Test bank Finance Management chapter 13 capital structure and leverage

Increasing the amount of debt in a firm’s capital structure is likely to increase the costs of both debt and equity financing?. Capital structure and stock price Answer: e Diff: MPublish

(Difficulty: E = Easy, M = Medium, and T = Tough)Multiple Choice: Conceptual

Easy:

following is not associated with (or not a part of) business risk?

a Demand variability

b Sales price variability

c The extent to which operating costs are fixed

d Changes in required returns due to financing decisions

e The ability to change prices as costs change

a The level of uncertainty regarding the demand for its product

b The degree of operating leverage

c The amount of debt in its capital structure

d Statements a and b are correct

e All of the statements above are correct

CHAPTER 13 CAPITAL STRUCTURE AND LEVERAGE

Business and financial risk Answer: d Diff: E

characteristics of its industry

b The factors that affect a firm’s business risk are determined partly by

Unfortunately, these and other factors that affect a firm’s businessrisk are not subject to any degree of managerial control

c One of the benefits to a firm of being at or near its target capitalstructure is that financial flexibility becomes much less important

d The firm’s financial risk may have both market risk and diversifiablerisk components

e None of the statements above is correct

a As a rule, the optimal capital structure is found by determining thedebt-equity mix that maximizes expected EPS

minimizes the WACC

c The optimal capital structure minimizes the cost of equity, which is anecessary condition for maximizing the stock price

d The optimal capital structure simultaneously minimizes the cost ofdebt, the cost of equity, and the WACC

e None of the statements above is correct

Entertainment Company

a Debt = 40%; Equity = 60%; EPS = $2.95; Stock price = $26.50

b Debt = 50%; Equity = 50%; EPS = $3.05; Stock price = $28.90

c Debt = 60%; Equity = 40%; EPS = $3.18; Stock price = $31.20

d Debt = 80%; Equity = 20%; EPS = $3.42; Stock price = $30.40

e Debt = 70%; Equity = 30%; EPS = $3.31; Stock price = $30.00

d Statements a and b are correct

Target capital structure Answer: e Diff: E

following?

a Maximum earnings per share (EPS)

b Minimum cost of debt (kd)

c Minimum risk

d Minimum cost of equity (ks)

e Minimum weighted average cost of capital (WACC)

its capital structure?

a An increase in the corporate tax rate

b An increase in the personal tax rate

c A decrease in the company’s degree of operating leverage

d Statements a and c are correct

e All of the statements above are correct

a A reduction in the corporate tax rate is likely to increase the debtratio of the average corporation

b An increase in the personal tax rate is likely to increase the debtratio of the average corporation

c If changes in the bankruptcy code make bankruptcy less costly tocorporations, then this would likely reduce the debt ratio of theaverage corporation

d All of the statements above are correct

e None of the statements above is correct

its debt ratio in its capital structure?

a Its sales become less stable over time

b Its corporate tax rate declines

c Management believes that the firm’s stock is overvalued

d Statements a and b are correct

e None of the statements above is correct

increase the proportion of debt in its capital structure?

a An increase in the corporate tax rate

b An increase in the personal tax rate

c An increase in the company’s degree of operating leverage

d The company’s assets become less liquid

Leverage and capital structure Answer: e Diff: E

increase its debt ratio in its capital structure?

a An increase in costs incurred when filing for bankruptcy

b An increase in the corporate tax rate

c An increase in the personal tax rate

d A decrease in the firm’s business risk

e Statements b and d are correct

its debt ratio?

a An increase in the corporate tax rate

b An increase in the personal tax rate

c Its assets become less liquid

d Both statements a and c are correct

e All of the statements above are correct

is considering a recapitalization plan in which the firm would issue term debt with a yield of 9 percent and use the proceeds to repurchase

assets nor would it affect the company’s basic earning power, which is

following is also likely to occur if the company goes ahead with theplanned recapitalization?

a The company’s net income will increase

b The company’s earnings per share will decrease

c The company’s cost of equity will increase

d The company’s ROA will increase

e The company’s ROE will decrease

a When a company increases its debt ratio, the costs of both equity and

(WACC) must also increase

b The capital structure that maximizes stock price is generally thecapital structure that also maximizes earnings per share

c Since debt financing is cheaper than equity financing, increasing acompany’s debt ratio will always reduce the company’s WACC

d The capital structure that maximizes stock price is generally thecapital structure that also maximizes the company’s WACC

