Question 1

After satisfying obligations to creditors, the government, and preferred stockholders, any remaining earnings will most likely be allocated to any of the following EXCEPT
A) retention by the firm for future investment.
B) common shareholders as cash dividends.
C) common shareholders as stock dividends.
D) a combination of retained earnings and cash dividends.

Accepted Answer

Stock dividends do not involve the allocation of earnings; they are a distribution of additional shares to shareholders, not a distribution of earnings.

Question 2

As debt is substituted for equity in the capital structure and the debt ratio increases, all of thefollowing statements about the component costs of capital are true EXCEPT
A) the cost of debt continually increases.
B) the overall cost of capital continually increases.
C) the cost of equity continually increases.
D) the overall cost of capital first declines, reaches a minimum, and then rises again.

Accepted Answer

The overall cost of capital does not continually increase as debt is substituted for equity. Initially, it may decrease due to the tax shield on debt, but after reaching a certain point, it will start to increase as the risk of financial distress outweighs the benefits of the tax shield.

Question 3

Business risk is affected by all of the following EXCEPT
A) operating leverage.
B) earnings per share.
C) revenue stability.
D) cost stability.

Accepted Answer

Business risk is the level of risk associated with the operations and financials of a company. It is affected by several factors such as operating leverage, revenue stability, and cost stability. However, earnings per share is not a factor affecting business risk. Earnings per share is a measure of a company's profitability that is calculated by dividing its net income by the number of outstanding shares of its common stock.

Question 4

In the EBIT-EPS approach to capital structure, risk is represented by
A) shifts in the times-interest-earned ratio.
B) the slope of the capital structure line.
C) shifts in the cost of debt capital.
D) shifts in the cost of equity capital.

Accepted Answer

The slope of the capital structure line in the EBIT-EPS approach indicates the level of financial risk, as it reflects how sensitive EPS is to changes in EBIT due to the use of debt.

Question 5

Generally,__________in leverage result in,__________return and,__________risk. 
A) increases, increased, increased
B) increases, decreased, increased
C) decreases, increased, decreased
D) increases, decreased, decreased

Accepted Answer

The trend is consistently increasing over time.

Question 6

A firm has fixed operating costs of $25,000, a per unit sales price of $5, and a variable cost per unit of $3. What is its operating break-even point if it desires net operating income of $10,000, not $0 (zero)?
A) 15,000 units
B) 17,500 units
C) 12,500 units
D) 25,000 units

Accepted Answer

The formula to calculate the operating break-even point is:

Operating Break-Even Point (in units) = (Fixed Costs + Target Net Operating Income) / Contribution Margin per Unit

Contribution Margin per Unit = Sales Price per Unit - Variable Cost per Unit

Using the given information:

Contribution Margin per Unit = $5 - $3 = $2

Operating Break-Even Point (in units) = ($25,000 + $10,000) / $2 = 17,500 units

Therefore, the best choice is B, as the operating break-even point with a net operating income of $10,000 is 17,500 units.

Question 7

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 reduction in risk as perceived by the common shareholders.
B) the tax-deductibility of interest payments.
C) the increase in the number of common shares outstanding.
D) the decrease in the cost of equity.

Accepted Answer

Increasing the debt ratio means that the company is relying more on debt financing as opposed to equity financing. This in turn increases the tax-deductibility of interest payments, which reduces the overall cost of capital for the company.

Question 8

__________is the potential use of fixed costs, both operating and financial, to magnify the effect of changes in sales on the firm's earnings per share.
A) Operating leverage
B) Debt service
C) Total leverage
D) Financial leverage

Accepted Answer

Total leverage refers to the combined effect of operating and financial leverage, which magnifies the impact of changes in sales on the firm's earnings per share.

Question 9

A decrease in fixed financial costs will result in___________in financial risk
A) no change
B) an undetermined change
C) a decrease
D) an increase

Accepted Answer

A decrease in fixed financial costs will result in a decrease in overall costs, leading to a decrease in the breakeven point and potentially increasing profitability.

Question 10

The firm's operating break-even point is the point at which
A) EBIT is less than sales.
B) total operating costs equal total fixed costs.
C) EBIT is zero.
D) total operating costs are zero.

Accepted Answer

The firm's operating break-even point is the level of sales at which Earnings Before Interest and Taxes (EBIT) is zero, meaning total revenue equals total operating costs.

Question 11

In the EBIT-EPS approach to capital structure, a constant level of EBIT is assumed
A) to emphasize the relationship between interest expenses and taxes.
B) to ease the calculations of owners' equity.
C) to isolate the impact on returns of the financing costs associated with alternative capital structures.
D) to concentrate on the effect of revenue and expense on capital structure decisions.

Accepted Answer

The EBIT-EPS approach to capital structure assumes a constant level of EBIT to isolate the impact on returns of the financing costs associated with alternative capital structures. This approach helps in analyzing the effect of different capital structures on the earnings per share (EPS) and the financial risk of the company. By assuming a constant level of EBIT, the analysis focuses on the effect of financing choices on the EPS of the company.

Question 12

A firm has fixed operating costs of $253,750, a sales price per unit of $100, and a variable cost perunit of $65. The firm's operating break-even point in dollars is__________ .
A) $700,000
B) $725,000
C) $390,385
D) $906,250

Accepted Answer

The answer of A firm has fixed operating costs of...

Question 13

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) using more financial leverage.
B) increasing EBIT.
C) using a lower level of financial leverage.
D) increasing sales.

Accepted Answer

When a firm has very high operating leverage, it means that a large proportion of its costs are fixed costs, which means that small changes in sales can result in large changes in profits. If the firm also uses a high level of financial leverage, it can amplify this effect, leading to potentially unpredictable and significant changes in profits. In order to moderate total risk, the firm should use a lower level of financial leverage.

