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Chapter 15

Analysis and Impact of Leverage

True/False

1. Financial risk refers to the relative dispersion of a firm’s earnings before interest and taxes.

Difficulty: Easy

Keywords: financial risk

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

Difficulty: Easy

Keywords: operating leverage

3. Financial leverage increases the variability of a net income.

Difficulty: Easy

Keywords: financial leverage

4. Break-even analysis utilizes known relationships to equate quantities of input to the quantities of output.

Difficulty: Moderate

Keywords: break-even analysis

5. As the volume of production increases, the fixed cost per unit of the product decreases.

Difficulty: Moderate

Keywords: fixed cost per unit

6. A decrease in the level of production results in decreased variable cost per unit.

Difficulty: Easy

Keywords: variable costs

7. If sales increase by 20 percent, the break-even model assumes that total variable costs will increase by 30 percent.

Difficulty: Moderate

Keywords: break-even analysis

8. The break-even model expresses the volume of output as a unit quantity.

Difficulty: Easy

Keywords: break-even analysis

9. The break-even model assumes that selling price per unit and fixed cost per unit of output are constant over the relevant range of output.

Difficulty: Moderate

Keywords: break-even analysis

10. If the cost estimates used in a break-even analysis make allowances for non-cash expenses, a firm’s production and sales levels do not have to be as great to cover the cash costs of production.

Difficulty: Moderate

Keywords: break-even analysis

11. Operating leverage is measured as the responsiveness of the firm’s earnings before interest and taxes (EBIT) relative to fluctuations in sales.

Difficulty: Moderate

Keywords: operating leverage

12. If a firm’s production process has fixed costs, the degree of financing leverage will decrease as sales exceed the break-even point.

Difficulty: Moderate

Keywords: break-even analysis

13. If a firm utilizes debt financing and experiences a 10% drop in earnings before interest and taxes, the resulting decrease in earnings per share will be greater than 10%.

Difficulty: Moderate

Keywords: earnings per share

14. Business risk refers to the relative dispersion of the firm’s earnings available to common stockholders.

Difficulty: Easy

Keywords: business risk

15. In the long run, all costs are variable.

Difficulty: Easy

Keywords: variable costs

16. If fixed costs are $120,000, price per unit is $8, and variable cost per unit is $5, the break-even point is 40,000 units.

Difficulty: Moderate

Keywords: fixed costs

17. Break-even analysis assumes a quadratic relationship between variable costs and the number of units produced.

Difficulty: Moderate

Keywords: break-even analysis

18. The break-even point on an accounting profit basis is equal to or less than the break-even point on a cash basis.

Difficulty: Moderate

Keywords: break-even analysis

19. Break-even analysis assumes that a multi-product firm maintains a constant production and sales mix.

Difficulty: Moderate

Keywords: break-even analysis

20. When calculating the degree of financial leverage for a firm with preferred stock in its financial structure, the preferred stock dividends must be adjusted to a before-tax basis.

Difficulty: Moderate

Keywords: financial leverage

21. The chance of insolvency borne by the common stockholder caused by the use of financial leverage is called financial risk.

Difficulty: Easy

Keywords: financial risk

22. Dispersion in operating income is caused by business risk.

Difficulty: Moderate

Keywords: business risk

23. The financial structure affects the level and variability of the firm’s net operating income (EBIT).

Difficulty: Moderate

Keywords: business risk

24. Financial leverage means financing a portion of the firm’s assets with securities bearing a fixed rate of return in hopes of increasing the stockholder’s ultimate return.

Difficulty: Moderate

Keywords: financial leverage

25. Operating leverage refers to the occurrence of fixed operating costs in the firm’s income stream.

Difficulty: Easy

Keywords: operating leverage

26. The break-even quantity of output is the quantity in units which results in a level of EBIT just equal to the cost of debt and preferred stock.

Difficulty: Moderate

Keywords: break-even analysis

27. As the level of fixed costs increases, break-even output decreases.

Difficulty: Easy

Keywords: fixed costs, break-even

28. A potential use of break-even analysis is in labor contract negotiations.

Difficulty: Easy

Keywords: break-even analysis

29. Over a particular range of output, total variable costs remain unchanged.

Difficulty: Easy

Keywords: variable costs

30. Unit contribution margin is the difference between the unit selling price and the unit variable cost.

Difficulty: Easy

Keywords: contribution margin

31. If unit sales price is $12, unit variable cost is $8, and fixed cost is $1 million, the break-even point is 125,000 units.

Difficulty: Moderate

Keywords: break-even analysis

32. If the degree of operating leverage is 4 times, we would expect an increase in EBIT of 1% for a 4% increase in sales.

Difficulty: Moderate

Keywords: degree of operating leverage

33. The greater the degree of operating leverage, the greater is the sensitivity of EPS to change in EBIT.

Difficulty: Moderate

Keywords: degree of operating leverage

34. If the degree of financial leverage is 1.25 times, we would expect an increase in EBIT of 4% to result in a 5% increase in EPS.

Difficulty: Moderate

Keywords: degree of financial leverage

35. The degree of combined leverage is the percentage change in sales divided by the percentage change in EPS.

Difficulty: Easy

Keywords: degree of combined leverage

36. If the degree of operating leverage is 2 times and the degree of financial leverage is 1.5 times, then if sales increase by 10%, we will expect EPS to increase by 30%.

