$ 92,854
b.
$ 97,741
c.
$102,885
d.
$108,300
e.
$114,000
e
1
CHALLENGING
FOFM.BRIG.16.14.14A – Degree of Leverage
United States – BUSPROG.FOFM.BRIG.16.03 – Analytic skills
United States – OH – DISC.FOFM.BRIG.16.10 – Capital structure
DOL, DFL, and DTL
Bloom’s: Application
Multiple Choice: Problem
13. Bell Brothers has $3,000,000 in sales. Fixed costs are estimated to be $100,000 and variable costs are equal to 50% of
sales. The company has $1,000,000 in debt outstanding at a before-tax cost of 10%. If Bell Brothers’ sales were to
increase by 20%, how much of a percentage increase would you expect in the company’s net income?
a.
18.80%
b.
19.79%
c.
20.83%
d.
21.92%
e.
23.08%
e
Sales
Debt
1
CHALLENGING
14A Degree of Leverage
WEB APPENDIX 14A—DEGREE OF LEVERAGE
1
CHALLENGING
14A Degree of Leverage
14. Monroe Corporation currently sells 150,000 units a year at a price of $4.00 a unit. Its variable costs are approximately
30% of sales, and its fixed costs amount to 50% of revenues at its current output level. Although fixed costs are based on
revenues at the current output level, the cost level is fixed. What is Marcus’s degree of operating leverage in sales dollars?
a.
3.1588
b.
3.3250
c.
3.5000
d.
3.6750
e.
3.8588
c
1
CHALLENGING
14A Degree of Leverage
15. A company has an EBIT of $4 million, and its degree of total leverage is 2.4. The firm’s debt consists of $20 million in
bonds with a YTM of 10%. The company is considering a new production process that will require an increase in fixed
costs but a decrease in variable costs. If adopted, the new process will result in a degree of operating leverage of 1.4. The
president wants to keep the degree of total leverage at 2.4. If EBIT remains at $4 million, what dollar amount of bonds
must be outstanding to accomplish this (assuming the yield to maturity remains at 10%)?
a.
$16,666,667
b.
$17,500,000
c.
$18,375,000
d.
$19,293,750
WEB APPENDIX 14A—DEGREE OF LEVERAGE
e.
$20,258,438
a
EBIT
DTL
Debt
YTM
DTL
= DOL × DFL
2.40
= 1.40 × DFL
DFL
= 1.7143
Debt = $16,666,667
1
CHALLENGING
14A Degree of Leverage
FOFM.BRIG.16.14.14A – Degree of Leverage
United States – BUSPROG.FOFM.BRIG.16.03 – Analytic skills
United States – OH – DISC.FOFM.BRIG.16.10 – Capital structure
Fin. leverage, DOL, and DTL
Bloom’s: Evaluation
Multiple Choice: Problem
16. The use of financial leverage by the firm has a potential impact on which of the following?
(1)
The risk associated with the firm.
(2)
The return experienced by the shareholder.
(3)
The variability of net income.
(4)
The degree of operating leverage.
(5)
The degree of financial leverage.
a.
1, 3, 5
b.
1, 2, 5
c.
2, 3, 5
d.
2, 3, 4, 5
WEB APPENDIX 14A—DEGREE OF LEVERAGE
e.
1, 2, 3, 5
e
1
MODERATE
14A Degree of Leverage
17. Assume that a firm has a degree of financial leverage of 1.25. If sales increase by 20%, the firm will experience a 60%
increase in EPS, and it will have an EBIT of $100,000. What will be the EBIT for this firm if sales do not increase?
a.
$57,931
b.
$60,980
c.
$64,189
d.
$67,568
e.
$70,946
d
DFL
1
CHALLENGING
14A Degree of Leverage
18. Which of the following is a key benefit of using the degree of leverage concept in financial analysis?
a.
It allows decision makers a relatively clear assessment of the consequences of alternative actions.
b.
It establishes the optimal capital structure for the firm.
c.
It shows how a given change in leverage will affect sales.
d.
It identifies, with certainty, the future net income based upon sales projections about the future.
e.