Question 14

A major assumption of break-even analysis and one which causes severe limitations in its use is that
A) revenues and operating costs are linear.
B) all costs are really semi-variable.
C) fixed costs really are fixed.
D) total revenue is nonlinear.

Accepted Answer

Revenues and operating costs are assumed to be linear in break-even analysis, which is a major assumption that limits its usefulness.

Question 15

A firm has an operating profit of $300,000, interest of $35,000, and a tax rate of 40 percent. The firm has an after-tax cost of debt of 5 percent and a cost of equity of 15 percent. The firm's target capital structure is set at a mix of 40 percent debt and 60 percent equity. According to the traditional approach to capital structure, the value of the firm is
A) $1.4 million.
B) $6.0 million.
C) $2.7 million.
D) $2.0 million.

Accepted Answer

Step 1: Calculate the Weighted Average Cost of Capital (WACC)
Debt proportion = 40%; Equity proportion = 60%
After-tax cost of debt = 5%*(1-40%) = 3%
WACC = (40%*3%) + (60%*15%) = 9%

Step 2: Calculate the firm value using the formula below
Firm Value = Operating Profit / WACC - Interest(1 - tax rate) / WACC
Firm Value = 300,000 / 9% - 35,000(1-40%) / 9%
Firm Value = $2.7 million

Therefore, the best choice is C.

Question 16

The firm's__________ is the level of sales necessary to cover all operating costs, i.e., the point at which EBIT = $0.
A) total break-even point
B) cash break-even point
C) financial break-even point
D) operating break-even point

Accepted Answer

The operating break-even point is the level of sales necessary to cover all of a company's variable and fixed operating costs, which is the point where EBIT is equal to $0. The other options do not accurately describe this concept. The total break-even point refers to the level of sales necessary to cover all costs, including interest and taxes. The cash break-even point is the level of sales necessary to cover all cash expenses, including investments in working capital. The financial break-even point is the level of sales necessary to cover all costs and generate a desired return on investment.

Question 17

Through the effects of financial leverage, when EBIT increases, earnings per share will
A) decrease.
B) remain unchanged.
C) increase.
D) change in an undetermined direction.

Accepted Answer

Financial leverage refers to the use of debt to finance a company's operations. When a company uses debt financing, it incurs interest expenses on the debt. This interest expense is deducted from EBIT to arrive at net income, which is used to calculate earnings per share (EPS).

As EBIT increases, the amount of interest expense remains constant, which means that net income increases at a faster rate than EBIT. This results in an increase in EPS when a company uses financial leverage. Therefore, the correct choice is C - increase.

Question 18

Earnings before interest and taxes (EBIT) is a descriptive label for
A) gross profits.
B) operating profits.
C) net profits before taxes.
D) earnings per share.

Accepted Answer

Earnings before interest and taxes (EBIT) refers to the profits earned by a company before deducting interest and taxes. It includes all operating expenses, such as cost of goods sold and operating expenses, and is a measure of the company's operating performance. Therefore, B) operating profits is the best choice.

Question 19

At a base sales level of $400,000, a firm has a degree of operating leverage of 2 and a degree offinancial leverage of 1.5. The firm's degree of total leverage is ____________.
A) 1.3
B) 0.5
C) 3.0
D) 3.5

Accepted Answer

Degree of total leverage = Degree of operating leverage x Degree of financial leverage
Degree of total leverage = 2 x 1.5
Degree of total leverage = 3.0

Question 20

The per dollar contribution toward fixed operating costs and profits provided by each dollar ofsales is the
A) expense ratio.
B) contribution margin.
C) fixed coverage ratio.
D) profit margin.

Accepted Answer

The contribution margin is the amount remaining from sales revenue after variable costs have been deducted. It represents the per dollar contribution toward fixed operating costs and profits provided by each dollar of sales. Thus, it is the best choice for this question. The expense ratio represents the percentage of sales that goes toward expenses, the fixed coverage ratio measures the ability of a company to cover its fixed costs with operating income, and the profit margin represents the percentage of sales that result in profit.

Quiz 10: Leverage and Capital Structure

After satisfying obligations to creditors, the government, and preferred stockholders, any remaining earnings will most likely be allocated to any of the following EXCEPT

As debt is substituted for equity in the capital structure and the debt ratio increases, all of thefollowing statements about the component costs of capital are true EXCEPT

Business risk is affected by all of the following EXCEPT

In the EBIT-EPS approach to capital structure, risk is represented by

Generally,in leverage result in,return and,__risk.

A firm has fixed operating costs of $25,000, a per unit sales price of $5, and a variable cost per unit of $3. What is its operating break-even point if it desires net operating income of $10,000, not $0 (zero) ?

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

__________is the potential use of fixed costs, both operating and financial, to magnify the effect of changes in sales on the firm's earnings per share.

A decrease in fixed financial costs will result in___________in financial risk

The firm's operating break-even point is the point at which

In the EBIT-EPS approach to capital structure, a constant level of EBIT is assumed

A firm has fixed operating costs of $253,750, a sales price per unit of $100, and a variable cost perunit of $65. The firm's operating break-even point in dollars is__________ .

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 major assumption of break-even analysis and one which causes severe limitations in its use is that

The firm's__________ is the level of sales necessary to cover all operating costs, i.e., the point at which EBIT = $0.

Through the effects of financial leverage, when EBIT increases, earnings per share will

Earnings before interest and taxes (EBIT) is a descriptive label for

At a base sales level of $400,000, a firm has a degree of operating leverage of 2 and a degree offinancial leverage of 1.5. The firm's degree of total leverage is ____________.

The per dollar contribution toward fixed operating costs and profits provided by each dollar ofsales is the