Difficulty: Moderate

Keywords: degree of operating leverage

37. Depreciation is considered a fixed cost.

Difficulty: Easy

Keywords: fixed costs

38. Operating leverage is more controllable by management than financial leverage.

Difficulty: Easy

Keywords: operating leverage

39. An increase in fixed costs will cause an increase in the contribution margin.

Difficulty: Moderate

Keywords: contribution margin

40. Fixed operating costs do not include interest expenses.

Difficulty: Easy

Keywords: fixed operating costs

41. The degree of operating leverage measure can never be less than zero.

Difficulty: Easy

Keywords: degree of operating leverage

42. The more fixed-charge securities the firm employs in its financial structure, the greater its degree of financial leverage.

Difficulty: Moderate

Keywords: degree of financial leverage

43. Financial risk is a direct result of the firm’s financing decisions.

Difficulty: Easy

Keywords: financial risk

44. In a manufacturing operation, direct labor is considered a fixed cost.

Difficulty: Easy

Keywords: direct labor

45. The cost-volume-profit relationship in a break-even analysis is presumed linear over the entire range of output.

Difficulty: Moderate

Keywords: break-even analysis

46. The break-even quantity of output is the annual fixed costs divided by the unit contribution margin.

Difficulty: Easy

Keywords: break-even analysis

47. A firm that incurs a low level of fixed costs could increase their degree of combined leverage by lowering its financial leverage.

Difficulty: Moderate

Keywords: degree of combined leverage

48. Business risk for multinational firms includes the degree of competition to which a firm is exposed.

Difficulty: Moderate

Keywords: multinational firm, business risk

49. Due to the linear assumption between variables, break-even analysis is NOT considered an essential tool to financial managers.

Difficulty: Moderate

Keywords: break-even analysis, financial management

50. The break-even model assumes proportionality between total variable costs and sales.

Difficulty: Moderate

Keywords: break-even analysis

51. The break-even quantity of output is used to determine the quantity of output that the firm must sell to cover its financing costs.

Difficulty: Moderate

Keywords: break-even analysis

52. Should a firm become over-leveraged in the eyes of the markets, a company’s stock price will slowly adjust downward.

Difficulty: Moderate

Keywords: financial leverage

53. Break-even analysis applications include capital expenditure analysis.

Difficulty: Easy

Keywords: break-even analysis

54. Semi-variable costs are fixed for a time but rise to higher levels as higher output occurs.

Difficulty: Easy

Keywords: semi-variable costs

55. Volume of output refers to the firm’s level of operations and is indicated as a unit quantity, not as sales dollars.

Difficulty: Easy

Keywords: volume of output

56. Unlike the contribution-margin technique, the trial-and-error approach to break-even analysis permits direct computation of the break-even quantity.

Difficulty: Moderate

Keywords: break-even analysis

57. The focus of operating leverage is on the operating cost structure of the firm.

Difficulty: Easy

Keywords: operating leverage

58. As the firm’s operations moves above the break-even point, the degree of operating leverage at the higher sales base will decline.

Difficulty: Moderate

Keywords: operating leverage

59. The greater the firm’s sales level above the break-even point, the lower the firm’s degree of operating leverage.

Difficulty: Moderate

Keywords: degree of operating leverage

60. According to financial leverage, earnings per share is the appropriate criteria for all financing decisions.

Difficulty: Moderate

Keywords: financial leverage, earnings per share

61. Combined leverage measures the responsiveness of the firm’s earnings per share to fluctuations in sales.

Difficulty: Easy

Keywords: combined leverage

Multiple Choice

62. A firm’s business risk is influenced by the:

a. competitive position of the firm within the industry.

b. demand characteristics of the firm’s products.

1. financing structure of the firm.
2. both a and b.

e. all of the above.

Difficulty: Moderate

Keywords: business risk

63. The break-even model enables the manager of the firm to:

a. calculate the minimum price of common stock for certain situations.

b. set appropriate equilibrium thresholds.

c. determine the quantity of output that must be sold to cover all operating costs.

d. determine the optimal amount of debt financing to use.

Difficulty: Moderate

Keywords: break-even analysis

64. Fixed costs include all of the following EXCEPT:

a. administrative salaries.

b. property taxes.

c. sales commissions.

d. insurance.

Difficulty: Easy

Keywords: fixed costs

65. Which of the following is NOT an example of variable costs?

a. Packaging

b. Depreciation

c. Direct labor

d. Freight costs on products

Difficulty: Easy

Keywords: variable costs

66. A plant can remain operating when sales are depressed:

a. if the selling price per unit exceeds the variable cost per unit.

b. to help the local economy.

c. in an effort to cover at least some of the variable cost.

d. unless variable costs are zero when production is zero.

Difficulty: Moderate

Keywords: break-even analysis

67. An example of a semi-variable or semi-fixed cost is:

a. rent.

b. salaries paid to a production foremen.

c. energy costs associated with production.

d. direct labor.

Difficulty: Moderate

Keywords: semi-variable cost

68. Which of the following is a non-cash expense?

a. Depreciation expenses

b. Interest expense

c. Packaging costs

d. Administrative salaries

Difficulty: Easy

Keywords: non-cash expenses

69. A firm that uses large amounts of debt financing in an industry characterized by a high degree of business risk would have __________ earnings per share fluctuations resulting from changes in levels of sales.

a. no

b. constant

c. large

d. small

Difficulty: Moderate

Keywords: business risk, earnings per share

70. Financial leverage means financing some of a firm’s assets with:

a. commercial paper.

b. preferred stock.

c. corporate bonds.

d. all of the above.

Difficulty: Moderate

Keywords: financial leverage

71. Potential applications of the break-even model include:

a. replacement for time-adjusted capital budgeting techniques.

b. pricing policy.

c. optimizing the cash-marketable securities position of a firm.

d. both a and c.

Difficulty: Moderate

Keywords: break-even analysis, applications

72. Break-even analysis can be useful in:

a. capital expenditure analysis.

b. bond refunding decisions.

c. rights offering decisions.

d. all of the above.

