Sample Questions and Answers
What happens when a company’s degree of financial leverage (DFL) is greater than 1?
A) The company has no fixed costs
B) The company is not using any debt
C) The company’s earnings will be highly sensitive to changes in sales
D) The company is incurring high interest expenses without debt
Answer: C
Which of the following is a potential advantage of using high financial leverage?
A) Lower tax liability due to interest expense deductions
B) A lower overall cost of capital compared to equity
C) Less risk for shareholders
D) More control retained by the company’s management
Answer: A
When does a company’s degree of operating leverage (DOL) reach its maximum?
A) When the company reaches its break-even point
B) When the company’s fixed costs are equal to its variable costs
C) When the company has no fixed costs
D) When sales volume is at its peak
Answer: A
If a company has low operating leverage, its break-even point will be:
A) High
B) Low
C) Unaffected by changes in fixed costs
D) Constant regardless of sales volume
Answer: B
A company with high operating leverage will experience greater profit fluctuations when:
A) Variable costs increase
B) Fixed costs decrease
C) Sales remain constant
D) Sales volume changes
Answer: D
If the cost of debt is lower than the return on assets, the use of financial leverage will likely result in:
A) Reduced profitability for equity holders
B) Increased earnings for shareholders
C) Decreased tax liabilities
D) A reduction in the company’s earnings volatility
Answer: B
What is the effect of financial leverage on a company’s overall capital structure?
A) It increases the proportion of debt to equity
B) It reduces the overall cost of capital
C) It eliminates the need for equity financing
D) It results in a greater reliance on short-term financing
Answer: A
Which of the following describes the primary benefit of operating leverage?
A) It provides a company with greater flexibility to manage fixed costs
B) It enables the company to achieve higher profitability when sales rise
C) It reduces the need for equity financing
D) It ensures that a company can always cover its fixed costs
Answer: B
How does a company with high operating leverage typically react to an increase in sales?
A) It experiences a proportional increase in profits
B) It experiences a smaller increase in profits
C) It experiences a larger increase in profits
D) Its profitability remains unchanged
Answer: C
A company with high financial leverage has:
A) A lower risk of default
B) Greater exposure to changes in interest rates
C) Lower interest expenses
D) A more flexible cost structure
Answer: B
The use of financial leverage increases the risk of:
A) Higher earnings volatility
B) Lower interest rates on debt
C) Greater tax benefits
D) Lower fixed costs
Answer: A
If a company’s degree of operating leverage (DOL) is 3, what would be the expected change in operating income if sales increase by 5%?
A) 3%
B) 5%
C) 15%
D) 50%
Answer: C
A company that uses financial leverage amplifies its:
A) Operating risk
B) Equity risk
C) Tax savings
D) Control over management decisions
Answer: B
When a company has a high degree of operating leverage, an increase in sales leads to:
A) A relatively larger increase in profits
B) A decrease in profit margins
C) A smaller increase in profits
D) A constant level of profit
Answer: A
A company with a high financial leverage ratio might face difficulty when:
A) Interest rates decline
B) Sales growth accelerates
C) Earnings before interest and taxes (EBIT) are volatile
D) The company maintains low levels of debt
Answer: C
Which of the following is a key factor in determining whether financial leverage is beneficial for a company?
A) The company’s return on equity (ROE)
B) The interest rate on the company’s debt
C) The company’s variable cost structure
D) The company’s market share
Answer: B
What is the effect of high financial leverage during periods of strong economic growth?
A) Reduced profitability
B) Increased risk of insolvency
C) Increased profitability
D) Decreased interest expense
Answer: C
What is a company’s operating leverage primarily determined by?
