WEB APPENDIX 13A: 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. $6,250,000
b. $6,907,895
c. $6,578,947
d. $5,937,500
e. $5,640,625
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. $1.66
b. $1.83
c. $1.92
d. $1.74
e. $1.57
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.
If a firm’s degree of operating leverage increases, its degree of financial leverage must also have increased.
c.
An increase in interest expense will reduce the company’s degree of financial leverage.
d.
If the company has no debt outstanding, then its degree of total leverage equals its degree of operating
leverage.
e.
If the company has no debt outstanding, then its degree of total leverage equals its degree of financial
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. $7.86
b. $7.47
c. $9.15
d. $8.27
e. $8.71
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. 6.0000
b. 5.4150
c. 5.7000
d. 4.8870
e. 5.1443
6.
Which of the following statements is CORRECT?
a.
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.
b.
The degree of total leverage (DTL) is equal to the DOL plus the degree of financial leverage (DFL).
c.
The degree of total leverage (DTL) is equal to the DFL divided by the degree of operating leverage (DOL).
d.
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.
e.
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.
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?
a. $380,000
b. $441,000
c. $400,000
d. $361,000
e. $420,000
8.
The degree of operating leverage has which of the following characteristics?
a.
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.
b.
The DOL relates the change in net income to the change in operating income.
c.
If the firm has no debt, the DOL will equal 1.
d.
The closer the firm is operating to the breakeven quantity, the smaller the DOL.
e.
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).
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. 13.89%
b. 14.59%
c. 13.23%
d. 12.60%
e. 12.00%
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 increase 10%, its net income and EPS would increase 17.5%. What is the company‘s interest expense?
a. $150,000
b. $142,857
c. $128,929
d. $135,714
e. $122,482
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. 1.2174
b. 1.3422
c. 1.2783
d. 1.1565
e. 1.0987
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. $108,300
b. $ 97,741
c. $ 92,854
d. $102,885
e. $114,000
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. 20.83%
b. 19.79%
c. 21.92%
d. 23.08%
e. 18.80%
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. 3.6750
b. 3.5000
c. 3.3250
d. 3.8588
e. 3.1588
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. $20,258,438
c. $19,293,750
d. $18,375,000
e. $17,500,000
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, 2, 3, 5
b. 2, 3, 5
c. 1, 3, 5
d. 2, 3, 4, 5
e. 1, 2, 5
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. $60,980
b. $70,946
c. $67,568
d. $57,931
e. $64,189
18.
Which of the following is a key benefit of using the degree of leverage concept in financial analysis?
a.
It shows how a given change in leverage will affect sales.
b.
It identifies, with certainty, the future net income based upon sales projections about the future.
c.
It establishes the optimal capital structure for the firm.
d.
It allows decision makers a relatively clear assessment of the consequences of alternative actions.
e.
None of the above statements is correct.
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 EBIT will equal the percentage change in net income.
b.
Since debt is used, the degree of operating leverage must be greater than 1.
c.
The percentage change in operating income will be less than the percentage change in net income.
d.
The percentage change in operating income (EBIT) resulting from the change in sales will exceed the
percentage change in net income.
e.
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.
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
b. 4.5581
c. 4.3411
d. 4.1344
e. 3.9375
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. $1,323,000
b. $1,083,000
c. $1,140,000
d. $1,260,000
e. $1,200,000
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. 5.0000
b. 5.2500
c. 4.7500
d. 4.5125
e. 4.2869
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
operating income (EBIT).
b.
The two companies have the same degree of total leverage.
c.
If sales increase 10% for both companies, then Company D will have a larger percentage increase in its net
income.
d.
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%.
e.
Company E has a higher degree of financial leverage.