Difficulty: Easy

Keywords: break-even analysis

73. Which of the following methods can be used to find the break-even point?

a. Algebraic analysis

b. Contribution margin analysis

c. Trial and error analysis

d. All of the above

Difficulty: Easy

Keywords: break-even analysis

74. An analytical income statement:

a. can be easily calculated from a corporation’s annual report.

b. emphasizes the relationship between fixed and variable costs.

c. assumes that the company produces only one product.

d. assumes that the company does not alter its degree of financial leverage.

Difficulty: Moderate

Keywords: analytical income statement

75. Which costs should be included when calculating the degree of operating leverage?

a. Depreciation

b. Administrative expenses

1. Real estate taxes
2. Both b and c

e. All of the above

Difficulty: Moderate

Keywords: degree of operating leverage

76. Break-even analysis is limited to:

a. linear cost-volume-profit relationships.

b. fixed production and sales mixes.

1. variable production and sales mixes.
2. both a and b.

e. all of the above.

Difficulty: Moderate

Keywords: break-even analysis

77. Which of the following would be considered a fixed operating cost of a firm?

a. Freight costs for products leaving the plant

b. Insurance

c. Property taxes

d. Both b and c

e. All of the above

Difficulty: Moderate

Keywords: fixed operating costs

78. The degree of operating leverage is defined as:

a. % change in EBIT

% change in variable cost

b. % change in EBIT

% change in sales

c. % change in sales

% change in EBIT

d. % change in EBIT

% change in contribution margin

Difficulty: Easy

Keywords: degree of operating leverage

79. The degree of operating leverage applies to:

a. sales.

b. net income.

c. earnings per share.

d. all of the above.

Difficulty: Easy

Keywords: degree of operating leverage

80. In general, as the level of sales rises above the break-even point, the degree of operating leverage:

a. increases.

b. decreases.

c. remains constant.

d. none of the above.

Difficulty: Moderate

Keywords: degree of operating leverage

Table 1

Average selling price per unit $16.00

Variable cost per unit $11.00

Units sold 200,000

Fixed costs $800,000

Interest expense $ 50,000

81. Based on the data in Table 1, what is the break-even point in units produced and sold?

a. $130,000

b. $140,000

c. $150,000

d. $160,000

Difficulty: Moderate

Keywords: break-even analysis

82. Based on the data contained in Table 1, what is the degree of operating leverage?

a. 1.00 times

b. 2.00 times

c. 3.00 times

d. 4.00 times

e. 5.00 times

Difficulty: Moderate

Keywords: degree of operating leverage

83. Based on the data contained in Table 1, what is the contribution margin?

a. $5.00

b. $4.00

c. $3.00

d. $2.00

Difficulty: Easy

Keywords: break-even analysis, contribution margin

84. Based on the data contained in Table 1, what is the degree of financial leverage?

a. 3.33 times

b. 2.50 times

c. 1.50 times

d. 1.33 times

Difficulty: Moderate

Keywords: degree of financial leverage

85. Based on the data contained in Table 1, what is the degree of combined leverage?

a. 6.33

b. 6.67

c. 7.33

d. 7.67

Difficulty: Moderate

Keywords: degree of combined leverage

86. Financing a portion of a firm’s assets with securities bearing a fixed rate of return in hopes of increasing the return to stockholders refers to:

a. business risk.

b. financial leverage.

c. operating leverage.

d. all of the above.

Difficulty: Moderate

Keywords: financial leverage

87. As fixed costs increase, ___________ increases.

a. degree of operating leverage

b. degree of financial leverage

c. earnings per share

d. leverage

Difficulty: Moderate

Keywords: business risk

88. Financial leverage measures the percentage change in _________ to the percentage change in _________.

a. EBIT; sales

b. sales; earnings per share

c. earnings per share; EBIT

d. sales; EBIT

Difficulty: Moderate

Keywords: financial leverage

89. Which of the following is a limitation of break-even analysis?

a. Cost-volume-profit relationship is assumed to be linear

b. Total revenue increases with changes in variable unit costs

c. Assumes a non-constant production and sales mix

d. Both a and b

1. All of the above

Difficulty: Moderate

Keywords: break-even analysis

90. Tom’s Trashbins, Inc. has fixed costs of $225,000. Tom’s trashbins sell for $45 and have a unit variable cost of $20. What is Tom’s break-even point in units?

a. 8,500

b. 8,750

c. 9,000

d. 9,250

Difficulty: Moderate

Keywords: break-even analysis

91. Due to a technical breakthrough, the fixed costs for a firm drop by 25%. Prior to this breakthrough, fixed costs were $100,000 and unit contribution margin was and remains at $5.00. The new amount of break-even units will be:

a. 25,000.

b. 20,000.

c. 15,000.

d. 10,000.

Difficulty: Moderate

Keywords: break-even analysis

92. The degree of financial leverage is found by dividing:

a. % change in EPS

% change in EBIT

b. % change in EBIT

% change in EPS

c. % change in EBIT

% change in sales

d. % change in EPS

% change in sales

Difficulty: Easy

Keywords: degree of financial leverage

93. Which of the following expenses are NOT included in the calculation of operating leverage?

a. Labor

b. Depreciation

1. Interest
2. Both b and c

Difficulty: Moderate

Keywords: operating leverage

94. Break-even analysis assumes that revenue increases linearly with:

a. fixed costs.

b. volume of output.

c. variable costs.

d. semi-variable costs.

