Chap005 - Chapter 05 Operating and Financial Leverage...

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Chapter 05: Operating and Financial Leverage Chapter 5 Operating and Financial Leverage Discussion Questions 5-1. Discuss the various uses for break-even analysis. Such analysis allows the firm to determine at what level of operations it will break even (earn zero profit) and to explore the relationship between volume, costs, and profits. 5-2. What factors would cause a difference in the use of financial leverage for a utility company and an automobile company? A utility is in a stable, predictable industry and therefore can afford to use more financial leverage than an automobile company, which is generally subject to the influences of the business cycle. An automobile manufacturer may not be able to service a large amount of debt when there is a downturn in the economy. 5-3. Explain how the break-even point and operating leverage are affected by the choice of manufacturing facilities (labor intensive versus capital intensive). A labor-intensive company will have low fixed costs and a correspondingly low break-even point. However, the impact of operating leverage on the firm is small and there will be little magnification of profits as volume increases. A capital-intensive firm, on the other hand, will have a higher break-even point and enjoy the positive influences of operating leverage as volume increases. 5-4. What role does depreciation play in break-even analysis based on accounting flows? Based on cash flows? Which perspective is longer term in nature? For break-even analysis based on accounting flows, depreciation is considered part of fixed costs. For cash flow purposes, it is eliminated from fixed costs. The accounting flows perspective is longer-term in nature because we must consider the problems of equipment replacement. 5-1
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Chapter 05: Operating and Financial Leverage 5-5. What does risk taking have to do with the use of operating and financial leverage? Both operating and financial leverage imply that the firm will employ a heavy component of fixed cost resources. This is inherently risky because the obligation to make payments remains regardless of the condition of the company or the economy. 5-6. Discuss the limitations of financial leverage. Debt can only be used up to a point. Beyond that, financial leverage tends to increase the overall costs of financing to the firm as well as encourage creditors to place restrictions on the firm. The limitations of using financial leverage tend to be greatest in industries that are highly cyclical in nature. 5-7. How does the interest rate on new debt influence the use of financial leverage? The higher the interest rate on new debt, the less attractive financial leverage is to the firm. 5-8. Explain how combined leverage brings together operating income and earnings per share.
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This note was uploaded on 01/31/2012 for the course FINC 3343 taught by Professor Terry during the Spring '11 term at University of Arkansas at Little Rock.

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Chap005 - Chapter 05 Operating and Financial Leverage...

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