FINA 3320 Ch. 8

(True or False) The degree of financial leverage gives an indication of how a change in EBIT will affect EPS.

True

(True or False) The higher a firm's operating leverage, the higher is its business risk.

True

(True or False) When a small change in sales results in a large change in operating income, one possible reason is that the firm is employing a relatively high degree of operating leverage.

True

The degree of financial leverage for ABC Inc. is 2.5, and the degree of financial leverage for XYZ Corporation is 1.5. According to this information, which firm is considered to have greater financial risk? a. ABC Inc. b. XYZ Corporation. c. The degree of financial leverage is not a measure of financial risk, so it is not possible to tell which firm has the greater financial risk given the above information. d. To determine which firm has the greater financial risk, we need to know the operating income (NOI or EBIT) of each firm. XYZ Corporation would have less financial risk if its operating income is at least twice that of ABC Inc. e. None of the above is a correct answer.

a

Which of the following is a key determinant of financial leverage? a. Level of debt. b. Technology. c. Labor costs. d. Amount of fixed assets used by the firm. e. Variable cost of goods sold.

a

sales forecast

a forecast of a firm's unit and dollar sales for some future period; generally based on recent sales trends plus forecasts of the economic prospects for the country, region, industry, and so forth

projected balance sheet method

a method of forecasting financial requirements based on forecasted financial statements

cash budget

a schedule showing cash receipts, cash disbursements, and cash balances for a firm over a specified time period

breakeven analysis

an analytical technique for studying the relationship among sales revenues, operating costs, and profits

lumpy assets

assets that cannot be acquired in small increments; instead, they must be obtained in large, discrete amounts

Other things held constant, which of the following statements is correct if a firm currently is operating at its financial breakeven point? a. EBIT must be greater than zero. b. EBIT would equal zero if the firm is financed only with common stock (i.e., there is no debt or preferred stock). c. EBIT would equal zero, hence EPS would be less than zero, if the firm has preferred stock but no debt. d. EPS would equal zero only if the firm is financed with some amount of debt. e. The firm would not be considered to have much financial risk, especially when compared to a firm that operates well above its financial breakeven point.

b

The degree of operating leverage for ABC Inc. is 3.5, and the degree of operating leverage for XYZ Corporation is 7.0. According to this information, which firm is considered to have greater business risk? a. ABC Inc. b. XYZ Corporation. c. The degree of operating leverage is not a measure of business risk, so it is not possible to tell which firm has the greater business risk given the above information. d. To determine which firm has the greater business risk, we need to know the operating income (NOI or EBIT) of each firm. XYZ Corporation would have less business risk if its operating income is at least twice that of ABC Inc. e. None of the above is a correct answer.

b

(True or False) Other things held constant, if a firm operates at a profit and sales increase, the degree of financial leverage will decline.

True

(True or False) The closer a firm is to its operating breakeven point, the greater is the absolute value of the degree of operating leverage.

True

(True or False) Any firm with a positive growth rate in sales will require some amount of external funding, assuming all existing ratios are to be maintained.

False

(True or False) At the firm's operating breakeven point, total revenues and total variable costs are exactly equal.

False

(True or False) One limitation of operating breakeven analysis is that variable cost must be assumed constant throughout the analysis in order to completely analyze changes in fixed investment.

False

(True or False) The DOL is an index number that measures the effect of a change in sales price on the operating breakeven point.

False

(True or False) The higher the percentage of a firm's total costs that are fixed, the higher the degree of operating leverage and the lower the operating breakeven point.

False

(True or False) The term "spontaneously generated funds" generally refers to increases in the cash account that result from growth in sales, assuming the firm is operating with a positive profit margin.

False

(True or False) To determine the amount of additional funds needed, you may subtract the expected increase in liabilities (a source of funds) from the sum of the expected increases in retained earnings and assets (both uses of funds).

False

(True or False) A high degree of operating leverage, other things held constant, means that a relatively small change in unit sales will result in a large change in operating income.

True

(True or False) As a firm's sales grow, the firm's purchases increase and its level of accounts payable will increase. Thus, spontaneously generated funds will arise.

True

(True or False) If a firm has no preferred stock, its financial breakeven point is the sales level that results in net income equal to zero.

True

(True or False) If firm A uses more operating leverage than firm B, firm A will probably have a greater percentage profit margin per unit than firm B, if both firms are otherwise identical and operating above their respective operating breakeven levels.

True

(True or False) One situation where operating breakeven analysis can be valuable is when a firm plans to increase fixed investment in order to lower variable cost, such as labor costs.

True

(True or False) Other things held constant, a high degree of operating leverage will mean that a relatively small change in sales will result in a large change in operating income.

True

(True or False) Other things held constant, a high degree of total leverage will mean that a relatively small change in sales will result in a large change in EPS.

