Chapter 13—CAPITAL STRUCTURE POLICY: FOUNDATION CONCEPTS
MULTIPLE CHOICE
1. Raw material and direct labor costs are examples of
a.
fixed costs
b.
overhead costs
c.
variable costs
d.
capital costs
2. When fixed operating costs are incurred by the firm, a change in ____ is magnified into a relatively
larger change in earnings before interest and taxes.
a.
overhead expenses
b.
interest charges
c.
labor costs
d.
sales revenue
3. When fixed capital costs are incurred by the firm, a change in ____ is magnified into a larger change in
earnings per share.
a.
earnings before interest and taxes
b.
overhead expenses
c.
interest charges
d.
preferred dividends
4. The percentage change in a firm’s EBIT that results in a 1% change in sales or output is known as the
a.
degree of combined leverage
b.
degree of financial leverage
c.
degree of operating leverage
d.
degree of business risk
5. The total variability of the firm’s EPS associated with a change in sales is an indication of combined
leverage and is best measured by
a.
DOL
b.
DFL
c.
DOL + DFL
d.
DOL DFL
6. In the analysis of financial leverage, all of the following are referred to as fixed charges except:
a.
bond interest
b.
common stock dividends
c.
bank interest
d.
preferred stock dividends
7. The degree of combined leverage is defined as the percentage change in earnings per share resulting
from a given percentage change in
a.
operating costs
b.
interest charges
c.
common stock dividends
d.
sales (or output)
8. The degree of combined leverage is equal to the degree of operating leverage ____ the degree of
financial leverage.
a.
added to
b.
divided by
c.
multiplied by
d.
subtracted from
9. Rent, insurance, and the salaries of top management are examples of:
a.
fixed costs
b.
capital costs
c.
variable costs
d.
fluctuating costs
10. A firm that employs relatively large amounts of labor- saving equipment in its operations will have a
relatively ____ degree of operating leverage.
a.
low
b.
constant
c.
insignificant
d.
high
11. A firm that employs a relatively large proportion of debt and preferred stock in its capital structure will
have a relatively ____ degree of financial leverage.
a.
low
b.
high
c.
insignificant
d.
constant
12. The degree of combined leverage is equal to the ____ multiplied by the ____.
a.
degree of operating leverage, variable cost ratio
b.
degree of financial leverage, variable cost ratio
c.
degree of operating leverage, degree of financial leverage
d.
degree of operating leverage, fixed cost ratio
13. A firm is considering the purchase of assets that will increase its fixed operating costs. The firm should
decrease the proportion of ____ it employs in its capital structure if it wants to maintain its existing
degree of combined leverage.
a.
debt
b.
warrants
c.
common stock
d.
none of the above
14. Financial leverage causes a firm’s ____ to change at a rate greater than the change in ____.
a.
EBIT; EPS
b.
EPS; EBIT
c.
EBIT; sales
d.
sales; EBIT
15. A firm that has a 2.5 DOL (degree of operating leverage) would find that an 8% increase in EBIT
would result from a ____ increase in sales.
a.
3.2%
b.
5.4%
c.
20.0%
d.
2.0%
16. A negative DOL indicates the percentage ____ in operating losses that occurs as the result of a 1%
increase in output.
a.
increase
b.
reduction
c.
change
d.
None of these are correct.
17. A DFL (degree of financial leverage) of 3.0 indicates that a 27% increase in EPS is the result of a ____
increase in EBIT.
a.
81%
b.
3%
c.
9%
d.
6%
18. The use of increasing amounts of combined leverage ____ the risk of financial distress.
a.
decreases
b.
increases
c.
has no effect on
d.
creates diversity in
19. The degree of financial leverage is defined as the percentage change in
a.
EBIT resulting from a given percentage change in sales
b.
EPS resulting from a given percentage changes in sales
c.
EBIT resulting from a given percentage change in EPS
d.
EPS resulting from a given percentage change in EBIT
20. All of the following factors influence a firm’s business risk except:
a.
degree of operating leverage
b.
variability of interest rates
c.
variability of operating costs
d.
variability of selling prices
21. Operating leverage involves the use of
a.
equity and debt in equal proportions
b.
market power
c.
debt
d.
assets having fixed costs
22. The use of fixed cost sources of funds, such as debt and preferred stock affect a firm’s ____.
a.
financial risk
b.
degree of operating leverage
c.
market power
d.
business risk
23. The use of fixed-cost financing sources is referred to as the use of
a.
operating leverage
b.
a leveraged buyout
c.
financial leverage
d.
combined leverage
24. The increased variability in earnings per share due to the firm’s use of debt is a definition of ____.
a.
