Name:
Class:
Date:
Multiple Choice
1. Raw material and direct labor costs are examples of ____.
a.
fixed costs
b.
overhead costs
c.
variable costs
d.
capital costs
c
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
d
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
a
4. The percentage change in a firm’s EBIT that results in a 1% change in sales or output is known as the degree of ____.
a.
combined leverage
b.
financial leverage
c.
operating leverage
d.
business risk
c
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 plus DFL
d.
DOL times DFL
d
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
Name:
Class:
Date:
d.
preferred stock dividends
b
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)
d
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
c
9. Rent, insurance, and the salaries of top management are examples of ____.
a.
fixed costs
b.
capital costs
c.
variable costs
d.
fluctuating costs
a
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
d
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
b
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
Name:
Class:
Date:
c.
degree of operating leverage; degree of financial leverage
d.
degree of operating leverage; fixed cost ratio
c
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.
common stock and warrants
a
14. To balance the operating and financial risks that are so variable for a multinational company, Nestlé allows its foreign
operating subsidiaries ____ operational flexibility and follows a ____ financing strategy.
a.
decentralized; centralized
b.
centralized; centralized
c.
centralized; decentralized
d.
decentralized; decentralized
a
15. 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
d
16. An analytical technique called ____ analysis can be used to help determine when debt financing is advantageous and
when equity financing is advantageous.
a.
DFL-EPS
b.
EBIT-EPS
c.
DCL–EPS
d.
DOL-EBIT
b
17. Cash insolvency analysis evaluates the adequacy of a firm’s cash position in a ____.
a.
bankruptcy proceeding
b.
non-normal environment
c.
highly competitive environment
d.
recessionary environment
d
18. Financial leverage causes a firm’s ____ to change at a rate greater than the change in ____.
a.
EBIT; EPS
Name:
Class:
Date:
b.
EPS; EBIT
c.
EBIT; sales
d.
sales; EBIT
b
19. In EBIT-EPS analysis, the indifference point is found at the point where ____ for the two alternative financing plans is
(are) equal.
a.
EBIT
b.
EPS
c.
stock prices
d.
DOL
b
20. 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%
a
21. 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
b
22. A DFL (degree of financial leverage) of 3.0 indicates a 27% increase in EPS is the result of a(n) ____ increase in
EBIT.
a.
81%
b.
3%
c.
9%
d.
6%
c
23. 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
b
24. A firm is said to be ____ if it is unable to meet its current obligations.
Name:
Class:
Date:
a.
cash insolvent
b.
bankrupt
c.
free cash challenged
d.
technically insolvent
d
25. 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%. ITC has 30,000 shares of
$5 preferred stock and 150,000 shares of common stock outstanding. ITC is in the 50% 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.
1.26
b
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%. ITC has 30,000 shares of
$5 preferred stock and 150,000 shares of common stock outstanding. ITC is in the 50% 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
d
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%. ITC has 30,000 shares of
$5 preferred stock and 150,000 shares of common stock outstanding. ITC is in the 50% 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.
1.25
c
28. Suppose 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% to $10,800,000.
a.
60%
b.
50%
c.
32%
d.
30%
a
29. The Lincoln Mint produces various types of one ounce silver commemorative medals for sale to collectors. The cost
Name:
Class:
Date:
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 determined from the information provided
c
30. Last year Avator’s operating income (EBIT) increased by 22% 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
c
31. 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
c
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 financial leverage.
a.
1.22
b.
2.07
c.
1.09
d.
1.04
b
Name:
Class:
Date:
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 combined leverage.
a.
26.8
b.
5.5
c.
29.1
d.
4.7
a
34. 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
c
35. Kenzel has an EPS of $4.20, and sales are $9 million. Assuming 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
a
36. Leigh Fibers expects its operating income over the coming year to equal $2.5 million with a standard deviation of
$800,000. Leigh must pay interest charges of $1.2 million next year and preferred dividends of $300,000. Leigh’s
marginal tax rate is 35%. What is the probability that Leigh will have negative EPS next year if its operating income is
expected to be normally distributed? (Problem requires a normal distribution table.)
a.
