Question 1

All of the following are likely to result in the use of less debt in a company's capital structure EXCEPT

Accepted Answer

Insufficient internal funds would likely lead to a company using more debt in its capital structure, not less, as it seeks external financing to support its operations or growth initiatives. Options A, B, and D are factors that would lead a company to use less debt to avoid financial risk, maintain creditworthiness, or when the tax benefits of debt are reduced, respectively.

Question 2

Operating leverage is the responsiveness of a firm's EBIT to changes in sales revenues.

Accepted Answer

Operating leverage measures the degree to which a firm's operating income (EBIT) is affected by changes in sales revenue.

Question 3

Financial leverage is typically more under the control of management than is operating leverage because the nature of the product often dictates the type of production process needed.

Accepted Answer

Financial leverage is related to the use of debt in the company's capital structure, which management can adjust based on strategic decisions. Operating leverage, however, is influenced by the company's fixed costs and production processes, which are often determined by the nature of the product and are less flexible.

Question 4

An increase in financial leverage will increase the absolute value of EPS,everything else equal.

Accepted Answer

Financial leverage refers to the use of debt financing to increase the potential return on equity. When a company increases its financial leverage, it takes on more debt, which means that interest expenses increase. However, because debt is cheaper than equity financing, the interest payments on debt reduce the company's taxable income, resulting in a higher net income. As the net income increases, the company's earnings per share (EPS) also increase. Therefore, an increase in financial leverage will increase the absolute value of EPS, everything else equal.

Question 5

If a firm's production process requires high operating leverage (use of fixed costs),then the firm should finance its assets with debt,so that the cost of capital will be reduced and financing costs will remain fixed.

Accepted Answer

High operating leverage means a firm has high fixed costs relative to its variable costs, making its earnings more sensitive to changes in sales volume. Financing with debt adds fixed financial obligations (interest payments), increasing the firm's financial leverage and risk. This doesn't necessarily reduce the cost of capital and can make the firm's earnings more volatile.

Question 6

Because fixed costs do not vary with a firm's revenues,firms with high levels of fixed cost enjoy lower levels of operating risk because their costs are more certain,making budgeting easier.

Accepted Answer

Firms with high levels of fixed costs actually face higher levels of operating risk because their break-even point is higher, making them more sensitive to fluctuations in sales volume.

Question 7

The Knight Corporation projects that next year its fixed costs will total $240,000.Its only product sells for $34 per unit,of which $18 is a variable cost.The management of Knight is considering the purchase of a new machine that will lower the variable cost per unit to $14.The new machine,however,will add to fixed costs through an increase in depreciation expense.How large can the addition to fixed costs be in order to keep the firm's break-even point in units produced and sold unchanged?

Accepted Answer

The answer of The Knight Corporation projects that next year...

Question 8

If a company sells bonds and uses the proceeds to buy back common stock,the company's financial leverage with increase.

Accepted Answer

When a company sells bonds and uses the proceeds to buy back common stock, it reduces the amount of equity in the company and increases its debt, which leads to an increase in financial leverage.

Question 9

Operating leverage is measured as the responsiveness of the firm's earnings before interest and taxes relative to fluctuations in sales.

Accepted Answer

This statement is true. Operating leverage is a measure of how much a firm's operating income (earnings before interest and taxes) changes in response to changes in revenues or sales. It shows how sensitive a company's profitability is to changes in its revenue.

Question 10

Because financial markets can be extremely volatile,with bond and stock prices changing significantly from day to day,a firm's management has much greater control over the firm's operating leverage than over its financial leverage.

Accepted Answer

Operating leverage is primarily determined by a firm's fixed versus variable costs in its production process, which is not easily adjustable in the short term, whereas financial leverage, determined by the firm's use of debt, can often be more directly managed or adjusted by the firm's management through decisions on borrowing and capital structure.

Question 11

Operating leverage means financing a portion of a firm's earnings per share with debt.

Accepted Answer

Operating leverage refers to the proportion of fixed costs versus variable costs in a company's operations. It does not necessarily involve financing with debt.

Question 12

A company that sells preferred stock and uses the money to pay off a loan is decreasing its amount of financial leverage.

Accepted Answer

The answer of A company that sells preferred stock and...

Question 13

The presence of debt and/or preferred stock in a firm's financial structure means the firm is using financial leverage.

Accepted Answer

Debt and preferred stock are forms of financial leverage because they allow a company to increase its return on equity by borrowing money or issuing preferred stock with a fixed dividend rate. However, using financial leverage also increases the risk of default or bankruptcy if the company is unable to meet its interest or dividend obligations.

Question 14

When is it useful or sometimes necessary to compute the break-even point in terms of sales dollars rather than units of output?

Accepted Answer

The answer of When is it useful or sometimes necessary...

Question 15

Financial risk applies to both the additional variability in earnings available to common shareholders and the additional chance of insolvency caused by the use of financial leverage.

Accepted Answer

Financial risk refers to the potential for financial losses or diminished returns that result from various financial transactions or activities. It applies to the additional variability in earnings available to common shareholders, as well as the increased likelihood of insolvency that may result from the use of financial leverage, such as debt financing. Therefore, both aspects of financial risk are true.

Question 16

A CEO concerned about variability of earnings per share may try to offset high operating leverage with a capital structure that is mostly debt in order to take advantage of the interest tax shield.

Accepted Answer

A CEO concerned about the variability of earnings per share (EPS) would likely prefer a capital structure with less debt to avoid the fixed interest payments that increase financial leverage and potentially the variability of EPS. High operating leverage already increases earnings variability; adding high financial leverage (mostly debt) would exacerbate this variability, not offset it.

Question 17

Operating leverage is easier to control and manage than financial leverage because operating leverage deals with the internal workings of the company while financing deals with outside parties.

Accepted Answer

Operating leverage is not necessarily easier to control and manage than financial leverage because it is tied to the company's fixed costs and business model, which can be difficult to adjust in the short term. Financial leverage, while involving outside parties, can sometimes offer more flexibility through refinancing options or adjusting terms.

Question 18

Operating leverage contributes ultimately to the variability of a firm's earnings per share.

Accepted Answer

Operating leverage refers to the proportion of fixed costs in a firm's cost structure. A higher degree of operating leverage means that a larger portion of the firm's costs are fixed, which in turn magnifies the impact of changes in sales on the firm's earnings. As a result, firms with higher operating leverage are more susceptible to fluctuations in earnings per share. Therefore, option A is true.

Question 19

A company that sells common stock and uses the money to pay off a loan is increasing its use of financial leverage.

Accepted Answer

Selling common stock does not increase a company's financial leverage as it does not involve taking on additional debt. Financial leverage refers to a company's use of debt to finance its operations and investments, and using funds from the sale of equity does not increase this leverage. In fact, selling common stock may actually decrease a company's financial leverage if the funds are used to pay off existing debt, as this reduces the company's outstanding debt balance.

Question 20

The more fixed-charge securities (such as bonds and preferred stock)the firm employs in its financial structure,the greater its financial leverage.

Accepted Answer

The use of fixed-charge securities increases a firm's financial leverage because these securities require a fixed payment regardless of the firm's performance. This means that if the firm's earnings decrease, the fixed payments on these securities become a larger proportion of the firm's total earnings, which can lead to financial distress. As such, the more fixed-charge securities a firm employs in its financial structure, the greater its financial leverage.

Quiz 12: Determining the Financing Mix