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91) Financial leverage measures the effect of fixed financial costs on the relationship between ________.
A) sales and EBIT
B) sales and EPS
C) EBIT and EPS
D) EBIT and preference dividend
92) ________ leverage is concerned with the relationship between earnings before interest and taxes and
earnings per share.
A) Financial
B) Operating
C) Variable
D) Total
93) In theory, a firm should maintain financial leverage consistent with a capital structure that ________.
A) meets the industry standards
B) meets the investor expectations
C) maximizes the owner's wealth
D) maximizes dividends
94) The degree of financial leverage is the ratio of ________ to percentage change in EBIT.
A) operating profit
B) percentage change in sales
C) percentage change in EPS
D) long-term debt
95) ________ is the potential use of fixed financial charges to magnify the effects of changes in earnings
before interest and taxes on a firm's earnings per share.
A) Financial leverage
B) Operating leverage
C) Total leverage
D) Degree of operating leverage
96) Financial leverage measures the effect of fixed financing costs on the relationship between ________.
A) sales and EBIT
B) sales and EPS
C) EBIT and EPS
D) net income and sales
97) ________ leverage measures the effect of fixed ________ costs on the relationship between EBIT and
EPS.
A) Operating; operating
B) Financial; financial
C) Operating; financial
D) Financial; operating
98) Fixed financial charges include ________.
A) common stock dividends and bond interest expense
B) common stock dividends and preferred stock dividends
C) bond interest expense and preferred stock dividends
D) stock repurchase expense
99) Higher financial leverage causes ________ to increase more for a given increase in ________.
A) EBIT; sales
B) EPS; sales
C) EPS; EBIT
D) EBIT; EPS
100) ________ is the potential use of fixed costs to magnify the effect of changes in sales on the firm's
earnings per share.
A) Investing leverage
B) Total leverage
C) Operating leverage
D) Financial leverage
101) Through the effects of financial leverage, when EBIT increases, ________.
A) earnings per share will increase
B) earnings per share will decrease
C) fixed operating costs will decrease
D) fixed operating costs will increase
102) A firm has EBIT of $375,000, interest expense of $75,000, preferred dividends of $6,000 and a tax rate
of 40 percent. The firm's degree of financial leverage at a base EBIT level of $375,000 is ________.
A) 0.97
B) 1.29
C) 1.27
D) 1.09
103) ________ leverage is concerned with the relationship between sales revenue and earnings per share.
A) Financial
B) Operating
C) Variable
D) Total
104) At a base sales level of $400,000, a firm has a degree of operating leverage of 2 and a degree of
financial leverage of 1.5. The firm's degree of total leverage is ________.
A) 3.5
B) 3.0
C) 0.5
D) 1.3
105) Because the degree of total leverage is multiplicative and not additive, when a firm has very high
operating leverage it can moderate its total risk by ________.
A) increasing sales
B) using a higher level of financial leverage
C) increasing EBIT
D) using a lower level of financial leverage
106) Total leverage measures the effect of fixed costs on the relationship between ________.
A) sales and EBIT
B) sales and EPS
C) EBIT and EPS
D) EBIT and dividend
107) Bamboo manufacturing sells its finished product for an average of $35 per unit with a variable cost
per unit of $21. The company has fixed operating costs of $1,050,000.
(a) Calculate the firm's operating breakeven point in units.
(b) Calculate the firm's operating breakeven point in dollars.
(c) Using 100,000 units as a base, what is the firm's degree of operating leverage?
108) Beijing Berings is considering purchasing a small firm in the same line of business. The purchase
would be financed by the sale of common stock or a bond issue. The financial manager needs to evaluate
how the two alternative financing plans will affect the earnings potential of the firm. Total financing
required is $4.5 million. The firm currently has $20,000,000 of 12 percent bonds and 600,000 common
shares outstanding. The firm can arrange financing of the $4.5 million through a 14 percent bond issue or
the sale of 100,000 shares of common stock. The firm has a 40 percent tax rate.
(a) What is the degree of financial leverage for each plan at $7,000,000 of EBIT?
(b) What is the financial breakeven point for each plan?
