The use of debt in the capital structure of a firm
Answer (A) is correct. Financial leverage is the use of fixed costs in a firmís capital structure indicated by high interest payments on debt. These increased fixed costs (and accompanying lowered variable costs) make profitable periods more profitable and unprofitable periods worse.
A financial analyst with Mineral, Inc., calculated the companyís degree of financial leverage as 1.5. If income before interest increases by 5%, earnings to shareholders will increase by
Answer (D) is correct. The degree of financial leverage (DFL) is the multiple of operating income (or earnings before interest and taxes, called EBIT) over earnings before taxes (EBT). A high multiple indicates heavy use of fixed costs in the firmís capital structure revealed by high interest payments on debt This firmís EBIT is 1.5 times EBT.
Thus, a given percentage change in EBIT will result in a change one-and-a-half times as great in EBT (1.5 ◊ 5% = 7.5%).
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?
Answer (A) is correct. Debt financing increases a firmís financial leverage that is the high fixed charges that accompany the legal obligation to pay interest to debtholders makes the firm riskier. These high fixed costs make profitable periods more profitable and unprofitable periods worse. Thus, a given decrease in EBIT will result in a proportionally larger decrease in EPS.
Since incorporating 3 years ago, Lawrence, Inc., has estimated bad debts at a rate of 3% using the income statement approach. During its fourth year in business, after recording the uncollectible accounts expense based on its previous estimate, Lawrence determined that its estimate of bad debts should be increased to 4.5%. During this fourth year, Lawrence recorded sales of $25,000,000 and had an ending accounts receivable balance of $2,000,000. This change would decrease
Answer (C) is correct. Lawrence increased its bad debt expense by 1.5% for the current year. This increase would cause a decrease in income of $375,0000 [25,000,000 ◊ (4.5% Ė 3%)]. Because Lawrence used the income statement approach of calculating bad debts, the accounts receivable balance of $2,000,000 is irrelevant. This decrease in income will cause both the numerator (contribution margin) and the denominator (operating income) of the firmís operating leverage to decrease by a proportional amount. However, this proportional decrease will cause the overall leverage to increase.
Which of the following costs, when subtracted from total revenue, yields economic profit?
Economic profit is calculated as follows:
Revenue ? Explicit Costs ? Implicit Costs = Economic ProfitImplicit costs are the opportunity costs of the
assets that are used in the operation of the business. Of the choices presented, this is the best choice.
All of the following are affected when merchandise is purchased on credit except
Net working capital is total current assets minus total current liabilities. When merchandise is purchased
on credit, inventory and accounts payable increase by the same amount. The difference between the two will
be unchanged by the equal increases.
On December 31, year 2, Northpark Co. collected a receivable
due from a major customer. Which of the following ratios
would be increased by this transaction?
(b) Collection of a receivable results in an increase in
cash and a decrease in the accounts receivable balance. The accounts
receivable turnover ratio is computed by dividing net
credit sales by the average net accounts receivable balance. Collection
of a receivable reduces the average net accounts receivable
balance. Thus the receivable turnover ratio increases. Since
this transaction does not affect cost of goods sold or inventory,
the inventory turnover ratio is unaffected. Neither the current
ratio nor the quick ratio is affected by the collection; neither
current assets nor quick assets would change as a result of the