Question 1

Financial leverage results from the use of a source of funds for

which the firm:

pays a variable return on each dollar amount

raised.

earns a higher rate of return from its use than its

cost.

pays a fixed percentage of revenue.

pays a fixed percentage of income.

You Answered Correctly!

Financial leverage results from financing asset acquisitions by

borrowing at a rate that is less than the rate that the firm can earn on
its investments. It is sometimes referred to as “trading on the equity.”

Question 2

Nelson Industries increased earnings before interest and taxes by

17%. During the same period, net income after tax increased by
42%. The degree of financial leverage (DFL) that existed during the
year is:

2.47.

0.40.

0.07.

0.25.

You Answered Correctly!

The DFL is defined as the percent change in net income after tax
given a percent change in operating income (earnings before
interest and taxes, or EBIT).
Nelson's degree of financial leverage is calculated as:

DFL = (% change in net income after tax) ÷ (% change in operating

income, or EBIT)

Nelson's DFL = (42%) ÷ (17%) = 2.47.

Question 3

Assume the following information for Ramer Company, Matson

Company and for their common industry for a recent year:

The attitudes of both Ramer and Matson concerning risk

are best explained by the:

debt/equity ratio and times interest earned.

current ratio and earnings per share.

return on investment and dividend payout ratio.

current ratio, accounts receivable turnover, and inventory

turnover.

You Answered Correctly!

Risk is a function of financial leverage. Financial leverage is

measured by the debt/equity ratio and the number of times interest
is earned (interest coverage).

Question 4
Given no other changes, which of the following actions would
effectively increase a firm's financial leverage index?

The firm issues new common stock and retires some of its long-term debt.

The firm purchases new long-term assets and pays for the purchase with
long-term debt.

The firm reduces operating expenses by cutting employee benefits.

The firm refinances its existing long-term debt at a lower interest rate.

You Answered Correctly!

A measure of financial leverage is the ratio of total assets to

common shareholders' equity. Common shareholders' equity is
calculated by taking total assets less total liabilities.

The purchase of assets by debt financing will increase total assets

and total liabilities without affecting common shareholders' equity.
Therefore, the financial leverage ratio of total assets to common
shareholders' equity will increase.

Question 5

The two financial statements that are most important for assessing a
firm's liquidity are the:

balance sheet and retained earnings

statement.

income statement and statement of cash

flows.

income statement and balance sheet.

balance sheet and statement of cash flows.

You Answered Correctly!

Liquidity is typically measured by cash flow from operations in the
statement of cash flows, by the current and quick ratios taken from
the balance sheet, and by the operating cash flow to current
liabilities ratio which uses both statements. The current ratio equals
current assets divided by current liabilities. The quick ratio (acid test)
equals the “quick” assets divided by the current liabilities. The
“quick” assets are cash, cash equivalents, short-term investments,
and receivables.

Question 6

A summary of the Income Statement of Sahara Company is shown

below.

Based on the above information, Sahara's degree of financial

leverage (DFL) is:

0.73.

2.27.

1.36.

2.73.

You Answered Correctly!

The DFL is calculated as:

DFL = EBIT ÷ EBT

Operating income = sales − cost of sales − operating expenses

Operating income = $15,000,000 − $9,000,000 − $3,000,000 =

$3,000,000

Earnings before tax (EBT) = operating income − interest expense

EBT = $3,000,000 − $800,000 = $2,200,000

DFL = $3,000,000 ÷ $2,200,000 = 1.36

(Note: Neither a preferred stock dividend nor tax rates are

mentioned in the problem, so they cannot be factored into the
solution.)

Question 7

A degree of operating leverage (DOL) of 3 at 5,000 units means that

a:

1% change in earnings before interest and taxes will cause a 3% change

in sales.

3% change in sales will cause a 3% change in earnings before interest

and taxes.

1% change in sales will cause a 3% change in earnings before interest

and taxes.

3% change in earnings before interest and taxes will cause a 3% change

in sales.

You Answered Correctly!

The DOL is calculated as the percent change in operating income

(also called earnings before interest and taxes, or EBIT) divided by
the percent change in sales.

DOL = (% change in EBIT) ÷ (% change in sales)

DOL is given as 3. DOL is used to gauge the expected change in
EBIT as a result of a change in sales. Given a DOL of 3, a 1%
change in sales will result in a 3% (DOL of 3 multiplied by 1%
change in sales) change in EBIT.

Question 8

A financial analyst with Mineral Inc. calculated the company's

degree of financial leverage (DFL) as 1.5. If net income before
interest increases by 5%, earnings to shareholders will increase by:

3.33%.

1.50%.

7.50%.

5.00%.

You Answered Correctly!

The DFL is calculated by taking the percent change in earnings

before interest and taxes (EBIT) divided by the percent change in
earnings to shareholders.

DFL is given as 1.5. DFL measures how an increase in EBIT will

affect earnings to shareholders. Therefore, a 5% increase in EBIT
will cause a 7.5% (1.5 × 5%) increase in earnings to shareholders.