Leverage and capital structure Answer: c Diff: E

a When a company increases its debt ratio, the costs of equity and debtcapital both increase Therefore, the weighted average cost of capital(WACC) must also increase

b The capital structure that maximizes stock price is generally thecapital structure that also maximizes earnings per share

c All else equal, an increase in the corporate tax rate would tend toencourage a company to increase its debt ratio

d Statements a and b are correct

e Statements a and c are correct

a Since debt financing raises the firm’s financial risk, increasing acompany’s debt ratio will always increase the company’s WACC

b Since debt financing is cheaper than equity financing, increasing acompany’s debt ratio will always reduce the company’s WACC

c Increasing a company’s debt ratio will typically reduce the marginalcosts of both debt and equity financing; however, it still may raisethe company’s WACC

d Statements a and c are correct

e None of the statements above is correct

currently has no debt in its capital structure The company’s basic earningpower is 15 percent The company is contemplating a recapitalization where

it will issue debt at 10 percent and use the proceeds to buy back shares of

recapitali-zation its operating income, total assets, and tax rate will remain thesame Which of the following will occur as a result of the recapitalization?

a The company’s ROA will decline

b The company’s ROE will increase

c The company’s basic earning power will decline

d Statements a and b are correct

e All of the statements above are correct

Capital structure, WACC, TIE, and EPS Answer: a Diff: E

a The capital structure that maximizes stock price is also the capitalstructure that minimizes the weighted average cost of capital (WACC)

b The capital structure that maximizes stock price is also the capitalstructure that maximizes earnings per share

c The capital structure that maximizes stock price is also the capitalstructure that maximizes the firm’s times interest earned (TIE) ratio

d Statements a and b are correct

Capital structure theory Answer: d Diff: E

correct?

a Signaling theory suggests firms should in normal times maintain reserveborrowing capacity that can be used if an especially good investmentopportunity comes along

b In general, an increase in the corporate tax rate would cause firms touse less debt in their capital structures

c According to the “trade-off theory,” an increase in the costs ofbankruptcy would lead firms to reduce the amount of debt in theircapital structures

d Statements a and c are correct

e All of the statements above are correct

Miscellaneous capital structure concepts Answer: c Diff: E N

a If Congress were to pass legislation that increases the personal taxrate, but decreases the corporate tax rate, this would encouragecompanies to increase their debt ratios

b If a company were to issue debt and use the money to repurchase commonstock, this action would have no impact on the company’s return on

operating income.)

c If a company were to issue debt and use the money to increase assets,this action would increase the company’s return on equity (Assume thatthe company’s return on assets remains unchanged.)

d Statements a and b are correct

e Statements b and c are correct

involve the company issuing new bonds and using the proceeds to buy back

company’s CFO does estimate that it will increase the company’s earnings

following statements is most correct?

a Since the proposed plan increases Volga’s financial risk, the company’sstock price still might fall even though its EPS is expected toincrease

b If the plan reduces the company’s WACC, the company’s stock price isalso likely to decline

c Since the plan is expected to increase EPS, this implies that netincome is also expected to increase

d Statements a and b are correct

e Statements a and c are correct

Financial leverage and EPS Answer: c Diff: E

a Increasing financial leverage is one way to increase a firm’s basicearning power (BEP)

b Firms with lower fixed costs tend to have greater operating leverage

c The debt ratio that maximizes EPS generally exceeds the debt ratio thatmaximizes share price

d Statements a and b are correct

e Statements a and c are correct

that exceeds their before-tax costs of debt, kd However, Company A has ahigher debt ratio and higher interest expense than Company B Which of thefollowing statements is most correct?

a Company A has a lower net income than B

b Company A has a lower ROA than B

c Company A has a lower ROE than B

d Statements a and b are correct

e None of the statements above is correct

income Which of the following statements is most correct?