Difficulty: Moderate

Keywords: break-even analysis

95. Which of the following is true about fixed costs? Assume a relevant range of output.

a. Only increase with sales volume

b. Are constant over any level of sales

c. Increase in a step-wise manner

d. Are considered a semi-variable cost

Difficulty: Moderate

Keywords: fixed costs

96. The break-even quantity of output results in an EBIT level equal to:

a. fixed costs.

b. contribution margin.

c. zero.

d. variable costs.

Difficulty: Moderate

Keywords: break-even analysis, EBIT

97. Calculating the break-even point in sales dollars rather than units of output is convenient if the firm:

a. sells a large amount of one product.

b. deals with more than one product.

c. is just starting up.

d. all of the above.

Difficulty: Moderate

Keywords: break-even analysis

98. Business risk is the result of all of the following EXCEPT:

a. degree of competition.

b. product diversification.

c. a firm’s growth prospects.

d. a firm’s use of debt in its capital structure.

Difficulty: Easy

Keywords: business risk

99. The break-even quantity of output is used to:

a. maximize a firm’s EBIT.

b. determine the quantity of output that the firm must sell to cover all of its operating costs.

c. calculate the quantity of output that the firm must sell to cover its financing costs.

d. all of the above.

Difficulty: Moderate

Keywords: break-even analysis

100. Break-even analysis applications include:

a. financing decisions.

b. labor contract negotiations.

c. capital expenditure analysis.

d. all of the above.

Difficulty: Easy

Keywords: break-even analysis

101. A firm has a degree of combined leverage of 1.25. Price per unit is $15 and variable cost per unit is $5. Interest expense is $10,000 and fixed costs are $190,000. Calculate the quantity of output produced.

a. 100,000 units

b. 120,500 units

c. 150,000 units

d. 200,000 units

Difficulty: Moderate

Keywords: degree of combined leverage

Use the following information to answer the questions. A friend of yours is trying to determine whether to open a sandwich stand at the local mall based on the following data. She expects total fixed costs per year of $24,000, a sale price per sandwich of $3.00, and variable costs per sandwich of $1.80.

102. The break-even level of output for this endeavor is:

a. 12,000.

b. 16,000.

c. 20,000.

d. 24,000.

Difficulty: Moderate

Keywords: break-even analysis

103. What percentage of every sales dollar will contribute to covering fixed costs?

a. 30%

b. 40%

c. 50%

d. 60%

Difficulty: Moderate

Keywords: contribution margin

104. The break-even point in sales dollars is:

a. $60,000.

b. $54,000.

c. $46,000.

d. $30,000.

Difficulty: Moderate

Keywords: break-even point

105. If your friend expects to sell no more than 15,000 sandwiches per year, then:

a. she should not undertake the endeavor given the current cost/volume/profit expectations.

b. she should undertake the endeavor given the current cost/volume/profit expectations.

c. she should assess the effect of lowering the sales price of sandwiches if she wishes to pursue this endeavor.

d. none of the above.

Difficulty: Moderate

Keywords: break-even analysis

106. A firm has a degree of combined leverage of 1.25. Price per unit is $15 and the quantity output is equal to 200,000 units. Interest expense is $10,000 and fixed costs are $270,000. Calculate the variable cost per unit.

a. $5

b. $6

c. $7

d. $8

Difficulty: Moderate

Keywords: degree of combined leverage

Use the following information to answer questions 107-114. Lambda, Inc. has a base level of sales of 150,000 units. Sales price per unit is $10.00 and variable cost per unit is $6.50. Total annual operating fixed costs are $155,000, and the annual interest expense is $90,000. (For consistency with answers below, carry all calculations to two decimals.)

107. Base level EBIT is:

a. $370,000.

b. $425,000.

c. $500,000.

d. $575,000.

Difficulty: Moderate

Keywords: base level EBIT

108. Lambda’s degree of operating leverage is:

a. 1.25.

b. 1.32.

c. 1.42.

d. 1.57.

Difficulty: Moderate

Keywords: degree of operating leverage

109. Assume that Lambda expects units sold to increase 20%. What will be the resulting percentage change in EBIT?

a. 20%

b. 28%

c. 31%

d. 36%

Difficulty: Moderate

Keywords: percentage change in EBIT

110. What will be the new level of EBIT given the expected 20% increase in units sold?

a. $230,000

b. $325,000

c. $444,000

d. $473,600

Difficulty: Moderate

Keywords: new level of EBIT

111. Lambda’s degree of financial leverage is:

a. 1.25.

b. 1.32.

c. 1.42.

d. 1.57.

Difficulty: Moderate

Keywords: degree of financial leverage

112. Lambda’s degree of combined leverage is:

a. 1.55.

b. 1.61.

c. 1.72.

d. 1.87.

Difficulty: Moderate

Keywords: degree of combined leverage

113. Assume that Lambda expects units sold to increase 20%. What will be the resulting percentage change in earnings per share?

a. 28%

b. 31%

c. 37%

d. 46%

Difficulty: Moderate

Keywords: percentage change in earnings per share

114. Assume that Lambda’s current level of earnings per share is $2.00. What will be the new level of earnings per share given the expected 20% increase in units sold?

a. $2.74

b. $2.62

c. $2.56

d. $2.44

Difficulty: Moderate

Keywords: projected level of earnings

115. Operating leverage increases when the percentage change in __________ increases.

a. earnings per share

b. sales

c. EBIT

d. both b and c

Difficulty: Moderate

Keywords: operating leverage

116. Break-even analysis enables corporate managers to:

a. calculate the minimum price of common stock.

b. determine the optimal amount of debt to use.

c. determine the quantity of output that must be sold to cover all operating costs.

d. all of the above.

Difficulty: Moderate

Keywords: break-even analysis

117. Business risk refers to the:

a. usage of debt in a firm’s capital structure.

b. variability of a firm’s expected EBIT.

c. issuance of common stock.

d. dividend payout ratio.