Question 9

Marble Savings Bank has received loan applications from three

companies in the auto parts manufacturing business and currently
has the funds to grant only one of these requests. Specific data,
shown below, has been selected from these applications for review
and comparison with industry averages.
Based on the information above, select the strategy that should be
the most beneficial to Marble Savings.

Grant the loan to Bailey as all the company's data approximate the industry average.

Marble Savings Bank should not grant any loans as none of these companies
represents a good credit risk.

Grant the loan to Nutron as both the debt/equity (D/E) ratio and degree of financial
leverage (DFL) are below the industry average.

Grant the loan to Sonex as the company has the highest net profit margin and degree
of financial leverage.

You Answered Correctly!

The D/E ratio and the DFL both measure an organization's risk. The
lower the debt/equity ratio, the lower the risk. Similarly, the lower the
degree of financial leverage, the lower the risk. In the case of Nutron,
both the D/E ratio and DFL measures are below the industry
averages. Therefore, it is the least risky of the three choices.

Question 10

Grand Savings Bank has received loan applications from three

companies in the plastics manufacturing business and currently has
the funds to grant only one of these requests. Specific data, shown
below, has been selected from these applications for review and
comparison with industry averages.
Based on the information above, select the strategy that should be
the most beneficial to Grand Savings.

Grand should not grant any loans as none of these companies represents a good
credit risk.

Grant the loan to Springfield as all the company's data approximate the industry
average.

Grant the loan to Reston as both the debt/equity (D/E) ratio and degree of financial
leverage (DFL) are below the industry average.

Grant the loan to Valley as the company has the highest net profit margin and degree
of financial leverage.

You Answered Correctly!

The D/E ratio and the DFL both measure an organization's risk. The
lower the D/E ratio, the lower the risk. Similarly, the lower the DFL,
the lower the risk. In the case of Reston, both the D/E ratio and DFL
measures are below the industry averages. Therefore, it is the least
risky of the three choices.

Question 11

Borglum Corporation is considering the acquisition of one of its parts

suppliers and has been reviewing the pertinent financial statements.
Specific data, shown below, has been selected from these
statements for review and comparison with industry averages.
Borglum's objective for this acquisition is assuring a steady source
of supply from a stable company. Based on the information above,
select the strategy that would fulfill Borglum's objective.

Borglum should not acquire any of these firms as none of them represents a good
risk.

Acquire Western as the company has the highest net profit margin and degree of
financial leverage.

Acquire Rockland as both the debt/equity (D/E) ratio and degree of financial leverage
(DFL) are below the industry average.

Acquire Bond as both the debt/equity ratio and degree of financial leverage exceed
the industry average.

You Answered Correctly!

The D/E ratio and the DFL leverage both measure an organization's
risk. The lower the D/E ratio, the lower the risk. Similarly, the lower
the DFL, the lower the risk. In the case of Rockland, both the D/E
ratio and DFL least risky of the three choices.

Question 12

Easton Bank has received loan applications from three companies

in the computer service business and will grant a loan to the
company with the best prospect of fulfilling the loan obligations.
Specific data, shown below, has been selected from these
applications for review and comparison with industry averages.
Based on the information above, select the strategy that would fulfill
Easton's objective.

Grant the loan to SysGen as the company has the highest net profit margin and
degree of financial leverage.

Easton should not grant any loans as none of these companies represents a good
credit risk.

Grant the loan to CompGo as all the company's data approximate the industry
average.

Grant the loan to Astor as both the debt/equity (D/E) ratio and degree of financial
leverage (DFL) are below the industry average.

You Answered Correctly!

The D/E ratio and the DFL both measure an organization's risk. The
lower the D/E ratio, the lower the risk. Similarly, the lower the DFL,
the lower the risk. In the case of Astor, both the D/E ratio and DFL
measures are below the industry averages. Therefore, it is the least
risky of the three choices.

Question 13

The capital structure of four corporations is as follows.

Which corporation is the most highly leveraged?

Pane.

Warwick.

Cooper.

Sterling.

You Answered Correctly!

Leverage involves the use of non-common stock equity to enhance

the return on common stock equity. The most highly leveraged firm
would be the one with the lowest percent of common equity in its
capital structure. Sterling has the lowest percent of common equity
in its capital structure.

Question 14

Douglas Company purchased 10,000 shares of its common stock at

the beginning of the year for cash. This transaction will affect all of
the following except the:

*Source: Retired ICMA CMA Exam Questions.

net profit margin.

earnings per
share.

current ratio.

debt-to-equity
 ratio.

You Answered Correctly!

Douglas Company purchasing 10,000 shares of its common stock

has no effect on net profit margin (net income divided by net sales).
First, this transaction would decrease equity, as treasury stock has a
debit balance, offsetting the credit balance of equity, increasing the
debt to equity ratio. Second, this transaction would reduce cash,
decreasing the current ratio. Third, this transaction would decrease
the number of shares outstanding, increasing the earnings per
share.

Question 15

Pearl Manufacturing Company has sales of $1,000,000, variable

costs of $500,000, and fixed costs of $250,000. In addition, Pearl
has interest payments of $50,000, common stock dividends of
$60,000, and faces an effective tax rate of 40%. What is the Degree
of Financial Leverage (DFL)?