a The two companies have the same times interest earned (TIE) ratio

b Firm L has a lower ROA than Firm U

c Firm L has a lower ROE than Firm U

d Statements a and b are correct

e Statements b and c are correct

Medium:

a Maximizes expected EPS also maximizes the price per share of commonstock

b Minimizes the interest rate on debt also maximizes the expected EPS

c Minimizes the required rate on equity also maximizes the stock price

d Maximizes the price per share of common stock also minimizes theweighted average cost of capital

e None of the statements above is correct

Operating and financial leverage Answer: e Diff: M

a Firms whose sales are very sensitive to changes in the business cycleare more likely to rely on debt financing

b Firms with large tax loss carry forwards are more likely to rely ondebt financing

c Firms with a high operating leverage are more likely to rely on debtfinancing

d Statements a and c are correct

e None of the statements above is correct

(EBIT), tax rate, and business risk Company A, however, has a much higher

its cost of debt financing (kd) Which of the following statements is mostcorrect?

a Company A has a higher return on assets (ROA) than Company B

b Company A has a higher times interest earned (TIE) ratio than Company B

c Company A has a higher return on equity (ROE) than Company B, and itsrisk, as measured by the standard deviation of ROE, is also higher thanCompany B’s

d Statements b and c are correct

e All of the statements above are correct

structure and degree of leverage analyses?

a It is nearly impossible to determine exactly how P/E ratios or equity

financial leverage

b Managers’ attitudes toward risk differ and some managers may set atarget capital structure other than the one that would maximize stockprice

c Managers often have a responsibility to provide continuous service;

goal of employing leverage to maximize short-run stock price andminimize capital cost may conflict with long-run viability

d All of the statements above are correct

e None of the statements above represents a serious impediment to the

determination

Signaling theory Answer: b Diff: M

new capital, and you know that investors do not have this information,signaling theory would predict that you would

a Issue debt to maintain the returns of equity holders

b Issue equity to share the burden of decreased equity returns betweenold and new shareholders

c Be indifferent between issuing debt and equity

improve

eliminate the information asymmetry

a The optimal capital structure minimizes the WACC

b If the after-tax cost of equity financing exceeds the after-tax cost of

increasing the amount of debt in their capital structure

c Increasing the amount of debt in a firm’s capital structure is likely

to increase the costs of both debt and equity financing

d Statements a and c are correct

e Statements b and c are correct

a A firm can use retained earnings without paying a flotation cost.Therefore, while the cost of retained earnings is not zero, the cost ofretained earnings is generally lower than the after-tax cost of debtfinancing

b The capital structure that minimizes the firm’s weighted average cost

of capital is also the capital structure that maximizes the firm’sstock price

c The capital structure that minimizes the firm’s weighted average cost

of capital is also the capital structure that maximizes the firm’searnings per share

d If a firm finds that the cost of debt financing is currently less thanthe cost of equity financing, an increase in its debt ratio will alwaysreduce its weighted average cost of capital

e Statements a and b are correct

Miscellaneous capital structure concepts Answer: a Diff: M

a In general, a firm with low operating leverage has a small proportion

of its total costs in the form of fixed costs

b An increase in the personal tax rate would not affect firms’ capitalstructure decisions

c A firm with high business risk is more likely to increase its use offinancial leverage than a firm with low business risk, assuming allelse equal

d Statements a and b are correct

e All of the statements above are correct

Miscellaneous capital structure concepts Answer: c Diff: M

a “Business risk” is differentiated from “financial risk” by the factthat financial risk reflects only the use of debt, while business riskreflects both the use of debt and such factors as sales variability,cost variability, and operating leverage

b If corporate tax rates were decreased while other things were heldconstant, and if the Modigliani-Miller tax-adjusted tradeoff theory ofcapital structure were correct, this would tend to cause corporations

to increase their use of debt

c If corporate tax rates were decreased while other things were heldconstant, and if the Modigliani-Miller tax-adjusted tradeoff theory ofcapital structure were correct, this would tend to cause corporations

to decrease their use of debt

(1) maximizes the price of the firm’s stock, (2) minimizes its WACC,and (3) maximizes its EPS

e None of the statements above is correct

Tough:

a Generally, debt to total assets ratios do not vary much among differentindustries although they do vary for firms within a particular industry

b Utilities generally have very high common equity ratios due to theirneed for vast amounts of equity-supported capital

c The drug industry has a high debt to common equity ratio because theirearnings are very stable and thus, can support the large interest costsassociated with higher debt levels

d Wide variations in capital structures exist between industries and alsobetween individual firms within industries and are influenced by uniquefirm factors including managerial attitudes

e Since most stocks sell at or around their book values, using accountingvalues provides an accurate picture of a firm’s capital structure

Multiple Choice: Problems

Easy:

will equal 40 percent of sales, while fixed costs will total $110,000 Atwhat price must each widget be sold for the company to achieve an EBIT of

$2.00, what price must the division charge in order to break even?