Difficulty: Easy

Keywords: business risk

118. Financing a portion of a public corporation’s assets with securities that bear a fixed rate of return in hopes of increasing the return to the common stockholders is referred to as:

a. business risk.

b. basic earning power.

c. operating leverage.

d. break-even analysis.

e. financial leverage.

Difficulty: Moderate

Keywords: financial leverage

119. An essential element of business risk is the relative dispersion (variability) of which of the following?

a. Sales volume

b. Gross profit

c. Operating profit (earnings before interest and taxes)

d. Net profit after tax

e. Preferred and common dividend payments

Difficulty: Moderate

Keywords: business risk

120. A firm’s business risk is influenced by which of the following?

a. The competitive position of the firm within the industry

b. Demand characteristics of the firm’s products

c. The operating cost structure of the firm

d. All of the above

Difficulty: Easy

Keywords: business risk

121. Financial leverage means financing some of a firm’s assets with which of the following?

a. Common stock

b. Money market instruments

c. Bonds

d. Accounts payable

Difficulty: Moderate

Keywords: financial leverage

122. Interfuron Corporation is currently on schedule to sell 200,000 units of its most popular product. The firm’s average selling price per unit is $16.00. Variable cost per unit is $11.00. Interest expense is running at $50,000 per year, while fixed costs total $800,000. What is the firm’s break-even point in units?

a. 100,000

b. 120,000

c. 140,000

d. 160,000

e. 180,000

Difficulty: Moderate

Keywords: break-even analysis

123. Tec-All Sound, Inc. expects to introduce a new line of speakers for computers, but first management wants to determine its break-even point. Tec-All’s expected price per unit is $15. The company expects to sell 30,000 units. Variable costs per unit are $7, and the firm will need to purchase $250,000 in equipment to produce the speakers. What is the firm’s break-even point in sales volume?

a. $742,250

b. $614,750

c. $532,250

d. $468,750

Difficulty: Moderate

Keywords: break-even analysis

124. Which of the following is considered with the degree of combined leverage?

a. Business risk

b. Financial risk

c. Degree of operating leverage

d. Both a and c

e. All of the above

Difficulty: Moderate

Keywords: degree of combined leverage

125. Dude’s Skateboards Enterprises has fixed costs of $225,000. Dude’s skateboards sell for $45 each and have a variable cost of $20 each. What is Dude’s break-even point in units?

a. 8,500

b. 8,750

c. 9,000

d. 9,250

Difficulty: Moderate

Keywords: break-even analysis

126. Which of the following can influence a firm’s operating income?

a. The amount of dividends a firm pays its shareholders

b. The extent to which a firm uses fixed assets

c. The number of common shares outstanding

d. A firm’s debt ratio

Difficulty: Moderate

Keywords: operating income impacts

127. Which of the following choices is the best example of how a firm can use operating leverage to increase its earnings before interest and taxes?

a. Issue new bonds to repurchase common stock.

b. Toughen credit standards to improve the collection of accounts receivable.

c. Purchase inventory in larger quantities.

d. Install an ATM (automated teller machine) instead of hiring a new teller.

Difficulty: Moderate

Keywords: operating leverage

128. Which of the below is the best description of a fixed operating cost?

a. Dividend payments

b. An indirect expense that is independent of the quantity of product produced

c. Direct labor

d. Interest expense

Difficulty: Moderate

Keywords: fixed operating costs

129. Operating leverage refers to:

a. financing a portion of a firm’s assets with securities that bear a fixed rate of return.

b. the additional chance of insolvency incurred by the common shareholder.

c. the incurrence of fixed operating costs in the firm’s income stream.

d. financing a portion of the firm’s assets with common stock.

Difficulty: Moderate

Keywords: operating leverage

130. If fixed operating costs are present in the firm’s cost structure, so is:

a. financial leverage.

b. capital leverage.

c. operating leverage.

d. net operating profit after tax.

Difficulty: Moderate

Keywords: operating leverage

131. How is the degree of operating leverage determined?

a. The percentage change in gross margin is multiplied by the percentage change in operating profit.

b. The percentage change in EBIT is divided by the percentage change in sales.

c. Total variable costs are divided by total fixed costs.

d. The percentage change in sales is divided by the percentage change in EPS.

Difficulty: Moderate

Keywords: degree of operating leverage

132. Which of the following statements is correct?

a. Firms whose sales are very sensitive to changes in the business cycle are more likely to rely on debt financing.

b. Firms with large tax loss-carry-forwards are more likely to rely on debt financing.

c. Firms with a high operating leverage are more likely to rely on debt financing.

d. None of the above statements is correct.

Difficulty: Moderate

Keywords: debt financing

133. Which of the following is an example of a variable cost?

a. Direct labor

b. Depreciation

c. Rent

d. Administrative salaries

Difficulty: Easy

Keywords: variable cost

134. Which of the following statements is correct?

a. In general, a firm with low operating leverage has a small proportion of its total costs in the form of fixed costs.

b. An increase in the personal tax rate would not affect firms’ capital structure decisions.

c. A firm with high business risk is more likely to increase its use of financial leverage than a firm with low business risk, assuming all else is equal.

d. All of the above are correct.

e. None of the above is correct.