True

(True or False) Other things held constant, if a firm is operating at a profit and then sales increase, the degree of operating leverage will decline.

True

Which of the following statements is correct? a. One of the key steps in the development of pro forma financial statements is to identify those assets and liabilities which increase spontaneously with net income. b. The first, and most critical, step in constructing a set of pro forma financial statements is establishing the sales forecast. c. Pro forma financial statements as discussed in the text are used primarily to assess a firm's historical performance. d. All else equal, if a firm operates at full capacity, the greater its payout ratio, the less additional funds that will be needed for a particular growth in sales. e. The projected balance sheet forecasting method produces accurate results when fixed assets are lumpy and when economies of scale are present.

b

Assume a portion of a firm's long-term funds includes either debt or preferred stock. Which of the following statements is correct? a. The firm must possess operating leverage, which means that a change in net income will result in a greater percentage change in earnings before interest and taxes (EBIT). b. The firm has financial leverage, which means that a change in sales will result in a greater percentage change in EBIT. c. The firm has financial leverage, which means that a change in EBIT will result in a greater percentage change in earnings per share (EPS). d. The firm doesn't have leverage, because leverage is created through the use of common equity financing only. e. None of the above is a correct answer.

c

Considering each action independently and holding other things constant, which of the following actions would reduce the firm's need for additional capital? a. An increase in the dividend payout ratio. b. A decrease in the profit margin. c. A decrease in the days sales outstanding. d. An increase in expected sales growth. e. A decrease in the accrual accounts (accrued wages and taxes).

c

The degree of operating leverage has which of the following characteristics? a. The closer the firm is operating to breakeven quantity, the smaller the DOL. b. A change in quantity demanded will produce the same percentage change in EBIT as an identical change in price per unit of output, other things held constant. c. The DOL is not a fixed number for a given firm, but will depend upon the time zero values of the economic variables Q (Quantity), P (Price), and V (Volume). d. The DOL relates the change in net income to the change in net operating income. e. If the firm has no debt, the DOL will equal 1.

c

If a firm's degree of total leverage (DTL) is 8.0, which of the following must be correct? a. The firm must have fixed operating costs. b. The firm must have fixed financial costs. c. The firm must have both fixed operating costs and fixed financial costs. d. The firm must have some fixed costs, but not enough information is given to determine whether the fixed costs are operating, financial, or both. e. With the information given, we cannot tell whether the firm has any fixed costs (either operating or financial) at all.

d

Which of the following is (are) typically part of the cash budget? a. Payments lag. b. Payment for plant construction. c. Cumulative cash. d. All of the above. e. Only answers a and c above.

d

Which of the following is a key determinant of operating leverage? a. Level of debt. b. Physical location of production facilities. c. Cost of debt. d. Technology. e. Capital structure.

d

The Price Company will produce 55,000 widgets next year. Variable costs will equal 40 percent of sales, while operating fixed costs will total $110,000. At what price must each widget be sold for the company to achieve an EBIT of $95,000? a. $2.00 b. $4.45 c. $5.00 d. $5.37 e. $6.21

e

The financial breakeven point for a firm is defined as the level of ____ that produces ____ equal to zero. a. sales; EBIT. b. sales; gross profit. c. EPS; sales. d. gross profit; EBIT. e. EBIT; EPS.

e

additional funds needed (AFN)

funds that a firm must raise externally through borrowing or by selling new stock

spontaneously generated funds

funds that are obtained from routine business transactions

disbursements and receipts method

net cash flow is determined by estimating the cash disbursements and the cash receipts expected to be generated each period

fixed operating costs

operating costs that remain the same (constant) regardless of the level of production

variable operating costs

operating costs that vary with production; variable costs are $0 when there is no production and high when production is high

financing feedbacks

the effects on the income statement and balance sheet of actions taken to finance forecasted increases in assets

financial leverage

the existence of fixed financial costs, such as interest; when a change in EBIT results in a larger change in EPS

operating leverage

the existence of fixed operating costs such that a change in sales will produce a larger change in operating income (EBIT)

breakeven point

the level of production and sales where operating income is $0. At this point, revenues from sales just equal TOC.

target (minimum) cash balance

the minimum cash balance that a firm desires to maintain while conducting business

degree of total leverage (DTL)

the percent change in EPS that results from a 1percentchangeinsales

degree of financial leverage (DFL)

the percentage change in EPS that results from a given percentage change in EBIT

degree of operating leverage (DOL)

the percentage change in NOI (or EBIT) associated with a given percentage change in sales

financial control

the phase in which financial plans are implemented; the feedback and adjustment process required to ensure adherence to plans and modification of plans because of unforeseen changes

financial planning

the projection of sales, income, and assets based on alternative production and marketing strategies as well as the determination of the resources needed to achieve these projections