Question 1

Financial leverage is concerned with the use of debt in the business.

Accepted Answer

Financial leverage refers to the use of debt in the business to increase the potential return on investment. It involves borrowing funds to finance the operations of the business, with the aim of generating higher profits or returns for the equity investors.

Question 2

The contribution margin is equal to price per unit minus total costs per unit.

Accepted Answer

The answer of The contribution margin is equal to price...

Question 3

Linear break-even analysis assumes that costs are linear functions of volume.

Accepted Answer

Linear break-even analysis assumes a linear relationship between costs and volume, meaning that costs increase at a constant rate as volume increases. This assumption allows for the calculation of a break-even point, where total revenue equals total costs, by dividing fixed costs by the contribution margin (the difference between price and variable cost per unit).

Question 4

The analysis of operating leverage assumes that relationships between revenues and costs are constant.

Accepted Answer

The concept of operating leverage assumes that the relationship between revenues and costs remains constant, which means that a change in sales results in a change in operating income by a constant percentage. This assumption helps in analyzing the impact of a change in sales volume on operating income.

Question 5

The closer a firm is to its break-even point,the lower the degree of operating leverage will be.

Accepted Answer

The closer a firm is to its break-even point, the higher the degree of operating leverage will be. This is because fixed costs represent a larger proportion of total costs at or near the break-even point, causing a relatively small change in sales volume to have a big impact on the firm's profitability.

Question 6

As the contribution margin rises,the break-even point goes down.

Accepted Answer

This statement is true. The break-even point is the level of sales at which revenue equals expenses, including fixed and variable costs. The contribution margin is the amount of revenue remaining after variable costs are deducted from sales. As the contribution margin increases, a company can cover its fixed costs with fewer sales, causing the break-even point to decrease.

Question 7

The degree of financial leverage measures the percentage change in EPS for every 1 percent move in EBIT.

Accepted Answer

The degree of financial leverage (DFL) formula is DFL = EBIT / (EBIT - Interest), which measures the impact of changes in EBIT on EPS. Therefore, the statement is True.

Question 8

If economic conditions were expected to be favourable,an investor would likely prefer a firm with a low degree of leverage.

Accepted Answer

The answer of If economic conditions were expected to be...

Question 9

Firms with cyclical sales should employ a high degree of leverage.

Accepted Answer

Firms with cyclical sales should be cautious in employing leverage as it can lead to higher financial risk during economic downturns or periods of decreased sales. It is advisable for such firms to maintain a lower level of leverage to ensure financial stability during uncertain times.

Question 10

Managers who are risk averse and uncertain about the future would most likely minimize combined leverage.

Accepted Answer

Managers who are risk averse tend to avoid taking on higher levels of debt, which is reflected in their lower use of combined leverage. They may prefer to rely more on equity financing to reduce the risk of financial distress or bankruptcy.

Question 11

Operating Leverage works best when volume is increasing.

Accepted Answer

Operating leverage is the degree to which a company uses fixed costs in its operations. When volume increases, the fixed costs are spread over a larger base, resulting in higher operating profits. Therefore, operating leverage works best when volume is increasing.

Question 12

The degree of combined leverage is the sum of the degree of operating leverage and the degree of financial leverage.

Accepted Answer

The degree of combined leverage is not the sum but the product of the degree of operating leverage and the degree of financial leverage.

Question 13

Operating income is not the same thing as EBIT.

Accepted Answer

Operating income is defined as revenue minus operating expenses, while EBIT (Earnings Before Interest and Taxes) includes non-operating income and expenses, such as interest income and expense and gains or losses from the sale of assets.

Question 14

Financial leverage primarily affects the left-hand side of the balance sheet.

Accepted Answer

Financial leverage primarily affects the right-hand side of the balance sheet by increasing the amount of debt and therefore increasing liabilities.

Question 15

Operating leverage influences the bottom half of the income statement while financial leverage deals with the top half.

Accepted Answer

It is the other way around. Operating leverage deals with the top half of the income statement (revenue and expenses) while financial leverage influences the bottom half of the income statement (net income and earnings per share).

Question 16

The degree of operating leverage is a number indicating the relationship between the percentage changes in sales to the percentage change in earnings per share.

Accepted Answer

The definition given in the statement is incorrect. The degree of operating leverage (DOL) measures the sensitivity of an organization's operating income to changes in sales revenue. It is calculated by dividing the percentage change in operating income by the percentage change in sales.

Question 17

If a firm has a DFL of 2.0,EPS will change 2% for every 1% change in volume.

Accepted Answer

The answer of If a firm has a DFL of...

Question 18

Operating leverage is concerned with the use of capital assets in the business.

Accepted Answer

Operating leverage refers to the degree to which fixed costs are used in the operations of a business, including the use of capital assets, in order to generate profits. Therefore, the statement is true.

Question 19

Operating leverage determines how income from operations is to be divided between debt holders and shareholders.

Accepted Answer

Operating leverage refers to the extent to which a company's revenue generation is dependent on its fixed costs as opposed to its variable costs. This does not directly determine the division of income between debt holders and shareholders. That division depends on the contractual agreements and ownership structure of the company.

Question 20

Cash break-even analysis eliminates the amortization expense and other non-cash charges from capital costs.

Accepted Answer

Cash break-even analysis only focuses on the costs and revenues that affect the cash flow of a business. Therefore, non-cash charges such as amortization expenses are not included in the analysis.

Quiz 5: Operating and Financial Leverage