Economics Chapter 13 The company's fixed operating costs total $500,000 and its variable

Web App 13A

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 1.375. 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.

$2,118,421.05

b.

$1,381,578.95

c.

$1,842,105.26

d.

$1,528,947.37

e.

$2,192,105.26

c

Q

EBIT

DTL

Debt

DFL

=

1.4545

EBIT

$4,000,000

1.4545I

=

$1,818,182

=

$1,250,000

9.50%

$13,157,894.74

$15,000,000.00

$13,157,894.74

=

$1,842,105.26

b.

c.

d.

e.

1

14A Degree of Leverage

2. Your firm’s EPS last year was $1.00. You expect sales to increase by 32.50% 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.

$1.86

b.

$2.42

c.

$2.40

d.

$1.82

e.

$2.03

b

b.

c.

d.

e.

1

MODERATE

14A Degree of Leverage

True

DFL

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

14A Degree of Leverage

Multiple Choice

False

FOFM.BRIG.17.14.14A – Degree of Leverage

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DOL, DFL, and DTL

Bloom’s: Comprehension

Multiple Choice: Conceptual

4. The Quick Company expects its sales to increase by 50% in the coming year. The firm’s current EPS is $2.50. 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.

$6.70

b.

$6.83

c.

$5.36

d.

$6.90

e.

$8.17

a

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Change in EPS

Bloom’s: Application

Multiple Choice: Problem

5. Alvarez Technologies has sales of $3,000,000. The company’s fixed operating costs total $500,000 and its variable

costs equal 45.00% 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.

3.0715

b.

2.9700

c.

2.1069

d.

2.5385

e.

3.0208

d

b.

c.

d.

e.

1

MODERATE

14A Degree of Leverage

True

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c.

d.

e.

1

CHALLENGING

14A Degree of Leverage

Multiple Choice

True

FOFM.BRIG.17.14.14A – Degree of Leverage

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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

Multiple Choice

False

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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 6.000, 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.

$619,200

b.

$720,000

Web App 13A

c.

$871,200

d.

$763,200

e.

$813,600

b

DTL

DFL

Determine DOL

DTL/DFL

3.200

b.

c.

d.

e.

1

CHALLENGING

14A Degree of Leverage

Multiple Choice

True

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Expected EBIT

Bloom’s: Evaluation

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).

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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

Multiple Choice

False

FOFM.BRIG.17.14.14A – Degree of Leverage

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Multiple Choice: Conceptual

9. Maxvill Motors has annual sales of $14,900. 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.

10.69%

b.

12.02%

c.

14.54%

d.

11.30%

e.

9.37%

b

b.

c.

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d.

e.

1

MODERATE

14A Degree of Leverage

True

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 9.5%, its net income and EPS would increase 17.5%. What is the company’s interest expense?

a.

$193,143

b.

$176,429

c.

$185,714

d.

$202,429

e.

$163,429

c

Sales

EBIT

17.50%

9.50%

1.84

DTL

=

1.84

=

$1,500,000

=

$1,842,105

1.84I

=

$342,105

=

$185,714

b.

c.

d.

e.

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 30%. If PQR’s degree of total leverage is equal to 1.30, what is its degree of operating leverage?

a.

0.8962

b.

1.2281

c.

1.0179

d.

1.3719

e.

1.1064

e

Debt

Sales

DTL

Interest

EBT

Taxes

EBIT

$1,007,143

$857,143

1.1750

=

1.1064

b.

1

CHALLENGING

14A Degree of Leverage

True

Web App 13A

c.

d.

e.

1

CHALLENGING

14A Degree of Leverage

True

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 2.75. 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 2.75, what is this

year’s expected EBIT with the increase in sales?

a.

$119,400

b.

$120,594

c.

$97,908

d.

$138,504

e.

$146,862

a

$60,000

125,000

$60,000

0.99

=

$60,000

$59,400

=

X

=

$119,400

b.

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c.

d.

e.

1

CHALLENGING

14A Degree of Leverage

True

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 13.5%. 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.

19.68%

b.

23.72%

c.

27.98%

d.

19.45%

e.

21.34%

b

Sales

Debt

$1,500,000

$1,265,000

1.1858

b.

c.

d.

e.

1

14. Monroe Corporation currently sells 150,000 units a year at a price of $4.00 a unit. Its variable costs are approximately

40.0% 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 Monroe’s degree of operating leverage in sales

dollars?

a.

4.8000

b.

6.3000

c.

7.3200

d.

5.6400

e.

6.0000

e

b.

c.

d.

e.

1

CHALLENGING

14A Degree of Leverage

True

CHALLENGING

14A Degree of Leverage

True

a

EBIT

DTL

Debt

YTM

DFL

=

1.7143

EBIT

$4,000,000

=

$1,666,667

11.60%

$14,367,816

b.

c.

d.

e.

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 11.60%. 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 11.60%)?

a.

$14,367,816

b.

$16,091,954

c.

$16,810,345

d.

$16,666,667

e.

$15,229,885

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

e.

1, 2, 3, 5

e

1

MODERATE

Multiple Choice

False

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Financial leverage

Bloom’s: Evaluation

Multiple Choice: Conceptual

17. Assume that a firm has a degree of financial leverage of 1.65. 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.

$86,533

b.

$71,867

c.

$73,333

d.

$90,200

e.

$89,467

c

DFL

% Sales

True

FOFM.BRIG.17.14.14A – Degree of Leverage

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Fin. leverage, DOL, and DTL

Bloom’s: Evaluation

Multiple Choice: Problem

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.

1

14A Degree of Leverage

% EPS

DTL =

b.

c.

d.

e.

1

14A Degree of Leverage

Multiple Choice

FOFM.BRIG.17.14.14A – Degree of Leverage

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Expected EBIT

Bloom’s: Analysis

Multiple Choice: Problem

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

Multiple Choice

False

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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 $93,000,000. What is Stromburg’s degree of operating leverage at the new projected sales

level?

a.

4.2086

b.

3.7831

c.

4.7288

d.

4.0668

e.

5.3436

c

Multiple Choice

False

FOFM.BRIG.17.14.14A – Degree of Leverage

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Degree of leverage

Bloom’s: Comprehension

Multiple Choice: Conceptual

21. Lincoln Lodging Inc. estimates that if its sales increase 10% then its net income will increase 15.00%. 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.

$720,000

b.

$558,000

c.

$624,000

d.

$600,000

e.

$534,000

d

b.

c.

d.

e.

1

CHALLENGING

14A Degree of Leverage

True

Web App 13A

1

CHALLENGING

14A Degree of Leverage

True

22. The “degree of leverage” concept is designed to show how changes in sales will affect EBIT and EPS. If a 20.00%

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.

2.1250

b.

2.8500

c.

2.4750

d.

2.5000

e.

2.0000

d

b.

c.

d.

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

Multiple Choice

False

FOFM.BRIG.17.14.14A – Degree of Leverage

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Debt ratio and DOL

Bloom’s: Evaluation

Multiple Choice: Conceptual

e.

1

CHALLENGING

14A Degree of Leverage

Multiple Choice

True

FOFM.BRIG.17.14.14A – Degree of Leverage

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Bloom’s: Application

Multiple Choice: Problem