A) The amount of debt in the capital structure
B) The proportion of fixed to variable costs in its cost structure
C) The level of taxes paid
D) The amount of equity capital invested
Answer: B
If a company’s return on assets (ROA) is higher than the interest rate on its debt, financial leverage:
A) Reduces the company’s overall profitability
B) Has no effect on the company’s return on equity (ROE)
C) Increases the company’s return on equity (ROE)
D) Increases the company’s financial risk
Answer: C
A company with significant operating leverage is most likely to have:
A) Low variable costs
B) High variable costs
C) Low fixed costs
D) High fixed costs
Answer: D
A company with high operating leverage will experience:
A) Small changes in profits from sales fluctuations
B) Large changes in profits from sales fluctuations
C) No change in profits when sales fluctuate
D) Lower sales volatility
Answer: B
What is the main benefit of using financial leverage?
A) It increases control over management decisions
B) It can magnify returns to shareholders
C) It eliminates all financial risks
D) It decreases the company’s dependence on fixed costs
Answer: B
What would happen to a company’s operating leverage if it shifts from a capital-intensive business model to one with a higher proportion of variable costs?
A) Operating leverage increases
B) Operating leverage decreases
C) Operating leverage remains unchanged
D) The company would become more reliant on debt
Answer: B
When analyzing financial leverage, what is the primary risk to shareholders?
A) Shareholders may lose their equity if debt holders are prioritized in liquidation
B) Shareholders benefit equally from increased debt
C) The company’s stock price is unaffected by debt levels
D) The company’s return on equity (ROE) becomes less volatile
Answer: A
Which of the following is true when a company increases its use of debt financing?
A) The company’s break-even point decreases
B) The company’s financial risk increases
C) The company’s earnings before interest and taxes (EBIT) become less sensitive to sales changes
D) The company’s operating leverage decreases
Answer: B
When is financial leverage most beneficial?
A) When the company’s return on assets exceeds the interest rate on its debt
B) When the company has high fixed costs
C) When the company has no debt obligations
D) When the company is in a declining industry
Answer: A
What happens to a company’s earnings per share (EPS) when it uses high financial leverage during periods of declining sales?
A) EPS remains unchanged
B) EPS increases
C) EPS decreases more sharply than it would without leverage
D) EPS increases less than it would without leverage
Answer: C
The primary purpose of calculating the degree of financial leverage (DFL) is to measure:
A) The company’s total debt
B) The company’s fixed cost obligations relative to equity
C) The sensitivity of earnings per share to changes in operating income
D) The company’s market valuation
Answer: C
Which of the following is a disadvantage of high financial leverage?
A) It may reduce a company’s tax burden
B) It increases the volatility of earnings
C) It decreases the cost of debt financing
D) It leads to lower interest payments
Answer: B
A company with low operating leverage is likely to:
A) Have high fixed costs
B) Experience significant profit fluctuations with sales changes
C) Rely more on variable costs
D) Use more debt financing
Answer: C
Which of the following is an effect of using high financial leverage during periods of economic downturn?
A) Increased profitability
B) Higher risk of financial distress
C) A higher return on equity
D) Reduced interest expenses
Answer: B
What would happen to a company’s return on equity (ROE) if it increases its financial leverage and the return on assets (ROA) exceeds the interest rate on its debt?
A) ROE would decrease
B) ROE would increase
C) ROE would remain the same
D) ROE would be unaffected by changes in debt
Answer: B
If a company’s degree of financial leverage (DFL) is greater than 1, it indicates that:
A) The company is not using any debt
B) The company’s earnings are more sensitive to changes in EBIT
C) The company has high operating leverage
D) The company is not exposed to interest rate risk
Answer: B
What is the most significant risk associated with a company’s use of high operating leverage?
A) The company may not be able to cover its fixed costs during periods of low sales
B) The company’s variable costs will increase sharply
C) The company will have lower earnings volatility
D) The company will be less affected by changes in sales volume
Answer: A
Which of the following would increase the financial risk of a company?
A) Reducing the amount of debt in the capital structure
B) Issuing more equity capital
C) Increasing the amount of debt in the capital structure
D) Reducing the company’s fixed costs
Answer: C
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