Leverage and Capital Structure

LEVERAGE AND CAPITAL STRUCTURE

PART A

1. Variable costs include all of the following EXCEPT

1. direct labor
2. shipping cost
3. property taxes
4. sales commissions

1. Which of the following would be considered a fixed cost?

1. Packaging
2. Depreciation
3. Direct materials
4. Sales commissions

1. Operating breakeven analysis may be used to show __________.

1. the relationship between sales and equity
2. the level of sales necessary to avoid losses
3. the level of output required to maximize profits
4. the relationship between debt financing and earnings

1. Fixed costs _________, and variable costs __________.

1. are greater than variable costs; are greater than fixed costs
2. are greater than variable costs; change with the level of output
3. do not change with the level of output; are greater than total costs
4. do not change with the level of output; change with the level of output

1. Which of the following statements is FALSE?

1. At the operating breakeven point, EBIT equals zero.
2. Contribution margin is the selling price per unit minus the variable cost per unit.
3. Operating breakeven analysis ignores fixed costs because fixed costs do not change.
4. If the selling price per unit increases, there will be a decrease in the operating breakeven point.

1. Which of the following statements regarding leverage are TRUE?

1. As interest increases, financial leverage will decrease.
2. A firm does not obtain financial leverage by issuing common stock.
3. As the use of operating leverage increases, the risk exposure of the firm decreases.
4. If a firm has a large amount of operating leverage, which suggests small change is sales will cause a large change in EBIT.

1. I and II only
2. I and III only
3. II and IV only
4. III and IV only

1. Use preferred stock in capital structure

1. increases operating leverage.
2. increases financial leverage.
3. decreases operating leverage.
4. decreases financial leverage.

1. High degree of financial leverage (DFL) means __________.

1. no debt
2. high debt proportion
3. equal debt and equity
4. lower debt proportion

1. Markisa Food Bhd has very high operating leverage due to the capital intensive nature of the manufacturing business.  Markisa’ Chief Financial Officer (CFO) is concerned about the variability in the firm’s EPS if sales should drop, and decides to take action.  Which of the following will reduce the variability in the firm’s EPS for a given change in sales

1. The CFO may decrease the firm’s financial leverage, thus lowering the firm’s total leverage.
2. The CFO may issue more corporate bonds and use the proceeds to pay off short-term liabilities.
3. The CFO may increase the firm’s total leverage by raising money from the sale of common stock.
4. The CFO may increase the firm’s financial leverage and hence reduce the variability by using non-shareholder money to support the business.

1. Quick Launch Rocket Company, a satellite launching firm, expects its sales to increase by 60% in the coming year as a result of NASA's recent problems with the space shuttle.  The firm's current EPS is RM3.25. Its degree of operating leverage (DOL) is 1.6, while its DFL is 2.1.  What is the firm's projected EPS for the coming year using the degree of combined leverage (DCL) approach?    

1. RM3.25
2. RM5.46
3. RM8.71
4. RM9.80

DCL        = DOL*DFL

      = 1.6*2.1

      = 3.36

[pic 1]

[pic 2]

[pic 3]

Thus, Current EPS        = RM3.25

Projected EPS                = (3.25*201.60%) + RM3.25

                                    = RM9.80

1. For a constant (unchanged) EBIT, if the debt level is further increased then

1. EPS may increase.
2. EPS will never increase.
3. EPS will always increase.
4. none of the above.

1. A firm has a DFL of 2.75 at X ringgit. What does this tell us about the firm?

1. If sales rise by2.75% at the firm, then EBIT will rise by 1%.
2. If EBIT rises by 2.75% at the firm, then EPS will rise by 1%.
3. If EBIT rises by 1% at the firm, then EPS will rise by 2.75%.
4. If sales rise by 1% at the firm, then EBIT will rise by 2.75%.

1. The EBIT-EPS indifference analysis identifies the point where

1. total revenue equals variable costs plus fixed costs.
2. the point where the more heavily levered firm will generate a lower EPS.
3. the value of the levered firm equals the present value of financial distress and agency costs.
4. the EBIT level at which the EPS will be the same regardless of the financing plan chosen by the financial manager.

1. Between 2 capital plans, if expected EBIT is more than indifference level of EBIT, then

1. both plans are good.
2. both plans be rejected.
3. one is better than other.
4. none of the above.

1. Refer to the information below.

How much are the fixed costs of producing the course packs?

1. 175,560
2. 242,550
3. 231,000
4. 381,000

EBIT                = Q (P-V)-F

[pic 4]

[pic 5]

F                                = RM231,000

PART B

1. What would the effect on the firm’s operating break-even point of the following individual changes?

1. An increase in selling price

Lower the break-even point.