Questions and Answers
Raw material and direct labor costs are examples of what?
When fixed operating costs are incurred by the firm, a change in ____ is magnified into a relatively larger change in earnings before interest and taxes.
sales revenue
When fixed capital costs are incurred by the firm, a change in ____ is magnified into a larger change in earnings per share.
earnings before interest and taxes
What is the percentage change in a firm's EBIT that results in a 1% change in sales or output known as?
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The total variability of the firm's EPS associated with a change in sales is best measured by what?
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In the analysis of financial leverage, which of the following is not referred to as a fixed charge?
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The degree of combined leverage is defined as the percentage change in earnings per share resulting from a given percentage change in ____.
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The degree of combined leverage is equal to the degree of operating leverage ____ the degree of financial leverage.
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Rent, insurance, and the salaries of top management are examples of what?
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A firm that employs relatively large amounts of labor-saving equipment in its operations will have a relatively ____ degree of operating leverage.
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A firm that employs a relatively large proportion of debt and preferred stock in its capital structure will have a relatively ____ degree of financial leverage.
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The degree of combined leverage is equal to the ____ multiplied by the ____.
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A firm considering the purchase of assets that will increase its fixed operating costs should decrease the proportion of ____ it employs in its capital structure to maintain existing leverage.
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To balance operating and financial risks for a multinational company, Nestle allows its foreign operational subsidiaries ____ operational flexibility and follows a ____ financing strategy.
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The degree of financial leverage is defined as the percentage change in ____ resulting from a given percentage change in EBIT.
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What analytical technique helps determine when debt financing is advantageous and when equity financing is advantageous?
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Cash insolvency analysis evaluates the adequacy of a firm's cash position in a ____.
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Financial leverage causes a firm's ____ to change at a rate greater than the change in ____.
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In EBIT-EPS analysis, the indifference point is found at the point where ____ for the two alternative financing plans are equal.
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A firm which has a 2.5 DOL (degree of operating leverage), would find that an 8% increase in EBIT would result from a ____ increase in sales.
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A negative DOL indicates the percentage ____ in operating losses that occurs as the result of a 1% increase in output.
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A DFL (degree of financial leverage) of 3.0 indicates that a 27% increase in EPS is the result of a ____ increase in EBIT.
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The use of increasing amounts of combined leverage ____ the risk of financial distress.
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A firm is said to be ____ if it is unable to meet its current obligations.
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What happens to the EBIT indifference point if the interest rate on new debt decreases and the common stock price remains constant?
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Study Notes
Variable Costs
- Raw material and direct labor costs are considered variable costs.
Operating Costs and Revenue
- Fixed operating costs lead to larger changes in earnings before interest and taxes (EBIT) with fluctuations in sales revenue.
Capital Costs Impact
- Fixed capital costs magnify changes in earnings before interest and taxes, translating to significant changes in earnings per share (EPS).
Operating Leverage
- Degree of operating leverage measures the percentage change in EBIT resulting from a 1% change in sales or output.
Combined Leverage Measurement
- Total variability in a firm's EPS due to sales changes indicates combined leverage, commonly assessed by DOL and DFL.
Fixed Charges
- Among fixed charges in financial leverage analysis, common stock dividends are not included.
Definitions of Leverage
- Degree of combined leverage indicates the percentage change in EPS due to a specific percentage change in sales.
Combined Leverage Formula
- Degree of combined leverage equals the degree of operating leverage multiplied by the degree of financial leverage.
Examples of Fixed Costs
- Fixed costs include rent, insurance, and salaries of top management.
Operating Leverage and Labor
- Firms utilizing more labor-saving equipment tend to have a higher degree of operating leverage.
Financial Leverage and Capital Structure
- A firm with a higher proportion of debt and preferred stock has a higher degree of financial leverage.
Maintaining Combined Leverage
- To preserve combined leverage when increasing fixed operating costs, a firm should reduce its debt proportion.
Nestle's Strategy
- Nestle provides foreign subsidiaries with decentralized operational flexibility and adopts a centralized financing strategy.
Financial Leverage Definition
- Degree of financial leverage is the percentage change in EPS resulting from a given percentage change in EBIT.
Analyzing Financing Options
- EBIT-EPS analysis helps determine when debt financing is more advantageous than equity financing.
Cash Insolvency Evaluation
- Cash insolvency analysis assesses a firm's cash adequacy, particularly in recessionary environments.
EPS and EBIT Relationship
- Financial leverage causes a firm's EPS to fluctuate more than changes in EBIT.
Indifference Point
- In EBIT-EPS analysis, the indifference point is where EPS for two differing financing plans is equal.
DOL Measurement Example
- A company with a DOL of 2.5 would see an 8% EBIT increase from a 3.2% sales increase.
Negative DOL Implications
- A negative DOL signifies the reduction in operating losses resulting from a 1% increase in output.
DFL Example
- A DFL of 3.0 indicates that a 27% increase in EPS results from a 9% increase in EBIT.
Financial Distress Risk
- Increased combined leverage raises the risk of financial distress for a firm.
Technical Insolvency Definition
- A firm unable to meet its current obligations is categorized as technically insolvent.
Albany Corporation's Financing Plans
- Albany Corporation considers two financing strategies for expansion, each with differing implications for EBIT indifference points, particularly if interest rates on new debt decrease while stock prices remain constant.
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Test your knowledge with these flashcards focused on Chapter 14 of finance. Each card highlights key terms and concepts related to costs and their impact on earnings. Perfect for reviewing essential finance principles before exams.