109) Yongman Electronics has decided to invest $10,000,000 in a new headquarters and needs to
determine the best way to finance the construction. The firm currently has $50,000,000 of 10 percent
bonds and 4,000,000 common shares outstanding. The firm can obtain the $10,000,000 of financing
through a 10 percent bond issue or the sale of 1,000,000 shares of common stock. The firm has a 40
percent tax rate.
(a) What is the degree of financial leverage for each plan at $25,000,000 of EBIT?
(b) What is the financial breakeven point for each plan?
110) China America Manufacturing is evaluating two different operating structures which are described
below. The firm has annual interest expense of $250, common shares outstanding of 1,000, and a tax rate
of 40 percent.
(a) For each operating structure, calculate
(a1) EBIT and EPS at 10,000, 20,000, and 30,000 units.
(a2) the degree of operating leverage (DOL) and degree of total leverage (DTL) using 20,000 units as
a base sales level.
(a3) the operating breakeven point in units.
(b) Which operating structure has greater operating leverage and business risk?
(c) If China America projects sales of 20,000 units, which operating structure is recommended?
13.2 The firm's capital structure
1) A firm's capital structure is the mix of short-term liabilities and long-term debt.
2) Poor capital structure decisions can result in a high cost of capital, thereby making some unacceptable
investments acceptable.
3) Debt is a relatively inexpensive source of capital because lenders take the least risk among the long-
term contributors of capital.
4) Debt capital is less risky than equity capital because a firm is legally obligated to pay interest to
bondholders but they are not legally obligated to pay dividends to preferred or common stockholders.
5) Due to its secondary position relative to equity, suppliers of debt capital face greater risk and therefore
must be compensated with higher expected returns than suppliers of equity capital.
6) All items on the right-hand side of a firm's balance sheet, excluding current liabilities are sources of
capital.
7) Generally, the greater a firm's times interest earned ratio, the less able it is to meet payments as they
come due.
8) A firm's capital structure can significantly affect the firm's value by affecting its risk and return.
9) In general, a low times interest earned ratio and a low fixed-payment coverage ratio are associated
with a high degree of financial leverage.
10) The probability that a firm will become bankrupt is largely dependent on its level of both business
and financial risk.
11) Holding all other factors constant, a firm that is subject to a greater level of business risk should
employ more total leverage than an otherwise equivalent firm that is subject to a lesser level of business
risk.
12) In general, the greater a firm's operating leverage, the higher its business risk.
13) Business risk is the risk that is reflected in fluctuations of the firm's cash flows before considering any
debt financing.
14) Financial risk refers to fluctuations in a firm's cash flows that occur because the firm uses financing
sources like debt and preferred stock.
15) Business risk is the risk to the firm of being unable to cover required financial obligations.
16) The more fixed cost financing a firm has in its capital structure, the greater is its financial leverage and
risk.
17) Asymmetric information results when managers of a firm have more information about the firm's
operations and future prospects than investors have.
18) In general, non-U.S. companies have much higher debt ratios than their U.S. counterparts because
financial markets are much more developed in the United States than elsewhere.
19) Effective capital structure decisions can lower the cost of capital, resulting in higher NPVs and more
acceptable projects, thereby increasing the value of a firm.
20) The pecking order theory describes a hierarchy of financing beginning with retained earnings,
followed by debt financing, and finally external equity financing.
21) A shift toward more fixed costs increases business risk, which in turn causes earnings before interest
and taxes to increase by less for a given increase in sales.
22) When considering the decision to shift a firm's cost structure away from variable costs toward more
fixed costs, a financial manager must weigh the increased financial risk associated with greater operating
leverage against the expected increase in returns.
23) Because of the extensive research conducted in recent years in the area of capital structure theory, it is
now possible for financial managers to pinpoint with great accuracy a firm's optimal capital structure.
24) Despite the extensive research conducted in recent years in the area of capital structure theory, it is
not yet possible to provide financial managers with a specified methodology for use in determining a
firm's optimal capital structure.
25) In general, a firm's theoretical optimal capital structure is that which balances the tax benefits of debt
financing against the increase probability of bankruptcy that result from its use.
26) In general, a firm's theoretical optimal capital structure is that which balances the tax benefits of
equity financing against the increase probability of bankruptcy that results from its use.