16.67 percent Sales are currently $750,000, and the total assets turnover

debt ratio?

a 100% equity

b 100% debt

c 20 percent debt, 80 percent equity

d 40 percent debt, 60 percent equity

e 50 percent debt, 50 percent equity

Net operating income Answer: b Diff: M

would use a less expensive machine (fixed cost = $5,000), but it would

price per deck of cards will be the same under each method, at what level

of output will the two methods produce the same net operating income?

expansion projects it considers Currently, the firm’s plastic bag businesssegment has fixed costs of $120,000, while its unit price per carton is

bag machine and an automatic carton folder as modifications to its existing

Hensley can lower its wholesale price to its distributors to $1.05 percarton (that is, its selling price), and this would likely more than double

change in the breakeven volume with the proposed project?

$7.00 per unit; its variable cost is $4.20 per unit; and fixed costs are

which would increase its fixed costs to $650,000 and would increase its

expects to sell 270,000 units at $7.00 per unit By how much will Martin’sbreakeven sales dollar level change?

Breakeven Answer: d Diff: M

royalties are reduced and sales remain constant; how much more money canthe publisher put into advertising (a fixed cost) and still break even?

by cutting its unit price from $2.15 to $1.95, but variable cost per unit

a No, EBIT decreases by $6,000

b No, EBIT decreases by $250

c Yes, EBIT increases by $11,500

d Yes, EBIT increases by $8,050

e Yes, EBIT increases by $5,050

company’s interest expense will be $50,000

Assume that the recapitalization has no effect on the company’s price

following the recapitalization?

Capital structure and stock price Answer: e Diff: M

Publishing:

The company has no growth opportunities (g = 0), so the company pays out

calculated by simply dividing earnings per share by the required return onequity capital, which currently equals the WACC because the company has nodebt

The consultant believes that the company would be much better off if itwere to change its capital structure to 40 percent debt and 60 percent

that the company could issue $1,200 million of debt at a before-tax cost of

7 percent, leaving the company with interest expense of $84 million The

$1,200 million raised from the debt issue would be used to repurchase stock

however, after the repurchase, the cost of equity will increase to 11

estimated stock price after the capital structure change?

Hamada equation and cost of equity Answer: a Diff: T

Right now, Simon has a capital structure that consists of 20 percent debt

percent and the market risk premium, kM – kRF, is 5 percent Currently thecompany’s cost of equity, which is based on the CAPM, is 12 percent and its

it were to change its capital structure to 50 percent debt and 50 percentequity?

Optimal capital structure and Hamada equation Answer: d Diff: T

company’s capital structure consists of debt and common stock In order toestimate the cost of debt, the company has produced the following table:

Debt-to-total- Equity-to-total- Debt-to-equity Bond Before-taxassets ratio (wd) assets ratio (wc) ratio (D/E) rating cost of debt

The company’s tax rate, T, is 40 percent

The company uses the CAPM to estimate its cost of common equity, ks Therisk-free rate is 5 percent and the market risk premium is 6 percent

“unlevered beta,” bU, equals 1.0.)

On the basis of this information, what is the company’s optimal capitalstructure, and what is the firm’s weighted average cost of capital (WACC)

at this optimal capital structure?

company retains 30 percent of its earnings to fund future growth ZPC’sexpected EPS (EPS1) and ks for various capital structures are given below.What is the optimal capital structure for ZPC?

Capital structure and stock price Answer: b Diff: T

Co.? (Assume that the company’s growth rate is 2 percent.)

company’s EBIT is $2,000,000, and EBIT is expected to remain constant over

percent

The company is considering issuing $2 million worth of bonds (at par) and

the economy is 6.6 percent, and the market risk premium is 6 percent.The company’s beta is currently 0.9, but its investment bankers estimatethat the company’s beta would rise to 1.1 if it proceeds with therecapitalization

Assume that the shares are repurchased at a price equal to the stock market

price following the recapitalization?

