1. "Degree of Operating Leverage" (DOL) measures the sensitivity of:
EBIT to changes in Sales.
EPS to changes in EBIT.
Sales to changes in Debt.
EBIT to changes in Interest.
Explanation:
DOL measures how much Operating Profit (EBIT) changes for a 1% change in Sales. It reflects business risk arising from fixed operating costs. (DFL measures EPS sensitivity to EBIT).
2. Combined Leverage measures the total risk of the firm and is calculated as:
DOL + DFL
DOL - DFL
DOL / DFL
DOL × DFL
Explanation:
Combined Leverage = Degree of Operating Leverage × Degree of Financial Leverage. It measures the sensitivity of EPS to changes in Sales.
3. A firm with high Operating Leverage and high Financial Leverage is considered:
Moderate Risk.
Low Risk.
Very High Risk.
Risk Free.
Explanation:
High operating leverage means high fixed costs. High financial leverage means high debt/interest. A small drop in sales can lead to massive losses or bankruptcy.
4. At the "Financial Break-even Point", the Earnings Per Share (EPS) is:
Zero.
Equal to Dividend.
Negative.
Maximum.
Explanation:
Financial Break-even Point is the level of EBIT at which EPS is zero. It is the point where operating profit is just enough to cover fixed financial charges (Interest + Preference Dividend).
5. If EBIT is equal to the Indifference Point level:
Market price will be maximum.
Interest will be zero.
EPS will be zero.
EPS will be the same for leveraged and unleveraged plans.
Explanation:
The indifference point is specifically calculated to find the EBIT level where the EPS outcome is identical regardless of the financing option chosen.
6. Degree of Financial Leverage (DFL) is calculated as:
EBIT / EBT
Contribution / EBIT
EBT / EBIT
Sales / Fixed Cost
Explanation:
DFL measures the impact of interest (fixed financial cost). It is Operating Profit (EBIT) divided by Profit Before Tax (EBT). DFL = EBIT / (EBIT - Interest).
7. Calculate the Degree of Financial Leverage (DFL) if EBIT is ?1,00,000, Interest is ?20,000, and Tax rate is 30%.
Explanation:
DFL = EBIT / (EBIT - Interest). DFL = 1,00,000 / (1,00,000 - 20,000) = 1,00,000 / 80,000 = 1.25. Tax rate is irrelevant for DFL calculation (unless Preference Dividend exists).
8. Financial Leverage is considered "Unfavorable" when:
Debt = Equity
EBIT is high
ROI > Cost of Debt
ROI < Cost of Debt
Explanation:
If the firm earns less on its assets (ROI) than the interest it pays on debt, using debt reduces the return to shareholders (Negative Leverage).
9. If a firm has ZERO fixed operating costs, its Degree of Operating Leverage (DOL) will be:
Explanation:
DOL = Contribution / EBIT. If Fixed Cost is 0, then Contribution = EBIT. So, DOL = Contribution / Contribution = 1. This implies no operating leverage (1% change in sales = 1% change in EBIT).