Measures of Leverage Exercise
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Apr 3, 2024
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FIN 220 Measures of Leverage Chang Liu 1 1. If two companies have identical unit sales volume and operating risk, they are most likely to also have identical: A. sales risk. B. business risk. C. sensitivity of operating earnings to changes in the number of units produced and sold. 2. Degree of operating leverage is best described as a measure of the sensitivity of: A. net earnings to changes in sales. B. fixed operating costs to changes in variable costs. C. operating earnings to changes in the number of units produced and sold. 3. The Fulcrum Company produces decorative swivel platforms for home televisions. If Fulcrum produces 40 million units, it estimates that it can sell them for $100 each. Variable production costs are $65 per unit and fixed production costs are $1.05 billion. Which of the following statements is most accurate? Holding all else constant, the Fulcrum Company would: A. generate positive operating income if unit sales were 25 million. B. have less operating leverage if fixed production costs were 10% greater than $1.05 billion. C. generate 20% more operating income if unit sales were 5% greater than 40 million. 4. The business risk of a particular company is most accurately measured by the company’s: A. debt-to-equity ratio. B. efficiency in using assets to generate sales. C. operating leverage and level of uncertainty about demand, output prices, and competition. 5. Consider two companies that operate in the same line of business and have the same degree of operating leverage: the Basic Company and the Grundlegend Company. The Basic Company and the Grundlegend Company have, respectively, no debt and 50 percent debt in their capital structure. Which of the following statements is most accurate? Compared to the Basic Company, the Grundlegend Company has: A. a lower sensitivity of net income to changes in unit sales. B. the same sensitivity of operating income to changes in unit sales. C. the same sensitivity of net income to changes in operating income.
FIN 220 Measures of Leverage Chang Liu 2 6. Myundia Motors now sells 1 million units at ¥3,529 per unit. Fixed operating costs are ¥1,290 million and variable operating costs are ¥1,500 per unit. If the company pays ¥410 million in interest, the levels of sales at the operating breakeven and breakeven points are, respectively: A. ¥1,500,000,000 and ¥2,257,612,900. B. ¥2,243,671,760 and ¥2,956,776,737. C. ¥2,975,148,800 and ¥3,529,000,000. 7. Juan Alavanca is evaluating the risk of two companies in the machinery industry: The Gearing Company and Hebelkraft, Inc. Alavanca used the latest fiscal year’s financial statements and interviews with managers of the respective companies to gather the following information: The Gearing Company Hebelkraft, Inc. Number of units produced and sold 1 million 1.5 million Sales price per unit $200 $200 Variable cost per unit $120 $100 Fixed operating cost $40 million $90 million Fixed financing expense $20 million $20 million Based on this information, the breakeven points for The Gearing Company and Hebelkraft, Inc. are: A. 0.75 million and 1.1 million units, respectively. B. 1 million and 1.5 million units, respectively. C. 1.5 million and 0.75 million units, respectively. The following information relates to Questions 8-16. Mary Benn, CFA, is a financial analyst for Twin Fields Investments, located in Storrs, Connecticut, U.S.A. She has been asked by her supervisor, Bill Cho, to examine two small Japanese cell phone component manufacturers: 4G, Inc., and Qphone Corp. Cho indicates that his clients are most interested in the use of leverage by 4G and Qphone. Benn states, “I will have to specifically analyze each company’s respective business risk, sales risk, operating risk, and financial risk.” “Fine, I’ll check back with you shortly,” Cho answers. Benn begins her analysis by examining the sales prospects of the two firms. The results of her sales analysis appear in Exhibit 1. She also expects very little price variability for these cell phones. She next gathers more data on these two companies to assist her analysis of their operating and financial risk. When Cho inquires as to her progress, Benn responds, “I have calculated Qphone’s degree of operating leverage (DOL) and degree of financial leverage (DFL) at Qphone’s 2009 level of unit sales. I have also calculated Qphone’s breakeven level for unit sales. I will have 4G’s leverage results shortly.”
