Measures of Leverage (Reading 38)

Exercise Problems:

A. financial risk.

B. sales risk.

C. interest rate risk.

B is correct because business risk is the combination of sales risk and operating risk. Business risk refers to the risk associated with a firm's operating income and is the result of uncertainty about a firm's revenues and the expenditures necessary to produce those revenues.  Sales risk is the uncertainty about the firm's sales.

A is incorrect because financial risk refers to the additional risk that the firm's common stockholders must bear when a firm uses fixed cost (debt) financing. When a company finances its operations with debt, it takes on fixed expenses in the form of interest payments. The greater the proportion of debt in a firm's capital structure, the greater the firm's financial risk.

C is incorrect because interest rate risk is Risk related to changes in the level of interest rates.

2.      Using the firm’s income statement presented, its degree of financial leverage is closest to:

A. 1.5.

B. 1.4.

C. 2.6.

DFL =

         = $3.5 ÷ ($3.5 – $1.0)

         = 1.40.

3.      Financial risk is most likely affected by:

A. dividends.

B. general and administrative costs.

C. long-term leases.

By taking on fixed obligations, a company increases its financial risk. These fixed costs may be fixed operating expenses, such as building or equipment leases, or fixed financing costs, such as interest payments on debt.

4.      Using the company’s income statement presented, its degree of operating leverage is closest to:

A. 1.1.

B. 1.7.

C. 2.4.

DOL =

=  

= 

=  1.71

Note that in this form, the numerator is contribution margin and the denominator is operating income (EBIT).

5.      The following information is available for a firm:

The firm’s degree of total leverage (DTL) is closest to:

A. 1.43.

B. 2.00.

C. 4.44.

Ans: C;

DTL =

= (700,000 - 500,000) ÷ 45,000

= 4.44

The degree of total leverage (DTL) combines the degree of operating leverage and financial leverage. DTL measures the sensitivity of EPS to change in sales. DTL is computed as:

DTL = DOL x DFL

6.      The unit contribution margin for a product is $20 and the firm’s fixed costs of production up to 300,000 units is $500000. The degree of operating leverage (DOL) is most likely the lowest at which of the following production levels (in units)?

A. 100,000

B. 200,000

C. 300,000

DOL =

DOL (100,000 units) =$20 × 100,000 / [$20 × 100,000 – $500,000] =1.333

DOL (200,000 units) =$20 × 200,000 / [$20 × 200,000 – $500,000]=1.143

DOL (300,000 units) =$20 × 300,000 / [$20 × 300,000 – $500,000]=1.091

The DOL is lowest at the 300,000 units production level.

7.      The “per unit contribution margin” for a product is $10. Assuming fixed costs of $12,000, interest costs of $3,000, and taxes of $2,000, the operating breakeven point (in units) is closest to:

A. 1,000.

B. 1,200.

C. 1,417.

B is correct. The operating breakeven point is:

= $12,000 ÷ $10

= 1,200 

8.      If the degree of financial leverage (DFL) is 1.00, the operating breakeven point compared to the breakeven point, is most likely:

A. the same.

B. higher.

C. lower.

When DFL =  = 1.00, the fixed cost of debt (interest) is zero.

The breakeven point is:   

The operating breakeven point is:

When the fixed cost of debt is zero, the company’s breakeven point equals to the operating breakeven point.