Capital structure and stock price Answer: a Diff: T

year based on the company’s current capitalization:

The company has $20 million worth of debt outstanding and all of its debt

price earnings (P/E) ratio has traditionally been 12, so the companyforecasts that under the current capitalization its stock price will be

$43.20 at year end

10 percent to repurchase 1 million shares of common stock Assume that thestock can be repurchased at today’s $40 stock price

Assume that the repurchase will have no effect on the company’s operatingincome; however, the repurchase will increase the company’s dollar interestexpense Also, assume that as a result of the increased financial risk thecompany’s price earnings (P/E) ratio will be 11.5 after the repurchase.Given these assumptions, what would be the expected year-end stock price ifthe company proceeded with the recapitalization?

$2,000,000, and EBIT is expected to remain constant over time The companypays out all of its earnings each year, so its earnings per share equalsits dividends per share The firm’s tax rate is 30 percent

The company is considering issuing $800,000 worth of bonds and using the

currently 1.0, but its investment bankers estimate that the company’s betawould rise to 1.2 if it proceeded with the recapitalization What would bethe company’s stock price following the repurchase transaction?

a $106.67

b $102.63

c $ 77.14

d $ 74.67

Capital structure and EPS Answer: d Diff: T

recapitalization, where it will issue $10 million worth of debt at a yield

to maturity of 10 percent and use the proceeds to repurchase common stock.Assume the stock price remains unchanged by the transaction, and the

share, if it proceeds with the recapitalization?

following characteristics

The firm will have total assets of $500,000, a tax rate of 40 percent, and

a book value per share of $10, regardless of the capital structure EBIT is

earnings per share (EPS) between the two alternatives?

Capital structure, leverage, and WACC Answer: d Diff: T N

plan the company would increase its debt by $2 million and use the proceeds

estimates that if it goes ahead with the plan, its bonds will have a nominal

The risk-free rate is 6 percent and the market risk premium is 7 percent.What is the company’s estimated WACC if it goes ahead with the plan?

c 12.27%

Multiple Part:

(The following information applies to the next four problems.)

Copybold Corporation is a start-up firm considering two alternative capitalstructures, one is conservative and the other aggressive The conservativecapital structure calls for a D/A ratio = 0.25, while the aggressive strategycalls for D/A = 0.75 Once the firm selects its target capital structure, itenvisions two possible scenarios for its operations: Feast or Famine The Feastscenario has a 60 percent probability of occurring and forecasted EBIT in thisstate is $60,000 The Famine state has a 40 percent chance of occurring andexpected EBIT is $20,000 Further, if the firm selects the conservative capitalstructure its cost of debt will be 10 percent, while with the aggressive capitalstructure its debt cost will be 12 percent The firm will have $400,000 in totalassets, it will face a 40 percent marginal tax rate, and the book value of equityper share under either scenario is $10.00 per share

the aggressive capital structure?

the conservative capital structure?

Capital structure and CV of EPS Answer: a Diff: M

(The following information applies to the next three problems.)

Currently, the Fotopoulos Corporation’s balance sheet is as follows:

The book value of the company (both debt and common equity) equals its marketvalue (both debt and common equity) Furthermore, the company has determined thefollowing information:

 The market risk premium, kM – kRF, is 6 percent.

In addition, the Fotopoulos Corporation is considering a recapitalization.The proposed plan is to issue $1 billion worth of debt and to use the money to

recapitalization, the firm’s size will not change

Hamada equation and unlevered beta Answer: c Diff: E N

Hamada equation and cost of common equity Answer: e Diff: M N

out to 4 decimal places.)

(The following information applies to the next two problems.)

An analyst has collected the following information regarding the MilbrettCorporation:

Currently, the company has no debt or preferred stock and its interest expense

common stock, and its stock price is $20 a share

Milbrett is considering a recapitalization, where they will issue $20 million ofdebt and use the proceeds to buy back common stock at the current price of $20 a

8 percent Assume that the recapitalization will have no effect on the company’sbasic earning power

Capital structure, financial leverage, and ratios Answer: d Diff: E N

a The company’s net income will increase

b The company’s ROA will increase

c The company’s operating income will decrease

d The company’s ROE will increase

e None of the statements above is correct

share following the recapitalization?

(The following information applies to the next two problems.)

Financial analysts for Naulls Industries have revealed the following informationabout the company:

percent common equity and 25 percent debt

 The risk-free rate, kRF, is 5 percent.

 The market risk premium , kM - kRF, is 6 percent.

and a face value of $1,000 The bonds sell today for $1,200

 The company’s tax rate is 40 percent.