combined leverage
b.
agency risk
c.
financial risk
d.
operating risk
25. The less a firm’s business risk, the ____ the amount of ____ that will be used in the optimal capital
structure, holding constant all other relevant factors.
a.
less; financial leverage
b.
more; financial leverage
c.
less; equity capital
d.
more; debt capital
26. Illinois Tool Company’s (ITC) fixed operating costs are $1,260,000 and its variable cost ratio (i.e.,
variable costs as a fraction of sales) is 0.70. The firm has $3,000,000 in bonds outstanding at an
interest rate of 8 percent. ITC has 30,000 shares of $5 preferred stock and 150,000 shares of common
stock outstanding. ITC is in the 50 percent corporate income tax bracket. Forecasted sales for next year
are $9 million. What is ITC‘s degree of operating leverage at a sales level of $9 million?
a.
1.60
b.
1.875
c.
3.0
d.
3.33
27. Illinois Tool Company’s (ITC) fixed operating costs are $1,260,000 and its variable cost ratio (i.e.,
variable costs as a fraction of sales) is 0.70. The firm has $3,000,000 in bonds outstanding at an
interest rate of 8 percent. ITC has 30,000 shares of $5 preferred stock and 150,000 shares of common
stock outstanding. ITC is in the 50 percent corporate income tax bracket. Forecasted sales for next year
are $9 million. What is ITC‘s degree of financial leverage at an EBIT level of $1,440,000.
a.
1.20
b.
1.875
c.
3.0
d.
1.60
28. Illinois Tool Company’s (ITC) fixed operating costs are $1,260,000 and its variable cost ratio (i.e.,
variable costs as a fraction of sales) is 0.70. The firm has $3,000,000 in bonds outstanding at an
interest rate of 8 percent. ITC has 30,000 shares of $5 preferred stock and 150,000 shares of common
stock outstanding. ITC is in the 50 percent corporate income tax bracket. Forecasted sales for next year
are $9 million. What is ITC‘s degree of combined leverage at a sales level of $10 million?
a.
2.00
b.
1.72
c.
2.50
d.
2.65
29. Suppose that ITC’s degree of combined leverage (DCL) is 3.00 at a sales volume of $9 million.
Determine ITC’s percentage change in earnings per share (EPS) if forecasted sales increase by 20
percent to $10,800,000.
a.
60%
b.
50%
c.
32%
d.
18%
30. The Lincoln Mint produces various types of one ounce silver commemorative medals for sale to
collectors. The cost of producing and selling a given medal is as follows:
Fixed costs:
Design and preparation of dies
$ 8,000
Promotion and selling expenses
25,000
Administrative overhead
7,000
Total
$40,000
Variable costs:
Silver blanks
$ 6.00
Striking medals
0.50
Mailing expenses
3.50
Total
$ 10.00
Projected selling price:
$ 14.00
What is the degree of operating leverage at an output level of 15,000 units?
a.
0.0
b.
1.0
c.
3.0
d.
cannot be computed from information given
31. Last year Avator’s operating income (EBIT) increased by 22 percent while its dollar sales increased by
15%. What is Avator’s degree of operating leverage (DOL)?
a.
0.68
b.
2.0
c.
1.47
d.
0.32
32. Kermit’s Hardware’s (KH) fixed operating costs are $20.8 million and its variable cost ratio is 0.30.
The firm has $10 million in bonds outstanding with a coupon interest rate of 9%. KH has 200,000
shares of common stock outstanding. The firm has revenues of $32.2 million and its marginal tax rate
is 40%. Compute KH’s degree of operating leverage.
a.
14.81
b.
5.19
c.
12.95
d.
4.54
33. Kermit’s Hardware’s (KH) fixed operating costs are $20.8 million and its variable cost ratio is 0.30.
The firm has $10 million in bonds outstanding with a coupon interest rate of 9%. KH has 200,000
shares of common stock outstanding. The firm has revenues of $32.2 million and its marginal tax rate
is 40%. Compute KH’s degree of financial leverage.
a.
1.22
b.
2.07
c.
1.09
d.
1.04
34. Kermit’s Hardware’s (KH) fixed operating costs are $20.8 million and its variable cost ratio is 0.30.
The firm has $10 million in bonds outstanding with a coupon interest rate of 9%. KH has 200,000
shares of common stock outstanding. The firm has revenues of $32.2 million and its marginal tax rate
is 40%. Compute KH’s degree of combined leverage.
a.
26.8
b.
5.5
c.
29.1
d.
4.7
35. Weis Products has fixed operating costs of $20 million and a variable cost ratio of 0.55. Weis has 4
million common shares outstanding and a marginal tax rate of 45%. What is Weis’s degree of
operating leverage at an expected sales level of $150 million.
a.
