Measures of Leverage

If two companies have identical unit sales volume and operating risk, they are

most likely to also have identical:

•  sales risk

• business risk

• sensitivity of operating earnings to changes in the number of units produced and sold

The business risk of a particular company is most accurately measured by the company’s:

• efficiency in using assets to generate sales

• operating leverage and level of uncertainty about demand, output prices, and competition

• debt-to-equity ratio

True or False: The degree of total leverage is the sum of the degree of operating leverage and the degree of financial leverage

• TRUE

• FALSE

Answer explanation

DTL = DOL * DFL

True or False: A firm with a high degree of combined leverage will, other things being equal, experience higher earnings in the expansionary part of the business cycle.

• TRUE

• FALSE

A company’s operating breakeven quantity of sales is equal to its ________ divided by its unit contribution margin or the difference between the price per unit and variable cost per unit

• fixed operating cost

• fixed financing cost

• Fixed operating cost and fixed financing cost

Answer explanation

A company has fixed operating costs of $2,500. The price per unit for one of its products is $8.00, and the variable cost per unit is $4.00. The company’s operating breakeven quantity of sales is closest to:

• 2,143

• 1,293

• 625

Answer explanation

$2,500/($8.00 - $4.00) = 625

If a company is financially over-leveraged, what happen to ROE and Net income?

• Decrease

• Remain unchanged

• Increase

When a firm achieves its optimal financial leverage, which condition for its net income and ROE to rise

• The operating income increase

• The operating income decrease

Business risk is the combination of:

• sales risk and financial risk

• operating risk and financial risk

• operating risk and sales risk

Which of the following is a key determinant of operating leverage

• Level and cost of debt

• The competitive nature of the business

• The trade-off between fixed and variable costs