14.7%
b.
5.2%
c.
10.6%
d.
15.7%
a
37. Chemex has a cash and marketable securities balance of $200 million. Management expects free cash flows of $320
million during the coming year. If management is considering a restructuring of its capital structure that would add an
additional $350 million of annual fixed financial charges, what is the expected cash balance at the end of the year?
a.
–$30 million
b.
$170 million
c.
$230 million
d.
$470 million
b
Name:
Class:
Date:
38. The Albany Corporation has a present capital structure consisting of common stock ($200 million, 10 million shares)
and debt ($150 million, 8%). The company is planning a major expansion and is undecided between two financing plans.
Plan A:
Equity financing. Under this plan, an additional 2.5 million shares of common stock
will be sold at $15 each.
Plan B:
Debt financing. Under this plan, $37.5 million of 10% long-term debt will be sold.
What is the EBIT-EPS indifference point? Assume a 40 percent marginal tax rate.
a.
$33.9 million
b.
$30.75 million
c.
$37.0 million
d.
$12.9 million
b
39. The Albany Corporation has a present capital structure consisting of common stock ($200 million, 10 million shares)
and debt ($150 million, 8%). The company is planning a major expansion and is undecided between two financing plans.
Plan A:
Equity financing. Under this plan, an additional 2.5 million shares of common stock
will be sold at $15 each.
Plan B:
Debt financing. Under this plan, $37.5 million of 10% long-term debt will be sold.
What happens to the EBIT indifference point if the interest rate on the new debt decreases and the common stock price
remains constant?
a.
The indifference point increases.
b.
The indifference point decreases.
c.
The indifference point does not change.
d.
Cannot be determined from the information provided
b
40. Two companies, Jefferson and Jackson, are virtually identical in all aspects of their operations except that the two
companies differ in their capital structures, as shown below.
Jefferson
Jackson
Debt (10%)
$200 million
$100 million
Common equity
$300 million
$400 million
No. shares outstanding
15 million
20 million
Both companies have $500 million in total assets and both have a 40% marginal tax rate. What is the EPS for Jefferson at
an EBIT level of $50 million?
a.
–$1.20
b.
$1.20
c.
$2.20
d.
$3.33
b
41. Two companies, Jefferson and Jackson, are virtually identical in all aspects of their operations except that the two
companies differ in their capital structures, as shown below.
Jefferson
Jackson
Debt (10%)
$200 million
$100 million
Name:
Class:
Date:
Common equity
$300 million
$400 million
No. shares outstanding
15 million
20 million
Both companies have $500 million in total assets and both have a 40% marginal tax rate. What is the EPS for Jackson at
an EBIT level of $50 million?
a.
$1.50
b.
$1.20
c.
$2.00
d.
$2.50
b
42. Onex expects to have an EBIT of $240,000 with a standard deviation of $90,000. The distribution of operating income
is approximately normal. What is the probability that Onex will have an EBIT below $0? (Problem requires a normal
distribution table.)
a.
0.47%
b.
2.67%
c.
0.38%
d.
2.25%
c
43. Alace is an all-equity firm with 10 million shares outstanding and is evaluating two alternative financing plans. With
the first plan, Alace will sell 1 million shares of common stock at $15 each. Under the second plan, the firm would sell
$15 million of 12% long-term debt. If Alace has a marginal tax rate of 35%, what is the EBIT-EPS indifference point?
a.
$12.9 million
b.
$19.8 million
c.
$11.7 million
d.
$18.0 million
b
44. Knight Moves is considering two alternative financing plans. The firm is expected to operate at the $75 million EBIT
level. Under Plan D (debt financing) EPS is expected to be $2.25, and under Plan E (equity financing) EPS is expected to
be $1.82. If the market is expected to assign a P/E ratio of 12 to the debt plan and 15 to the equity plan, which plan should
Knight pursue?
a.
debt
b.
equity
c.
indifferent between the two alternatives
d.
neither is satisfactory
b
45. Dagger Company has a current capital structure consisting of $60 million in long-term debt with an interest rate of 9%
and $60 million in common equity (12 million shares). The firm is considering an expansion plan costing $23 million. The
expansion plan can be financed with additional long-term debt at a 12% interest rate or the sale of new common stock at
$8 per share. The firm’s marginal tax rate is 40%. Determine the indifference level of EBIT for the two financing plans.
a.