1.00
b.
1.74
c.
1.42
d.
1.32
36. Kenzel has an EPS of $4.20 and sales are $9 million. If the firm has a degree of operating leverage of
4.0 and a degree of financial leverage of 5.2, forecast EPS if the firm expects a 4% sales decline.
a.
$0.71
b.
$3.49
c.
$4.03
d.
$3.33
37. Centex, a producer of telephone systems for small businesses, has current sales of $43 million and
variable operating costs of $27.95 million. Centex expects to increase sales in the coming year by 15%
while keeping fixed operating costs constant at $9.1 million. What is the DOL for Centex?
a.
3.3
b.
2.5
c.
7.2
d.
1.0
38. TCA Cable has fixed operating cost of $2.6 million, and its variable cost ratio is 0.30. TCA has $4.0 in
bonds outstanding with a coupon interest rate of 12%. TCA has 1.0 million common shares and
1,000,000 shares of $1.75 preferred stock outstanding. Total revenues for TCA Cable are $14.2
million. If TCA has a marginal tax rate of 40%, what is its degree of combined leverage?
a.
2.1
b.
1.0
c.
1.9
d.
2.5
39. Borkstran has sales of $7.8 million, a variable cost ratio of 0.6, EBIT of $1.1 million, and a degree of
combined leverage of 3.4. What is Borkstran’s degree of financial leverage?
a.
1.20
b.
0.73
c.
2.29
d.
0.84
40. Archive Storage earned $3.20 a share on sales of $13.6 million. Archive has determined that its degree
of operating leverage is 1.87 and its degree of financial leverage is 2.91. If sales are expected to
increase 15%, what will be the EPS forecast?
a.
$2.61
b.
$4.60
c.
$5.81
d.
$3.68
41. Last year Alpine Growers experienced a 34% increase in earnings per share on 11% increase in sales.
If management knows that Alpine’s DOL is 1.5, what is its DFL?
a.
3.09
b.
2.06
c.
3.55
d.
1.67
42. If a firm sees its EPS increase 27% on a 12% increase in sales, what is the firm’s DOL. During the
same period the firm saw its EBIT increase only 8%.
a.
1.50
b.
3.38
c.
1.34
d.
0.67
43. Given the following financial data for Boston Technology, compute the firm’s degree of combined
leverage. Assume a marginal tax rate of 40%.
2004
2005
Sales
$700,000
$760,000
Fixed costs
175,000
190,000
Variable costs
406,000
448,000
EBIT
119,000
122,000
Interest
42,000
46,000
Shares outstanding
100,000
102,000
a.
0.29
b.
-0.38
c.
-0.15
d.
0.38
2004
2005
EBIT
$119,000
$122,000
I
EBT
T
30,400
EAT
$ 45,600
DCL = [($0.447 – $0.462)/$0.462]/[($760,000 – $700,000)/$700,000] = -0.38
44. Given the following financial data for Cosmos, compute the firm’s degree of combined leverage.
2004
2005
Sales
$780,000
$874,000
Fixed costs
195,000
218,500
Variable costs
460,200
524,400
EBIT
124,800
131,100
Interest
46,800
52,400
EPS
$0.42
$0.51
a.
$0.42
b.
8.37
c.
-2.15
d.
1.78
45. Given the following financial data for Cosmos, compute the firm’s degree of financial leverage.
Sales
$780,000
$874,000
Fixed costs
195,000
218,500
Variable costs
460,200
524,400
EBIT
124,800
131,100
Interest
46,800
52,400
EPS
$0.42
$0.51
a.
23.81
b.
4.24
c.
0.42
d.
2.18
46. Buffalo Bonsai Tree Farms sells small bonsai trees. It has fixed operating costs of $400,000. The
firm’s sales price is $35 per tree and its variable cost per tree is $22.50. The firm’s operating
breakeven point in units is:
a.
23,330
b.
32,000
c.
42,0000
d.
52,000
47. Chirping Charlie Canary Farms has fixed operating costs of $10,000. It is trying to determine its
breakeven point in dollars for its special bird seed. The sale price for each bag of bird seed is $25 and
its variable cost per bag is $15. The firm’s operating breakeven point in dollars is:
a.
$10,000
b.
$16,667
c.
$6,250
d.
$25,000
48. Breakeven analysis is also known as:
a.
Cost of sales analysis
b.
Financial leverage analysis
c.
Cost-volume-profit analysis
d.
EBIT-EPS analysis
ESSAY
1. Explain Degree of Combined Leverage.
2. List factors that influence the business risk of a firm.