None of the above statements is correct.
a
1
CHALLENGING
14A Degree of Leverage
FOFM.BRIG.16.14.14A – Degree of Leverage
United States – BUSPROG.FOFM.BRIG.16.03 – Analytic skills
United States – OH – DISC.FOFM.BRIG.16.10 – Capital structure
Degree of leverage
Bloom’s: Comprehension
Multiple Choice: Conceptual
19. If a firm uses debt financing (Debt ratio = 0.40) and sales change from the current level, which of the following
statements is CORRECT?
a.
The percentage change in operating income (EBIT) resulting from the change in sales will exceed the
percentage change in net income.
b.
The percentage change in EBIT will equal the percentage change in net income.
c.
The percentage change in net income relative to the percentage change in sales (and in EBIT) will not depend
on the interest rate paid on the debt.
d.
The percentage change in operating income will be less than the percentage change in net income.
e.
Since debt is used, the degree of operating leverage must be greater than 1.
d
1
MODERATE
14A Degree of Leverage
FOFM.BRIG.16.14.14A – Degree of Leverage
United States – BUSPROG.FOFM.BRIG.16.03 – Analytic skills
United States – OH – DISC.FOFM.BRIG.16.10 – Capital structure
Financial leverage
Bloom’s: Comprehension
Multiple Choice: Conceptual
20. Stromburg Corporation makes surveillance equipment for intelligence organizations. Its sales are $75,000,000. Fixed
costs, including research and development, are $40,000,000, while variable costs amount to 30% of sales. Stromburg
plans an expansion which will generate additional fixed costs of $15,000,000, decrease variable costs to 25% of sales, and
also permit sales to increase to $100,000,000. What is Stromburg’s degree of operating leverage at the new projected sales
level?
a.
3.7500
Multiple Choice: Problem
WEB APPENDIX 14A—DEGREE OF LEVERAGE
b.
3.9375
c.
4.1344
d.
4.3411
e.
4.5581
a
1
CHALLENGING
14A Degree of Leverage
21. Lincoln Lodging Inc. estimates that if its sales increase 10% then its net income will increase 18%. The company’s
EBIT equals $2.4 million, and its interest expense is $400,000. The company’s operating costs include fixed and variable
costs. What is the level of the company’s fixed operating costs?
a.
$1,083,000
b.
$1,140,000
c.
$1,200,000
d.
$1,260,000
e.
$1,323,000
c
EBIT
Interest
22. The “degree of leverage” concept is designed to show how changes in sales will affect EBIT and EPS. If a 10%
increase in sales causes EPS to increase from $1.00 to $1.50, and if the firm uses no debt, then what is its degree of
operating leverage?
a.
4.2869
DTL
1.80
CHALLENGING
WEB APPENDIX 14A—DEGREE OF LEVERAGE
b.
4.5125
c.
4.7500
d.
5.0000
e.
5.2500
d
% ΔSales
10.00%
Debt
0
DFL
1
$1.50
= $1.00 + $1.00 × DTL × 10.00%
$1.50
= $1.00 + $0.10DTL
$0.50
= $0.10DTL
DTL
= 5.00
DTL
= DOL × DFL
5.00
= DOL × 1
= 5.0000
1
CHALLENGING
14A Degree of Leverage
FOFM.BRIG.16.14.14A – Degree of Leverage
United States – BUSPROG.FOFM.BRIG.16.03 – Analytic skills
United States – OH – DISC.FOFM.BRIG.16.10 – Capital structure
Bloom’s: Application
Multiple Choice: Problem
23. Company D has a 50% debt ratio, whereas Company E has no debt financing. The two companies have the same level
of sales and the same degree of operating leverage. Which of the following statements is most CORRECT?
a.
If sales increase 10% for both companies, then Company D will have a larger percentage increase in its net
income.
b.
If sales increase 10% for both companies, then Company D will have a larger percentage increase in its
operating income (EBIT).
c.
If EBIT increases 10% for both companies, then Company D’s net income will rise by more than 10%, while
Company E’s net income will rise by less than 10%.
d.
Company E has a higher degree of financial leverage.
e.
The two companies have the same degree of total leverage.
a
1
CHALLENGING
14A Degree of Leverage
FOFM.BRIG.16.14.14A – Degree of Leverage
United States – BUSPROG.FOFM.BRIG.16.03 – Analytic skills
United States – OH – DISC.FOFM.BRIG.16.10 – Capital structure