-$30.24 million
b.
$18.36 million
c.
$30.24 million
Name:
Class:
Date:
d.
$19.68 million
d
46. The Ames Company has an expected EBIT of $16 million with a standard deviation of $8 million. The indifference
point between a debt financing alternative and a common stock financing alternative was computed to be $12 million.
Determine the probability that the equity financing alternative will be superior to the debt financing alternative (i.e., have
a higher EPS). (Problem requires normal distribution table.)
a.
50.0%
b.
30.85%
c.
69.15%
d.
cannot be computed
b
47. 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
b
48. TCA Cable has fixed operating costs of $2.6 million, and its variable cost ratio is 0.30. TCA has $4.0 million 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
d
49. 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
a
50. 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
Name:
Class:
Date:
c.
$5.81
d.
$3.68
c
51. 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
b
52. If a firm sees its EPS increase 27% on a 12% increase in sales. During the same period the firm saw its EBIT increase
only 8%. What is the firm’s DOL?
a.
1.50
b.
3.38
c.
1.34
d.
0.67
d
53. Given the following financial data for Boston Technology, compute the firm’s degree of combined leverage. Assume a
marginal tax rate of 40%.
2010
2011
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
b
54. ASG expects next year’s operating income (EBIT) to equal $22 million, with a standard deviation of $16 million. The
coefficient of variation of operating income is equal to 0.73. Interest expenses will be $9 million next year and debt
retirement will require a principal payment of $2.5 million. ASG’s marginal tax rate is 40%. If EBIT is normally
distributed, what is the probability that ASG will have a negative EPS next year? (Problem requires a normal distribution
table.)
a.
20.9%
b.
25.5%
c.
23.3%
d.
25.8%
a
Name:
Class:
Date:
55. Sulzar’s capital structure consists only of common stock (20 million shares), but the firm is planning a major
expansion, which will require $100 million of new capital. Sulzar has a choice of obtaining the needed capital through the
sale of 5 million shares of common stock at $20 per share or the sale of $100 million of first mortgage bonds that would
have a coupon rate of 9%. Assuming Sulzar has a marginal tax rate of 40%, calculate the EBIT-EPS indifference point.
a.
$45 million
b.
$36 million
c.
$5 million
d.
$9 million
a
56. Given the following financial data for Cosmos, compute the firm’s degree of combined leverage.
2010
2011
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
d
57. Given the following financial data for Cosmos, compute the firm’s degree of financial leverage.
Last Year
This Year
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
b
58. Higgins currently has 2 million shares of common stock outstanding that are selling for $32 per share. Higgins also
has a $20 million mortgage bond outstanding that has an 11% coupon rate. Higgins is considering two alternatives to
financing a major expansion. Plan A is to sell $10 million of additional long-term debt with a 12.5% coupon. Plan B is to
sell 200,000 shares of common stock at $30 per share and $4 million in long-term debt with an 11.25% coupon. What is
the EBIT indifference level between these two alternatives? Assume the marginal tax rate is 40%.
a.
$1,374,000
b.
$11,450,000
Name:
Class:
Date:
c.
$4,554,000
d.
$2,650,000
b
59. Onyx expects to have an EBIT of $240,000 with a standard deviation of $110,000. The distribution of operating
income is approximately normal. If Onyx has interest expenses of $50,000, what is the probability that it will have an
operating income that is below $0? (Problem requires a normal distribution table.)
a.
4.27%
b.
1.46%
c.
0.02%
d.