Difficulty: Moderate

Keywords: operating leverage

135. Wahoo, Inc. is currently on schedule to sell 200,000 units of its most popular product. The firm’s average selling price per unit is $16.00. Variable cost per unit is $11.00. Interest expense is running at $50,000 per year, while fixed costs total $800,000. What is the firm’s break-even point in sales?

a. $3,240,000

b. $2,560,000

c. $1,720,000

d. $980,000

Difficulty: Moderate

Keywords: break-even analysis

136. Dude’s Skateboards Enterprises has projected sales of 15,000 skateboards. The boards will sell for $45 each, and variable costs are expected to be $20 per unit. Dude’s has fixed costs of $225,000. What is Dude’s break-even point in sales?

a. $925,000

b. $820,000

c. $675,000

d. $510,000

e. $405,000

Difficulty: Moderate

Keywords: break-even analysis

137. Which of the following is considered a limitation of break-even analysis?

a. The cost-volume-profit relationship is assumed to be linear.

b. The total revenue curve (sales curve) is presumed to increase linearly with the volume of output.

c. A constant production and sales mix is assumed.

d. The break-even chart and the break-even computation must remain static.

e. All of the above.

Difficulty: Moderate

Keywords: break-even analysis

138. Wet Walrus Clothing has fixed operating costs of $380,000, variable operating costs per unit of $16, and a selling price of $63.50 per unit. What is the firm’s operating profit (earnings before interest and taxes) at 11,000 units?

a. $398,500

b. $250,000

c. $176,000

d. $142,500

Difficulty: Moderate

Keywords: operating profit

139. Under which of the following conditions would the usage of fixed costs in the operation of a business be most beneficial?

a. During an economic recession

b. When a business is expanding and sales revenues are rising

c. When interest rates are rising

d. When a business is expected to experience a period of declining sales

Difficulty: Moderate

Keywords: fixed costs

140. Atlantic Pacific Clothing generates sales of $10 million. The firm’s selling price per unit is $10; variable operating costs per unit are $5 per unit. After deducting fixed operating costs of $2.5 million, Atlantic Pacific generates an operating profit (earnings before interest and taxes) of $2.5 million. If sales were to increase to $15 million, operating profit (earnings before interest and taxes) would increase to $5 million. What is Atlantic Pacific’s degree of operating leverage?

a. 1.25

b. 1.50

c. 1.75

d. 2.00

e. 2.50

Difficulty: Moderate

Keywords: degree of operating leverage

141. Plankton Food’s latest year’s sales were $650,000 for which the firm generated an operating profit of $78,000 and a net profit after tax of $37,800. If Plankton were to purchase new equipment that would lower production costs such that the firm earned an operating profit of $97,175 and an after-tax profit of $48,405 on sales of $747,500, what is Plankton’s degree of operating leverage?

a. 2.47

b. 2.12

c. 1.85

d. 1.64

Difficulty: Moderate

Keywords: degree of operating leverage

142. Western American Clothing generates sales of $10 million. The firm’s selling price per unit is $10; variable operating costs per unit are $5.00 per unit. After deducting fixed operating costs of $2.5 million, Atlantic Pacific generates an operating profit (earnings before interest and taxes) of $2.5 million. If sales were to increase to 1.5 million units, what would Western American’s operating profit (earnings before interest and taxes) be?

a. $5 million

b. $4 million

c. $3 million

d. $2 million

Difficulty: Moderate

Keywords: operating profit

143. Tec-All Sound, Inc. expects to introduce a new line of speakers for computers, but first management wants to determine its break-even point. Tec-All’s expected price per unit is $15. Variable costs per unit are $7, and the firm will need to purchase $250,000 in equipment to produce the speakers. What is the firm’s break-even point in units?

a. 26,750

b. 31,250

c. 37,750

d. 42,250

Difficulty: Moderate

Keywords: break-even analysis

144. Priority One Stores generates operating profits (earnings before interest and taxes) of $10 million, interest expense of $2 million, and an income tax rate of 40%. The firm presently has 2 million shares of common stock outstanding. What are Priority One’s earnings per share?

a. $1.20

b. $1.80

c. $2.40

d. $2.60

e. $3.00

Difficulty: Moderate

Keywords: earnings per share

145. If fixed interest expense is present in a firm’s cost structure, so is:

a. financial leverage.

b. capital leverage.

c. operating leverage.

d. net operating profit after tax.

Difficulty: Easy

Keywords: financial leverage

146. Financial leverage has to do with which of the following?

a. Using fixed operating costs such as depreciation in the cost structure of a business in order to improve EBIT

b. Using fixed costs such as cost of goods sold in order to improve a firm’s Return on Assets (ROA)

c. Using fixed financial costs such as interest in the cost structure of a business in order to improve EPS

d. Using fixed common stock dividends in the cost structure of a business in order to improve ROA

Difficulty: Moderate

Keywords: financial leverage

147. Specific Mills is reviewing its financial condition. Sales are $18 million from which the firm generated an operating profit of $5,220,000 and a net profit after tax of $2,622,000. If the firm’s interest expense was $850,000, what is the firm’s degree of financial leverage?

a. 1.81

b. 1.66

c. 1.34

d. 1.19

Difficulty: Moderate

Keywords: degree of financial leverage

148. Pay More Drug Store is reviewing its financial condition. Sales are $18 million from which the firm generated an operating profit of $5,220,000 and an operating leverage of 1.18. The firm’s net profit after tax was $2,622,000. If the firm’s financial leverage was 1.19, what is the firm’s degree of combined leverage?

a. 1.20

b. 1.40

c. 1.60

d. 1.80

Difficulty: Moderate

Keywords: degree of combined leverage

149. Floor Mart Stores generates operating profits (earnings before interest and taxes) of $10 million, interest expense of $2 million, and has an income tax rate of 40%. The firm presently has 2 million shares of common stock outstanding. As a result, Floor Mart’s earnings per share are $2.40. If Floor Mart were able to increase its operating profit to $14 million without increasing its interest expense, what would the firm’s degree of financial leverage be?

a. 1.00

b. 1.25

c. 1.50

d. 1.75

e. 2.00

Difficulty: Moderate

Keywords: degree of financial leverage

Short Answer

150. Explain how a firm’s total risk exposure can be managed by combining operating and financial leverage in different degrees.