Hamada equation and unlevered beta Answer: c Diff: E N

Hamada equation and cost of common equity Answer: c Diff: M N

it were to change its capital structure to 40 percent debt and 60 percent

equity, not the WACC!)

(The following information applies to the next four problems.)

the company’s before-tax cost of debt is 8 percent The risk-free rate (kRF) is

5 percent and the market risk premium (kM – kRF) is also 5 percent At the firm’scurrent capital structure, the company’s beta is 1.15 (i.e., its current cost of

its interest expense is $80,000, and its tax rate is 40 percent The company has80,000 outstanding shares of common stock The company’s net income is currently

$132,000, and its earnings per share (EPS) is $1.65 The company pays out all of

follows that the company’s stock price is currently $15.3488 ($1.65/0.1075)

Capital structure, leverage, and WACC Answer: c Diff: E N

Hamada equation and unlevered beta Answer: b Diff: M N

Hamada equation and cost of common equity Answer: d Diff: M N

the firm is considering a capital structure that consists of 50 percent

company would issue additional debt and use the proceeds to repurchase

change would have no effect on the company’s total assets, operating

$16 a share, which is slightly above the current stock price of $15.3488.What would be the company’s new cost of common equity if it adopts acapital structure that consists of 50 percent debt and 50 percent commonequity?

Capital structure, leverage, and EPS Answer: c Diff: M N

structure with 50 percent debt and 50 percent common equity?

Web Appendix 13A Multiple Choice: Conceptual

Easy:

13A-1 Which of the following statements is most correct?

constant) will reduce the company’s degree of operating leverage

b An increase in interest expense will reduce the company’s degree offinancial leverage

c If the company has no debt outstanding, then its degree of totalleverage equals its degree of operating leverage

d Answers a and b are correct

e Answers b and c are correct

Medium:

13A-2 The use of financial leverage by the firm has a potential impact on which

of the following?

(1) The risk associated with the firm

(2) The return experienced by the shareholder

(3) The variability of net income

13A-3 If a firm uses debt financing (Debt ratio = 0.40) and sales change from

the current level, which of the following statements is most correct?

a The percentage change in net operating income (EBIT) resulting fromthe change in sales will exceed the percentage change in net income(NI)

b The percentage change in EBIT will equal the percentage change in netincome

c The percentage change in net income relative to the percentage change

in sales (and in EBIT) will not depend on the interest rate paid onthe debt

d The percentage change in net operating income will be less than thepercentage change in net income

e Since debt is used, the degree of operating leverage must be greater

Financial risk Answer: b Diff: M

13A-4 Which of the following statements is most correct?

a Suppose Company A's EPS is expected to experience a larger percentagechange in response to a given percentage change in sales than Company

more business risk than Company B

b Statement a would be correct if the term “EBIT” were substituted for

e The statements above are false

13A-5 Which of the following statements is most correct?

a The degree of operating leverage (DOL) depends on a company's fixed

fixed costs are constant and (2) that variable costs are a constantproportion of sales

b The degree of total leverage (DTL) is equal to the DOL plus the degree

of financial leverage (DFL)

c Arithmetically, financial leverage and operating leverage offset one

Therefore, the formula shows that the greater the degree of financialleverage, the smaller the degree of operating leverage

d The statements above are true

e The statements above are false

13A-6 Which of the following statements is most correct?

a All else being equal, an increase in a firm's fixed costs willincrease its degree of operating leverage

b Firms that have large fixed costs and low variable costs have a higherdegree of financial leverage than do firms with low fixed costs andhigh variable costs

c If a firm's net income rises 10 percent every time its EBIT rises 10percent, this implies the firm has no debt outstanding

d None of the statements above is correct

e Answers a and c are correct

DOL Answer: c Diff: M

characteristics?

a The closer the firm is operating to breakeven quantity, the smallerthe 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, otherthings held constant

c The DOL is not a fixed number for a given firm, but will depend uponthe 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 netoperating income

e If the firm has no debt, the DOL will equal 1

13A-8 Company D has a 50 percent debt ratio, whereas Company E has no debt

d Answers a and c are correct

e None of the answers above is correct

13A-9 Which of the following is a key benefit of using the degree of leverage

concept in financial analysis?

a It allows decision makers a relatively clear assessment of theconsequences of alternative actions

b It establishes the optimal capital structure for the firm

c It shows how a given change in leverage will affect sales

d All of the statements above

e Only statements a and c above are correct