2.4%
b
60. Midwest Can Company is considering opening a new plant in St. Louis that is expected to produce an average EBIT
of $3 million per year. To finance this new plant, Midwest is considering two financing plans. The first plan is to sell
600,000 shares of common stock at $15 each. The second plan is to sell 200,000 shares of common stock at $15 each and
$6 million of 13% long-term debt. Assuming Midwest has a marginal tax rate of 40%, what is the EBIT-EPS indifference
point for this plant?
a.
$702,000
b.
$234,000
c.
$2,234,000
d.
$1,170,000
d
61. Ipsy Dipsy Preschools Inc. has a capital structure that consists of 60% common equity (2.0 million shares), 30% long-
term debt ($10 million with 12% coupon), and 10% preferred stock ($50 par value with $4.75 dividend). The company is
planning a major plant expansion and is undecided between the following two financing plans:
1) Equity financing: Sale of 400,000 shares of common at $10 each
2) Debt financing: Sale of $4 million of 12.5 percent long-term bonds
Calculate the EBIT-EPS indifference point, assuming the marginal tax rate is 40%.
a.
$4.253 million
b.
$3.051 million
c.
$3.654 million
d.
$4.728 million
d
62. River Rafts has determined that its expected EBIT for the coming year is $8.3 million. The EBIT is approximately
normally distributed with a standard deviation of $5.1 million. If River Rafts has $1.9 million in annual interest payments,
what is the probability that the firm will have negative earnings?
a.
4.65%
b.
10.47%
c.
5.16%
d.
35.20%
b
Name:
Class:
Date:
63. Twin City Printing is considering two financial alternatives for financing a major expansion program. Under either
alternative EBIT is expected to be $15.6 million. Currently the firm’s capital structure consists of 4 million shares of
common stock and $35 million in 11% long-term bonds. Under the debt financing alternative $10 million in 12% long-
term bonds will be sold, and under the equity financing alternative the firm would sell 500,000 shares of common stock.
The P/E under the debt alternative would be 15, and the P/E under the equity alternative would be 16. The firm’s marginal
tax rate is 40%. Which alternative would produce the higher stock price?
a.
debt–stock price of $23.70
b.
debt–stock price of $32.29
c.
equity–stock price of $25.12
d.
equity–stock price of $33.28
c
64. Sitco has a total of $12 million in cash and marketable securities. Free cash flows during the coming year are expected
to be $47 million with a standard deviation of $31 million. Assume that Sitco’s free cash flows are approximately
normally distributed. What is the probability that Sitco will run out of cash during the coming year?
a.
29.98%
b.
34.83%
c.
97.13%
d.
2.87%
d
65. Crown Data(CD) has a current capital structure that consists of $120 million in common equity (15 million shares)
and $80 million in long-term debt with an average interest rate of 11%. CD is considering an expansion project that will
cost $22 million. The project will be financed either by issuing long-term debt at a cost of 12.5%, or the sale of new
common stock at $35 per share. The firm’s marginal tax rate is 40%. What is the EBIT indifference point between the two
financing options?
a.
$71.5 million
b.
$77.2 million
c.
$68.3 million
d.
$1.0 million
b
66. In considering EBIT-EPS analysis, which of the following statements is (are) correct?
a.
If the expected earnings are above the indifference point, the debt option is preferred.
b.
If the expected earnings are below the indifference point, the equity option is preferred.
c.
Both statements are correct.
d.
Neither statement is correct.
c
67. What type of security is used to purchase a target company in a leveraged buy-out?
a.
common stock
b.
dividends
c.
debt
d.
retained earnings
c
Name:
Class:
Date:
68. A change in EBIT is magnified into a larger change in EPS. This means that financial leverage is using ____ as its
fulcrum.
a.
short-term costs
b.
fixed costs
c.
variable costs
d.
retained earnings
b
69. In using Nestlé Corporation as a model, when a subsidiary is first formed, about one-half of the financing needed to
acquire fixed assets comes from ____.
a.
debt
b.
federal funds
c.
tax breaks
d.
equity from the parent company
d
70. Some companies use debt or preferred stock financing instead of common stock financing. The purpose is to ____.
a.
retain control
b.
facilitate record-keeping
c.
maintain privacy
d.
