Question 1

Suppose a firm uses a high degree of operating leverage and operates in an industry whose sales are greatly affected by changes in the overall level of economic activity.The riskiness of that firm's earnings stream will likely be greater than the earnings of a firm in the same industry which has a lower degree of operating leverage.

Accepted Answer

A firm with high operating leverage has a higher proportion of fixed costs in its cost structure, which means that small changes in revenue can have a significant impact on its profits. In an industry where sales are greatly affected by changes in the overall level of economic activity, a high degree of operating leverage amplifies the impact of these changes on the firm's earnings. Therefore, the riskiness of the earnings stream of a high operating leverage firm in such an industry is greater than that of a low operating leverage firm in the same industry.

Question 2

Other things held constant,the greater the firm's use of debt,the greater the change in EPS that will result from a change in sales volume.

Accepted Answer

This is because increased debt means higher interest payments, which increase the fixed costs of the firm. Therefore, a change in sales volume, which affects variable costs, will have a greater impact on the firm's earnings per share (EPS) due to the higher fixed costs associated with the increased use of debt.

Question 3

When a firm increases its degree of operating leverage by substituting fixed costs for variable costs,it normally does so to decrease its breakeven point and to increase its profit.

Accepted Answer

Increasing the degree of operating leverage by substitifying fixed costs for variable costs typically increases a firm's breakeven point because more revenue is needed to cover higher fixed costs before profit is realized. However, it can increase profits beyond the breakeven point due to lower variable costs per unit.

Question 4

Lumpy assets primarily affect the turnover of fixed assets and,consequently,the financial requirements associated with the expansion of operations.

Accepted Answer

Lumpy assets, such as large machinery or real estate, can significantly impact the turnover of fixed assets and increase financial requirements. This is because the acquisition and maintenance of these assets require a significant amount of capital investment, which can limit a company's ability to expand operations.

Question 5

If firm A uses more operating leverage than firm B,firm A will probably have a greater percentage profit margin per unit than firm B,if both firms are otherwise identical and operating above their respective operating breakeven levels.

Accepted Answer

Operating leverage refers to the degree to which fixed costs are used in a company's operations. A company with higher operating leverage will have a higher proportion of fixed costs relative to variable costs. This means that when sales increase, the company's profits will increase by a larger percentage due to the higher contribution margin. However, when sales decrease, the company's profits will decrease by a larger percentage.

If both firms are identical in all other aspects and are operating above their respective operating breakeven levels, then a higher operating leverage would result in a greater percentage profit margin per unit for firm A compared to firm B. This is because firm A has a higher proportion of fixed costs, which means that a higher percentage of each unit's revenue will contribute to profits.

Question 6

An advantage of breakeven analysis is that it can be applied with equal precision whether a firm's cost curve is linear or nonlinear.

Accepted Answer

The statement is false because breakeven analysis assumes that cost curves are linear, which means that the relationship between costs and output is fixed and consistent. Nonlinear cost curves, on the other hand, have changing shapes and slopes, making it difficult to determine the precise point where the firm's total costs equal its total revenue.

Question 7

A high degree of operating leverage,other things held constant,means that a relatively small change in unit sales will result in a large change in operating income.

Accepted Answer

A high degree of operating leverage is a measure of how sensitive a company's operating income is to changes in sales revenue. It indicates that a small increase or decrease in sales can have a significant impact on operating income due to fixed costs and high contribution margins. In other words, a high degree of operating leverage means that the company has a relatively large proportion of fixed costs in its cost structure, which magnifies the impact of changes in sales volume on profitability.

Question 8

With lumpy assets,a small projected increase in sales could potentially mandate a significant increase in plant and equipment,which would lead to a very large financial requirement.

Accepted Answer

Lumpy assets refer to assets that require a large investment or expenditure, such as plants and equipment. If there is a small increase in sales, it may require a significant increase in such assets, leading to a substantial financial requirement.

Question 9

All else equal,excess capacity means that more external financing is required to support increases in sales than would be needed if the firm previously operated full capacity.

Accepted Answer

Excess capacity means a firm can increase production without significant additional investment in fixed assets, thus reducing the need for external financing to support sales growth.

