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Exam 13: Leverage and Capital Structure

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Question 101

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The EBIT-EPS analysis tends to concentrate on maximization of earnings rather than maximization of owners' wealth.

A) True
B) False

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Question 102

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When a firm has fixed operating costs, operating leverage is present. In that case, an increase in sales results in a more-than-proportional increase in EBIT, and a decrease in sales results in a more-than-proportional decrease in EBIT.

A) True
B) False

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Question 103

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China America Manufacturing is evaluating two different operating structures which are described below. The firm has annual interest expense of $250, common shares outstanding of 1,000, and a tax rate of 40 percent. (a) For each operating structure, calculate (a1) EBIT and EPS at 10,000, 20,000, and 30,000 units. (a2) the degree of operating leverage (DOL) and degree of total leverage (DTL) using 20,000 units as a base sales level. (a3) the operating breakeven point in units. (b) Which operating structure has greater operating leverage and business risk? (c) If China America projects sales of 20,000 units, which operating structure is recommended?

The higher the degree of financial leverage (DFL), the greater the leverage a given financing plan has, and the steeper its slope when plotted on EBIT-EPS axes.

Because of the extensive research conducted in recent years in the area of capital structure theory, it is now possible for financial managers to pinpoint with great accuracy a firm's optimal capital structure.

The amount of leverage in a firm's capital structure-the mix of long-term debt and equity maintained by the firm-can significantly affect its value by affecting return and risk.

The levels of fixed-cost assets and funds that management selects affect the variability of returns.

The higher the financial breakeven point and the steeper the slope of the capital structure line, the greater the financial risk.

Operating leverage may be defined as the potential use of fixed operating costs to magnify the effects of changes in sales on a firm's earnings before interest and taxes (EBIT).

The pecking order explanation of capital structure states that a hierarchy of financing exists for firms, in which retained earnings are employed first, followed by debt financing and finally by external equity financing.

Which of the following is a fixed cost?

The basic shortcoming of EBIT-EPS analysis is that this model focuses on the maximization of stock returns rather than on the maximization of share price.

Which of the following is a basic source of capital for a firm ?

Because risk premiums increase with increases in financial leverage, maximizing EPS does not assure owners' wealth maximization.

The reason why maximizing share value and maximizing EPS do not give the same optimal capital structure is because ________.

Bamboo manufacturing sells its finished product for an average of $35 per unit with a variable cost per unit of $21. The company has fixed operating costs of $1,050,000. (a) Calculate the firm's operating breakeven point in units. (b) Calculate the firm's operating breakeven point in dollars. (c) Using 100,000 units as a base, what is the firm's degree of operating leverage?

Tony's Beach T-Shirts has fixed annual operating costs of $75,000. Tony retails his T-shirts for $14.99 each and the variable cost per T-shirt is $4.99. Based on this information, the breakeven sales level in units is ________.

Financial leverage may be defined as the potential use of variable financial costs to magnify the effects of changes in earnings before interest and taxes (EBIT) on a firm's earnings per share (EPS).

Tony's Beach T-Shirts has fixed annual operating costs of $75,000. Tony retails his T-shirts for $14.99 each and the variable cost per T-shirt is $4.99. Based on this information, the breakeven sales level in dollars is ________.

Total leverage measures the effect of fixed costs on the relationship between ________.