prevent audit problems
a
71. There are three categories of costs: fixed costs, variable costs and semi-variable costs. Which of the following is a
semi-variable cost?
a.
depreciation
b.
labor costs
c.
raw materials
d.
management salaries
d
72. Fanny Nanny Weight Monitors Inc. is considering two financial alternatives for financing a major expansion program.
Under either alternative, EBIT is expected to be $12.5million. Currently the firm’s capital structure consists of 2 million
shares of common stock and $15 million in 6% long-term bonds. Under the debt financing alternative $8 million in 4%
long-term bonds will be sold and under the equity financing alternative the firm would sell 150,000 shares of common
stock. The P/E under the debt alternative would be 21 and the P/E under the equity alternative would be 22. The firm’s
marginal tax rate is 40%. Which alternative would produce the higher stock price?
a.
debt–stock price of $57.36
b.
debt–stock price of $70.98
c.
equity–stock price of $71.28
d.
equity–stock price of $85.32
c
73. Dippity Doodle Noodle Makers has a capital structure that consists of 2.0 million shares outstanding and $2.0 million
of debt at 8% interest. The company is planning a major plant expansion and must decide between the following two
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financing plans. Option 1 is to increase debt by $1.0 million at 9% interest and sell 10,000 new shares of stock at $50 per
share. Option 2 is to sell 30,000 new shares of stock at $50 per share. What would be the indifference point and,
considering that EBIT is expected to be $10,000,000, which option would be best?
a.
Indifference of $10,750,000; use stock option.
b.
Indifference of $1,600,000; use stock option.
c.
Indifference of $16,270,000; use the debt option.
d.
Indifference of $9,250,000; use the debt option.
d
74. What is the degree of operating leverage for Flippin’ Out Company, a maker of scuba flippers, if the firm sells its
finished product for $50 per unit with variable costs per unit of $15? The company has fixed operating costs of
$2,000,000 and sells 200,000 units. (The answer is rounded.)
a.
2.0
b.
3.7
c.
6.5
d.
1.4
d
75. Magnificent Manes Hair Salons is forecasting a 17% increase in sales. What would be its degree of operating leverage
if it anticipates that its EBIT will go from $150,000 to $175,000 during the same time frame?
a.
1.76
b.
2.5
c.
.98
d.
1.11
c
76. What would be the degree of financial leverage for Foggy Futures Weather Forecasters if the company has earnings
before interest and taxes of $750,000, has a 4.5% loan on $1,000,000, and is in the 38% tax bracket? The firm does not
have any preferred stock outstanding.
a.
1.22
b.
1.78
c.
1.06
d.
0.97
c
77. What would be the degree of financial leverage for Under A Cloud Skydiving School if the company will have
earnings before interest and taxes of $750,000, which would be a 15% increase? The firm had EPS of $1.25 but, with the
increased earnings, anticipates paying $1.37.
a.
0.80
b.
1.08
c.
2.01
d.
1.25
a
78. In evaluating degree of operating leverage , it is best that the firm’s DOL is ____.
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a.
higher than 1
b.
higher than 2
c.
lower than 1
d.
equal to 1
c
79. In evaluating a firm’s degree of financial leverage, financial risk is ____ with an increase in DFL.
a.
increased
b.
decreased
c.
not impacted
d.
reflective of excess inventory
a
Essay
80. What are the effects of leverage on shareholder wealth and the cost of capital?
value of the firm and a rise in its cost of capital.
81. Explain the difference between short-run costs and long-run costs.
number of management personnel in response to changes in the level of sales.
82. Why does a firm use operating and financial leverage? In what ways does it help the firm and in what ways does it
hurt the firm?
Leverage concepts highlight the risk-return trade-off of various types of financial decisions.
83. List the five steps developed to assist financial managers in making capital structure decisions.
4. Analyze these estimates in the context of the risk the firm is willing to assume.
5. Examine the market evidence to determine whether the proposed capital structure is too risky.
84. Some firms prefer to use debt or preferred stock for financing to retain control. Explain the rationale behind this
method.
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85. In what way does management’s willingness to assume risk impact the firm?