Question 10

The higher the DOL,the greater the firm's use of debt and the more earnings will change following a change in sales.

Accepted Answer

DOL (Degree of Operating Leverage) measures the sensitivity of a company's operating income to changes in sales, not the use of debt. The use of debt is measured by the Degree of Financial Leverage (DFL).

Question 11

The financial control phase of financial forecasting is concerned with implementing the financial plans,and with managing the feedback and adjustment process needed to ensure that the goals of the firm are pursued appropriately.

Accepted Answer

The statement accurately describes the purpose of the financial control phase in financial forecasting.

Question 12

If a small change in sales results in a large change in EPS,then it must be caused by the financial leverage associated with the firm.

Accepted Answer

A large change in EPS from a small change in sales can also be caused by operating leverage, not just financial leverage. Operating leverage results from fixed costs in the business, while financial leverage comes from the use of debt financing.

Question 13

One potential benefit of high operating leverage is that it can reduce the average cost per unit at high levels of output,thus generating a competitive cost advantage.

Accepted Answer

High operating leverage means that a company has a higher proportion of fixed costs compared to variable costs. At high levels of output, the fixed costs can be spread over a larger number of units, resulting in lower average cost per unit. This can lead to a competitive cost advantage over other companies with lower operating leverage.

Question 14

It is more difficult to estimate fixed and variable cost per unit for a project during planning than once the project is underway.This is because,once a project is operational,the firm has access to clearly reported and separated actual costs that the project incurs.

Accepted Answer

It is actually easier to estimate fixed and variable cost per unit during the planning phase when the project is not yet underway. Once the project is operational, there may be unexpected costs or variations that make it more challenging to estimate per unit costs accurately.

Question 15

Potential changes in sales prices,fixed operating costs and/or variable costs should be taken into account when using breakeven analysis.

Accepted Answer

Breakeven analysis is a useful tool for calculating the point at which a business will break even (neither make a profit nor suffer a loss). However, it assumes that sales prices, fixed operating costs, and variable costs remain constant. In reality, these factors may change over time, which can affect the accuracy of the breakeven analysis. To account for these potential changes, it is important to regularly review and update the analysis.

Question 16

Firms A and B produce exactly the same products,but use different production technology.Firm A's variable costs are greater than those of Firm B,but its operating breakeven point is lower.From this information,other things held constant,we can conclude that Firm B has greater operating leverage than Firm A.

Accepted Answer

Operating leverage is the degree to which a company uses fixed costs in its operations. A higher operating leverage means that a company has higher fixed costs relative to its variable costs. Since Firm A's variable costs are greater than those of Firm B, it implies that Firm A has lower fixed costs than Firm B. However, since Firm A's operating breakeven point is lower than that of Firm B, it suggests that Firm A has a higher contribution margin, which means that the firm can cover its fixed costs with a smaller volume of sales. Therefore, Firm A has lower operating leverage than Firm B.

Question 17

The use of a high level of operating leverage can enable a firm to maintain a steady operating income despite large changes in the level of sales.

Accepted Answer

A high level of operating leverage means that a firm has higher fixed costs relative to its variable costs, which actually makes its operating income more sensitive to changes in the level of sales, not steadier.

Question 18

The degree of financial leverage (DFL)is an index number that measures the effect of a change in sales on the financial breakeven point.

Accepted Answer

The degree of financial leverage (DFL) measures the sensitivity of a company's earnings per share (EPS) to fluctuations in its operating income, due to changes in its capital structure.

Question 19

The operating breakeven volume in units can be found by dividing the firm's total fixed cost in dollars by its profit margin per unit (i.e. ,price less variable cost).

Accepted Answer

This is the correct formula for calculating the operating breakeven volume in units.

Question 20

Other things held constant,a high degree of operating leverage will mean that a relatively small change in sales will result in a large change in operating income.

Accepted Answer

This is the definition of operating leverage - it describes the extent to which fixed costs impact a company's net income, meaning that a small increase in sales will result in a larger increase in profits due to the higher contribution margin from the fixed costs. Therefore, a high degree of operating leverage will result in a larger impact on operating income from changes in sales.

Quiz 8: Financial Planning and Control