Difficulty: Moderate

Keywords: degree of combined leverage

151. The Basic Sports Company produces graphite surf-casting fishing rods. The average selling price for one of their rods is $132. The variable cost per unit is $80. Basic Sports has average fixed costs per year of $90,000.

a. What is the break-even point in units for Basic Sports?

b. What is the break-even point in dollar sales?

c. What would be the profit or loss associated with the production and

sale of (1) 2,000 rods, and (2) 10,000 rods?

d. Determine the degree of operating leverage for the two levels of

production and sales given in part (c) above.

a. QB1= $90,000/($132-$80) = 1,731

b. S = 1,731 × $132 = $228,492

c. (1) 2,000 × $132 = $264,000

-2,000 × $ 80 = -160,000

- 90,000

Profit $14,000

(2) 10,000 × $132 = $1,320,000

-10,000 × $ 80 = - 800,000

- 90,000

Profit $ 430,000

d. (1) DOL (2,000) =

[2,000($132 - $80)]/[2,000 ($132 - $80) - $90,000] = 7.43

(2) DOL (10,000) =

[10,000($132 - $80)]/[10,000($132 - $80) - $90,000] = 1.21

Difficulty: Moderate

Keywords: break-even analysis, degree of operating leverage

152. As the financial manager for a manufacturing firm, you have constructed the following partial pro forma income statement for the next fiscal year.

Sales $11,200,000

Variable costs 5,600,000

Revenue before fixed costs 5,600,000

Fixed costs 2,400,000

EBIT 3,200,000

Interest expenses 1,600,000

Earnings before taxes 1,600,000

Taxes (40%) 640,000

Net income $ 960,000

a. What is the degree of operating leverage at this level of output?

b. What is the degree of financial leverage?

c. What is the degree of combined leverage?

d. What is the break-even point in sales dollars for the firm?

e. If the average unit cost is $8, what is the break-even point in

units?

a. DOL = $5,600,000/$3,200,000 = 1.75

b. DFL = $3,200,000/($3,200,000 - $1,600,000) = 2.00

c. CL = 1.75 × 2.00 = 3.50

d. S* = $2,400,000/(1 - 0.5) = $4,800,000

e. 600,000 units

Difficulty: Moderate

Keywords: degree of operating leverage, financial leverage, combined leverage

153. Rodney Racket, Inc. produces a high-quality racquetball racket. At a production and sales level of 75,000 rackets, the firm is characterized as follows:

Return on operating assets = 12%

Operating asset turnover = 4 times

Operating assets = $1 million

Degree of operating leverage = 6 times

What is the break-even point in units for the firm?

Return on operating assets = 0.12 = EBIT/1,000,000

EBIT = $120,000

Operating asset turnover = 4 = Sales/1,000,000

Sales = $4,000,000

DOL (75,000) = 6 = Revenue before fixed costs/120,000

Revenue before fixed costs = $720,000

Variable cost = $4,000,000 - $720,000 = $3,280,000

Variable cost per unit = $3,280,000/75,000 = $43.73

Fixed cost = $720,000 - $120,000 = $600,000

Price = $4,000,000/75,000 = $53.33

BE = $600,000/($53.33 - $43.73)

= $600,000/$9.60 = 62,500 units

Difficulty: Moderate

Keywords: break-even analysis

154. The Clearwater Aquarium Company will produce 66,000 10-gallon aquariums next year. Variable costs are 40% of sales while fixed costs total $133,200. At what price must each aquarium be sold for Clearwater to obtain an EBIT of $114,000?

66,000P - (.40)(66,000)P - $133,200 = $114,000

66,000P - 26,400P - $133,200 = $114,000

39,600P = $247,200

P = $6.24

Difficulty: Moderate

Keywords: selling price

155. Positronic Products manufactures three lines of heavy equipment for electrical, chemical, and atomic research. Each of the three lines constitutes a third of the total sales of Positronic. The contribution margin ratio is 10% for the electrical line, 25% for the chemical line, and 65% for the atomic research line. Total sales have been forecast at $24 million for the next year, while total fixed costs are expected to be $5.5 million.

a. Prepare a table showing (1) sales, (2) total variable costs, and

(3) the total contribution margin associated with each product line.

b. At the given sales mix, what is the break-even point in dollars?

a.

Sales Variable Contribution

Costs Margin

Electrical $8,000,000 $7,200,000 $80,000

Chemical 8,000,000 6,000,000 2,000,000

Atomic 8,000,000 2,800,000 5,200,000

b. S* =

$5,500,000/[1 - ($7,200,000 + $6,000,000 + $2,800,000)/($24,000,000)]

= 5,500,000/(1 - 0.67)

= $5,500,000/0.33 = $16,666,667

Difficulty: Moderate

Keywords: break-even analysis

156. APM, Inc. has a break-even sales level of $5 million and has fixed costs of $2 million per year. The selling price per unit is $50. What is the variable cost per unit?

S - VC = f

$5,000,000 - VC = $2,000,000

VC = $3,000,000

Number of units sold = $5,000,000/$50 = 100,000 units

Variable cost per units = $3,000,000/100,000 = $30

Difficulty: Moderate

Keywords: break-even analysis

157. For a sales level of $3 million, BCD Company has a degree of operating leverage of 2.00 and a degree of combined leverage of 3.00. The company’s contribution margin from sales is 60%. What are the company’s fixed costs and interest expense?

