Use the following information for questions 8-13: A company is trying to decide
ID: 2649998 • Letter: U
Question
Use the following information for questions 8-13: A company is trying to decide on their use of operating and financial leverage from among four choices. Their Interest Expense is the Interest Rate times Debt. Their Tax Rate is 40%
Option Fixed Costs Variable Costs Debt Interest Rate
1. 20000 70% of Sales 0 0%
2. 50000 40% of Sales 0 0%
3. 20000 70% of Sales 500,000 10%
4. 50000 40% of Sales 500,000 10%
8. What is their Degree of Operating Leverage under option 1 if sales are $200,000?
a) 1 b) 1.5 c) 2 d) 3
9. What is their Degree of Financial Leverage under option 4 if EBIT is $120,000?
a) 1 b) 1.2 c) 1.7 d) 2.2
10. If Sales rise by 10% from 300,000 to 330,000 under option 3, then EBT will increase by what percent?
a) 13% b) 25% c) 35% d) 45%
11. At what level of Sales will the Degree of Operating Leverage = 2 under Option 2?
a) 100,000 b) 166,667 c) 250,000 d) 333,333
12. At what level of Sales will the EBT under Option 1 equal the EBT under Option 4?
a) 133,333 b) 166,667 c) 266,667 d) 333,333
13. At what level of Net Income will options 2 and 3 have the same Net Income?
a) -54,000 b) 28,000 c) 66,667 d) 90,000
14. Company A and Company B have the same EBIT, tax rate, total assets, and Cost of Debt. However, Company A has a higher debt ratio than Company B. Which of the following statements is correct? (ROA = Net Income / Assets and ROE = Net Income / Equity)
a. Company A has a higher net income than Company B.
b. Company A has a lower ROA than Company B.
c. Company A has a lower ROE than Company B.
d. The two companies have the same ROE.
15. Firms with _____________ should have _________________.
Higher Operating Leverage; More Debt
Less Volatile EBITs; Less Debt
Less Business Risk; More Financial Leverage
Lower Operating Leverage; Lower Financial Leverage
Explanation / Answer
8. What is their Degree of Operating Leverage under option 1 if sales are $200,000?
Degree of Operating Leverage = Contribution Margin/Operating Income
Degree of Operating Leverage = (Sale - Variable Cost)/ (Sale - Variable Cost - Fixed Cost)
Degree of Operating Leverage = (200000 - 70%*200000)/ (200000 - 70%*200000-20000)
Degree of Operating Leverage = 1.5
Answer
b) 1.5
9. What is their Degree of Financial Leverage under option 4 if EBIT is $120,000?
Degree of Financial Leverage = EBIT/EBT
Degree of Financial Leverage = 120000/ (120000 - 500000*10%)
Degree of Financial Leverage =1.7
Answer
c) 1.7
10. If Sales rise by 10% from 300,000 to 330,000 under option 3, then EBT will increase by what percent?
EBT will increase by = Increase Sale*(1-Variable cost %)
EBT will increase by = 30000 *(1-70%)
EBT will increase by = $ 9000
Current EBT = Sale*(1-Variable cost %) - Fixed Cost - Interest Expenses
Current EBT = 300000*(1-70%) - 20000 - 500000*10%
Current EBT = $ 20000
EBT will increase by what percent = EBT will increase by/Current EBT
EBT will increase by what percent = 9000/20000
EBT will increase by what percent = 45%
Answer
d) 45%
11. At what level of Sales will the Degree of Operating Leverage = 2 under Option 2?
Degree of Operating Leverage = 2
Degree of Operating Leverage = (Sale - Variable Cost)/ (Sale - Variable Cost - Fixed Cost)
Let sale be 100x
2 = (100x - 40%*100x)/ (100x - 40%*100x- 50000)
2 * (60x - 50000) = 60x
120x - 100000 = 60x
60x = 100000
x = 100000/60
x = 1666.67
Sale= 100*1666.67
Sale= 166,667
Answer
b) 166,667
12. At what level of Sales will the EBT under Option 1 equal the EBT under Option 4?
Total Fixed & Interest Expenses in Option 1 = 20000
Total Fixed & Interest Expenses in Option 4 = 50000 + 500000*10%
Total Fixed & Interest Expenses in Option 4 = 100000
Level of Sales will the EBT under Option 1 equal the EBT under Option 4 = Differnece in Total Fixed & Interest Expenses in both option/ Differnece in Variable cost%
Level of Sales will the EBT under Option 1 equal the EBT under Option 4 = (100000 - 20000)/(70% - 40%)
Level of Sales will the EBT under Option 1 equal the EBT under Option 4 = $ 266,667
Answer
c) 266,667
13. At what level of Net Income will options 2 and 3 have the same Net Income?
Total Fixed & Interest Expenses in Option 2 = 50000
Total Fixed & Interest Expenses in Option 3 = 20000 + 500000*10%
Total Fixed & Interest Expenses in Option 3 = 70000
Level of Sales will the EBT under Option 2 equal the EBT under Option 3 = Differnece in Total Fixed & Interest Expenses in both option/ Differnece in Variable cost%
Level of Sales will the EBT under Option 2 equal the EBT under Option 3 = $ 66,667
level of Net Income will options 2 and 3 have the same Net Income = -66667*60% - 50000
level of Net Income will options 2 and 3 have the same Net Income = -$ 90000
Answer
-d) 90,000