FIN 220 Measures of Leverage Chang Liu 3 Cho responds, “Good, I will call a meeting of some potential investors for tomorrow. Please help me explain these concepts to them, and the differences in use of leverage by these two companies.” In preparation for the meeting, Cho says he has a number of questions: •
“You mentioned business risk; what is included in that?” •
“How would you classify the risk due to the varying mix of variable and fixed costs?” •
“Could you conduct an analysis and tell me how the two companies will fare relative to each other in terms of net income if their unit sales increased by 10 percent above their 2009 unit sales levels?” •
“Finally, what would be an accurate verbal description of the degree of total leverage?” The relevant data for analysis of 4G is contained in Exhibit 2, while Benn’s analysis of the Qphone data appears in Exhibit 3. Exhibit 1 Benn’s Unit Sales Estimates for 4G, Inc. and Qphone Corp. Company 2009 Unit Sales Standard Deviation of Unit Sales 2020 Expected Unit Sales Growth Rate (%) 4G, Inc. 1,000,000 25,000 15 Qphone Corp. 1,500,000 10,000 15 Exhibit 2 Sales, Cost, and Expense Data for 4G, Inc. (At Unit Sales of 1,000,000) Number of units produced and sold 1,000,000 Sales price per unit ¥108 Variable cost per unit ¥72 Fixed operating cost ¥22,500,000 Fixed financing expense ¥9,000,000 Exhibit 3 Benn’s Analysis of Qphone (At Unit Sales of 1,500,000) Degree of operating leverage 1.40 Degree of financial leverage 1.15 Breakeven quantity (units) 571,429 8. Based on Benn’s analysis, 4G’s sales risk relative to Qphone’s is most likely to be: A. lower. B. equal. C. higher. 9. What is the most appropriate response to Cho’s question regarding the components of business risk? A. Sales risk and financial risk. B. Operating risk and sales risk.
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FIN 220 Measures of Leverage Chang Liu 4 C. Financial risk and operating risk. 10. The most appropriate response to Cho’s question regarding the classification of risk arising from the mixture of variable and fixed costs is: A. sales risk. B. financial risk. C. operating risk. 11. Based on the information in Exhibit 2, the degree of operating leverage (DOL) of 4G, Inc., at unit sales of 1,000,000, is closest to: A. 1.60. B. 2.67. C. 3.20. 12. Based on the information in Exhibit 2, 4G, Inc.’s degree of financial leverage (DFL), at unit sales of 1,000,000, is closest to: A. 1.33. B. 2.67. C. 3.00. 13. Based on the information in Exhibit 1 and Exhibit 3, Qphone’s expected percentage change in operating income for 2010 is closest to: A. 17.25%. B. 21.00%. C. 24.30%. 14. 4G’s breakeven quantity of unit sales is closest to: A. 437,500 units. B. 625,000 units. C. 875,000 units.
FIN 220 Measures of Leverage Chang Liu 5 15. In response to Cho’s question regarding an increase in unit sales above 2009 unit sales levels, it is most likely that 4G’s net income will increase at: A. a slower rate than Qphone’s. B. the same rate as Qphone’s. C. a faster rate than Qphone’s. 16. The most appropriate response to Cho’s question regarding a description of the degree of total leverage is that degree of total leverage is: A. the percentage change in net income divided by the percentage change in units sold. B. the percentage change in operating income divided by the percentage change in units sold. C. the percentage change in net income divided by the percentage change in operating income.
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Which of the following is NOT one of the steps taken in the financial planning process?
O a. Consult with key competitors about the optimal set of prices to charge, i.e., the prices that will maximize profits for our firm and its competitors.
O b. Projected ratios are calculated and analyzed.
O c. Assumptions are made about future levels of sales, costs, and interest rates for use in the forecast.
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QUESTION 6
You have information about 4 different companies below in the table. The variable and fixed costs are expressed as the percentage of revenue based on the current sales. The companies are otherwise very similar. Which of these companies is probably have the highest degree of operating
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A B с D
Variable cost (%) 35% 27% 50% 80%
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O Project C
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QUESTION 9
The Net Present Value method always uses the weighted average cost of capital as the present value interest rate (discount rate).
True
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QUESTION 10
To decrease the overall risk of a firm, products, investment should be made that have positive correlation to each other.
True
False
QUESTION 11
The Break Even formula calculates a Break Even production, and sale, point at Operating Income level on the Income
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True
False
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Help question 30
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Lion Completion Status:
30
50
7D
10
11D 12D 13D 140
15
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17
18
19
20
21
22
23
24
25
26
27
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Question 10
If Q equals the level of output, P is the selling price per unit, V is the variable expense per unit, and F is the fixed expense, then the degree of operating leverage is equal to:
O [P-V)QI/[(P-V)Q- F].
O F/(P-V).
O Q(P-V).
F/[(P-V)/P].
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