1.25.

2.5.

0.8.

2.0.

You Answered Correctly!

The Degree of Financial Leverage is computed as follows: DFL =

EBIT ÷ EBT. Placing the numbers into the formula, DFL =
$(1,000,000 − $500,000 − $250,000) ÷ $(1,000.000 − $500,000 −
$250,000 − $50,000), which equals 1.25. A DFL of 1.25 implies that
every 1% of increase in operating income will result in a 1.25%
increase in Earnings Per Share.
Question 16

Pearl Manufacturing Company has sales of $1,000,000, variable

costs of $500,000, and fixed costs of $250,000. What is the Degree
of Operating Leverage?

2.

1.5.

1.

0.5.

You Answered Correctly!

Business risk is often measured by the degree of operating leverage.

The formula to calculate degree of operating leverage is DOL =
Contribution Margin ÷ Operating Income. Therefore, DOL =
($1,000,000 − $500,000) ÷ ($1,000,000 − $500,000 − $250,000) = 2.

Question 17

In which one of the following circumstances would operating

leverage be likely to increase?

Firm purchases assets with debt.

Firm accepts a large order from a new customer. Excess capacity exists to fill
the order.

Firm issues bonds to repurchase some of its own common stock.

Firm signs a contract to rent a new manufacturing site.

You Answered Correctly!

Operating leverage relates to the fixed operating costs of a firm. Of

the choices given, the rental of a new manufacturing site is the only
one that will increase fixed operating costs.
Question 18

In which of the following circumstances would financial leverage be

likely to increase?

Firm issues bonds to repurchase some of its own common stock.

Firm purchases assets with cash.

Firm signs a contract to rent a new manufacturing site.

Firm accepts a large order from a new customer. Excess capacity exists to fill
the order.

You Answered Correctly!

Financial leverage relates to the fixed financing costs of a firm. Of

the choices given, issuing new bonds is the only one that affects
fixed financing costs.

Question 19

LMN Corporation has return on common equity of 7% and return on

total assets of 10%. Which of the following statements is true?

The financial leverage index is 1.43, which is considered a

good value.

The financial leverage index is 1.43, which is considered a poor

value.

The financial leverage index is 0.7, which is considered a good

value.

The financial leverage index is 0.7, which is considered a poor

value.

You Answered Correctly!

The formula for the financial leverage index is return on common

equity divided by return on total assets. The financial leverage index
for LMN Corporation is 0.7 (7% ÷ 10%). Any value above 1 is
considered good; an index value below 1 is considered poor.

Question 20

Assume that you examine the following selected ratios for JoJo. Inc.

Which of the following statements best describes an analysis of

JoJo's ratios?

JoJo has excessive debt and manages that debt poorly; therefore, managers should
attempt to reduce debt usage.

JoJo has more debt than the industry average. While improvement is seen when
compared to prior years, JoJo should decrease debt usage further.

JoJo has improved in debt management; however, further reduction of debt is

needed.

JoJo has more debt than the industry; however, the times interest earned ratio
indicates that JoJo is capable of managing its debt.

You Answered Correctly!

Note that JoJo's debt ratio is indicating less reliance on debt but that
it has more debt than the industry. The times interest earned ratio,
however, is indicating that JoJo can pay its interest payment 17
times over (compared to only 15 in industry). The combination of
these two factors indicates that JoJo is managing its debt well, even
though the firm does have a little more debt than industry average.

Question 21

The use of debt in the capital structure of a firm:

*Source: Retired ICMA CMA Exam Questions.

increases its operating

leverage.

decreases its financial

leverage.

decreases its operating

leverage.

increases its financial

leverage.

You Answered Correctly!

Financial leverage is the use of debt (fixed cost funds) to increase

returns to owners (stockholders).

Question 22

Which one of the following statements concerning the effects of

leverage on earnings before interest and taxes (EBIT) and earnings
per share (EPS) is correct?

*Source: Retired ICMA CMA Exam Questions.

Financial leverage affects both EPS and EBIT, while operating leverage only effects
EBIT.

If Firm A has a higher degree of operating leverage than Firm B, and Firm A offsets
this by using less financial leverage, then both firms will have the same variability in
EBIT.

For a firm using debt financing, a decrease in EBIT will result in a proportionally larger
decrease in EPS.

A decrease in the financial leverage of a firm will increase the beta value of the firm.
You Answered Correctly!

Debt financing creates financial leverage (the percent change in

EPS given a percent change in EBIT) which is always greater than
one. Therefore, a change in EBIT causes a proportionally larger
change in EPS.

Question 23

Earnings power is:

the best possible estimate of the average business earnings over a number of years.

a forecasting tool that anticipates probable future conditions instead of making the
assumption of a continued trend.

a mathematical calculation based on past earnings that can absolutely predict future
earnings.

the company's ability to turn liabilities into income-generating activities.

You Answered Correctly!

Earnings power is defined as the best possible estimate of the

average business earnings that can be expected to be sustained in
the future for a number of years, preferably over an entire business
cycle. Earnings power is used as a forecasting tool but does not try
to anticipate probable future conditions other than a continued trend.