27) The pecking order explanation of capital structure states that a hierarchy of financing exists for firms,
in which retained earnings are employed first, followed by debt financing and finally by external equity
financing.
28) The pecking order explanation of capital structure states that a hierarchy of financing exists for firms,
in which new external debt financing is employed first, followed by retained earnings and finally by
external equity financing.
29) The asymmetric information explanation of capital structure suggests that firms will issue new equity
only when the managers believe the firm's stock is overvalued; as a result, issuing new equity is
considered a negative signal that will result in a decline in share price.
30) The asymmetric information explanation of capital structure suggests that firms will issue new debt
only when the managers believe the firm's stock is overvalued; as a result, issuing new debt is considered
a negative signal that will result in a decline in share price.
31) Holding all other factors constant, a firm that is subject to a greater level of business risk should
employ less operating leverage than an otherwise equivalent firm that is subject to a lesser level of
business risk.
32) Holding all other factors constant, a firm that is subject to a greater level of business risk should
employ more operating leverage than an otherwise equivalent firm that is subject to a lesser level of
business risk.
33) Holding all other factors constant, a firm that is subject to a greater level of business risk should
employ less financial leverage than an otherwise equivalent firm that is subject to a lesser level of
business risk.
34) Holding all other factors constant, a firm that is subject to a greater level of business risk should
employ more financial leverage than an otherwise equivalent firm that is subject to a lesser level of
business risk.
35) Holding all other factors constant, a firm that is subject to a greater level of business risk should
employ less total leverage than an otherwise equivalent firm that is subject to a lesser level of business
risk.
36) A firm's ________ is the mix of long-term debt and equity utilized by the firm, which may
significantly affect its value by affecting return and risk.
A) dividend policy
B) capital budget
C) capital structure
D) working capital
37) The lower risk nature of long-term debt in a firm's capital structure is due to the fact that ________.
A) the debt holders are the true owners of the firm
B) equity capital has a fixed return
C) creditors have a higher position in the priority of claims
D) dividend payments are tax-deductible
38) Which of the following is a reason why equity capital is considered riskier than debt capital?
A) Equity capital has a higher priority claim against assets and earnings.
B) Equity capital requires regular periodic payments in the form of dividends.
C) Equity capital expects dividend payments which are not tax-deductible.
D) Equity capital remains invested in a firm indefinitely.
39) The inexpensive nature of long-term debt in a firm's capital structure is partly because ________.
A) the debt holders are the true owners of the firm
B) equity capital has a fixed return
C) long-term debt has a fixed return and a maturity date
D) dividend payments are tax-deductible
40) The inexpensive nature of long-term debt in a firm's capital structure is partly because ________.
A) the equity holders are the true owners of the firm
B) equity capital has a fixed return
C) creditors have a higher position in the priority of claims
D) dividend payments are tax-deductible
41) The inexpensive nature of long-term debt in a firm's capital structure is partly because ________.
A) the equity holders are the true owners of the firm
B) equity capital has a fixed return
C) interest payments are tax-deductible
D) equity holders have a higher position in the priority of claims
42) Which of the following is a basic source of capital for a firm?
A) short-term debt
B) discounts from suppliers
C) current liabilities
D) common stock
43) A decrease in the use of financing that requires fixed payments will result in a(n)________.
A) increase in financial risk
B) decrease in financial risk
C) increase in operating leverage
D) decrease in operating leverage
44) As debt is substituted for equity in the capital structure and the debt ratio increases, the behavior of
the overall cost of capital is partially explained by ________.
A) the tax-deductibility of interest payments
B) the increase in the number of common shares outstanding
C) the reduction in risk as perceived by the common shareholders
D) the decrease in the cost of equity
45) According to the pecking order theory, which of the following is the order in which corporations use
different financing sources to fund investment projects?
A) retained earnings, equity, debt
B) retained earnings, debt, equity
C) debt, retained earnings, equity
D) equity, retained earnings, debt
46) ________ is the risk reflected in fluctuations of a firm's cash flows because it uses debt or other fixed-
cost financing.
A) Systematic risk
B) Business risk
C) Financial risk
D) Diversifiable risk