DOL = revenue before fixed costs/EBIT

2.00 = [($3,000,000)(.60)]/[($3,000,000)(.60) - F]

2.000 ($1,800,000) - 2F = $1,800,000

- 2F = -$1,800,000

F = $900,000

DCL = DOL × DFL

DFL = DCL/DOL = 3.00/2.00 = 1.50

DFL = EBIT/(EBIT - I)

1.50 = $900,000/($900,000 - I)

(1.50)($900,000 - I) = $900,00

-1.50 I = -$450,000

I = $450,000/1.5 = $300,000

Difficulty: Moderate

Keywords: fixed costs and interest expense

158. DXZ, Inc. currently produces one product which sells for $250 per unit. The company’s fixed costs are $75,000 per year; variable costs are $205 per unit. A salesman has offered to sell the company a new piece of equipment which will increase fixed costs to $100,000. The salesman claims that the company’s break-even point will not be altered if the company purchases this equipment. What will be the company’s new variable cost per unit?

Current break-even point = $75,000/(250 - $205)

= 1.667 units

$100,000/($250 - VC) = 1,667 units

1,667 ($250 - VC) = $100,000

$416,750 - 1,667 VC = $100,000

-1,667 VC = -$316,750

VC = $190

Difficulty: Moderate

Keywords: variable cost per unit

159. The following is an analytical income statement for The Swill & Spoon, a fine dining establishment:

Sales $ 150,000

Variable costs 90,000

Revenue before fixed costs $ 60,000

Fixed costs 35,000

EBIT $ 25,000

Interest expense $ 10,000

Earnings before taxes $ 15,000

Taxes (.34) 5,100

Net income $ 9,900

a. Calculate the degree of operating leverage at this output level.

b. Calculate the degree of financial leverage at this level of EBIT.

c. What is the degree of combined leverage?

a. DOL $150,000 = $60,000/$25,000 = 2.4 times

b. DFL $25,000 = $25,000/($25,000 - $10,000) = 1.67 times

c. DCL $150,000 = 2.4 × 1.67 = 4.01 times

Difficulty: Moderate

Keywords: degree of operating leverage, financial leverage, combined leverage

160. Stan’s Cans, Inc. expects to earn $150,000 next year after taxes on sales of $2,200,000. Stan’s manufactures only one size of garbage can and is located in the small, but beautiful, town of Mount Dora, Florida. Stan sells his cans for $8 a piece and they have a variable cost of $2.40 a piece. Stan’s tax rate is currently 34%.

a. What are the firm’s expected fixed costs for next year?

b. What is the break-even point in units?

a. ([P × Q] - [(V × Q) + F])(1 - T) = $150,000

($2,200,000 - $660,000 - F)(.66) = $150,000

($1,540,000 - F)(.6) = $150,000

$866,400 = .66F

F = $1,312,727

b. Q = $1,312,727/($8 - $2.40) = 234,416 units

Difficulty: Moderate

Keywords: break-even analysis

161. The Western Boot Company will produce 94,000 pairs of boots next year. Variable costs are 35% of sales, while fixed costs total $223,000. At what price must each pair of boots be sold for Western to obtain an EBIT of $1,391,500?

94,000P - (0.35)(94,000)P - $223,000 = $1,391,500

94,000P - 32,900P - $223,000 = $1,391,500

61,100P = $1,614,500

P = $26.42

Difficulty: Moderate

Keywords: break-even analysis

162. Bob’s Donuts, Inc. expects to earn $60,500 next year after taxes on sales of $250,000. Bob’s bakes only one type of specialty donut and is located in the small, but beautiful, town of Oviedo, Florida. Bob sells his donuts for $.75 a piece, and they have a variable cost of $.25 a piece. Bob’s tax rate is currently 34%.

a. What are the firm’s expected fixed costs for next year?

b. What is the break-even point in units?

a. ([P × Q] - [V × Q] - F)(1 - T) = $60,500

($250,000 - $83,333 - F)(0.66) = $60,500

($166,667 - F)(0.66)= $60,500

$49,500= 0.66F

F = $75,000

b. Q = $75,000/($0.75 - $0.25) = 150,000 donuts

Difficulty: Moderate

Keywords: break-even analysis

163. 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?

Step 1

Compute the percent level of break-even output:

QB = F/(P - V) = $240,000/($34 - $18) =

$240,000/$16 = 15,000 units

Step 2

Compute the new level of fixed cost at the break-even output:

F + ($14)(15,000) = $34(15,000)

F + $210,000 = $510,000

F = $300,000

Step 3

Compute the addition to fixed costs:

$300,000 - $240,000 = $60,000 addition

Difficulty: Moderate

Keywords: break-even analysis

164. Alpha Accessories, Inc. produces three different lines of automobile accessories. The product lines are numbered. The firm’s sales mix and contribution margin ratios appear in the chart below.

Product % of Contribution

Line Total Sales Margin Ratio

1 20 42%

2 25 31%

3 55 20%

Forecasted sales for the coming year are $1.5 million. The firm’s fixed costs are $250,000.

a. Prepare a table showing sales, total variable costs, and the total

contribution margin (dollars) associated with each line.

b. What is the aggregate contribution margin ratio indicative of this mix?

c. What is the break-even point in dollars for this particular sales mix?

a.

Product 1 2 3 Total

Sales $300,000 $375,000 $825,000 $1,500,000

VC* $174,000 $258,000 $660,000 $1,092,750

Contribution

Margins $126,000 $116,250 $165,000 $407,250

b.

Contribution

Margin Ratio 42% 31% 20% 27.15%

c. S* = FC/[1 - (TVC/S)] = $250,000/0.2715 = $920,810

Difficulty: Moderate

Keywords: break-even analysis