Chapter 11

Leverage and Capital Structure

 Learning Goals
1. Discuss leverage, capital structure, breakeven analysis, the operating breakeven point, and the effect
of changing costs on it.

2. Understand operating, financial, and total leverage and the relationships among them.

3. Describe the basic types of capital, external assessment of capital structure, the capital structure of
non-U.S. firms, and capital structure theory.

4. Explain the optimal capital structure using a graphical view of the firm’s cost-of-capital functions
and a zero-growth valuation model.

5. Discuss the EBIT-EPS approach to capital structure.

6. Review the return and risk of alternative capital structures, their linkage to market value, and other
important considerations related to capital structure.

 True/False
1. Generally, increases in leverage result in increased return and risk.
Answer: TRUE
Level of Difficulty: 1
Learning Goal: 1
Topic: Leverage

2. Breakeven analysis is used by the firm to determine the level of operations necessary to cover all
fixed operating costs and to evaluate the profitability associated with various levels of sales.
Answer: FALSE
Level of Difficulty: 1
Learning Goal: 1
Topic: Breakeven Analysis

3. The firm’s operating breakeven point is the level of sales necessary to cover all fixed operating
costs.
Answer: FALSE
Level of Difficulty: 1
Learning Goal: 1
Topic: Operating Breakeven Point
438 Gitman • Principles of Finance, Brief Fourth Edition

4. Leverage results from the use of fixed-cost assets or funds to magnify returns to the firm’s owners.
Answer: TRUE
Level of Difficulty: 1
Learning Goal: 1
Topic: Leverage

5. Operating leverage is concerned with the relationship between the firm’s sales revenue and its
operating expenses.
Answer: FALSE
Level of Difficulty: 1
Learning Goal: 1
Topic: Operating Leverage

6. Financial leverage is concerned with the relationship between the firm’s earnings after interest and
taxes and its common stock earnings per share.
Answer: FALSE
Level of Difficulty: 1
Learning Goal: 1
Topic: Financial Leverage

7. Total leverage is concerned with the relationship between the firm’s sales revenue and its common
stock earnings per share.
Answer: TRUE
Level of Difficulty: 1
Learning Goal: 1
Topic: Total Leverage

8. Firm’s capital structure is the mix of the short-term debt, long-term debt, and equity maintained by
the firm.
Answer: FALSE
Level of Difficulty: 1
Learning Goal: 1
Topic: Capital Structure

9. The levels of fixed-cost assets and funds that management selects affect the variability of returns.
Answer: TRUE
Level of Difficulty: 2
Learning Goal: 1
Topic: Total Leverage

10. The amount of leverage in the firm’s capital structure—the mix of long-term debt and equity
maintained by the firm—can significantly affect its value by affecting return and risk.
Answer: TRUE
Level of Difficulty: 2
Learning Goal: 1
Topic: Financial Leverage
 Chapter 11 Leverage and Capital Structure 439

11. Sales commission may be considered as a semivariable cost because it may be fixed for a certain
volume of sales and then increase to higher levels for higher volumes.
Answer: TRUE
Level of Difficulty: 2
Learning Goal: 1
Topic: Operating Leverage

12. At the operating breakeven point, the sales revenue is equal to the sum of the fixed and variable
operating costs.
Answer: TRUE
Level of Difficulty: 2
Learning Goal: 1
Topic: Operating Breakeven Point

13. Earnings before interest and taxes are positive above the operating breakeven point, and a loss
occurs below it.
Answer: TRUE
Level of Difficulty: 2
Learning Goal: 1
Topic: Operating Breakeven Point

14. For sales levels below the operating breakeven point, sales revenue exceeds total operating costs,
and earnings before interest and taxes is greater than zero.
Answer: FALSE
Level of Difficulty: 2
Learning Goal: 1
Topic: Operating Breakeven Point

15. An increase in cost (fixed cost or variable cost) tends to increase the operating breakeven point,
whereas an increase in the sales price per unit will decrease the operating breakeven point.
Answer: TRUE
Level of Difficulty: 3
Learning Goal: 1
Topic: Operating Breakeven Point

16. The contribution margin is defined as the percent of each sales dollar that remains after satisfying
fixed operating costs.
Answer: FALSE
Level of Difficulty: 4
Learning Goal: 1
Topic: Contribution Margin

17. Since the sales price per unit generally decreases with volume and the cost per unit generally
increases with volume, the true breakeven point may be different from those obtained using linear
revenue and cost functions as assumed in the breakeven analysis.
Answer: TRUE
Level of Difficulty: 4
Learning Goal: 1
Topic: Breakeven Analysis
440 Gitman • Principles of Finance, Brief Fourth Edition

18. One of the limitations of breakeven analysis is its short-term time horizon. A large outlay in the
current financial period could significantly raise the firm’s breakeven point, while the benefits may
occur over a period of years.
Answer: TRUE
Level of Difficulty: 4
Learning Goal: 1
Topic: Breakeven Analysis

19. Generally, increases in leverage result in increased return and risk, whereas decreases in leverage
result in decreased return and risk.
Answer: TRUE
Level of Difficulty: 1
Learning Goal: 2
Topic: Leverage

20. Total leverage can be defined as the potential use of fixed costs, both operating and financial, to
magnify the effect of changes in sales on the firm’s earnings per share.
Answer: TRUE
Level of Difficulty: 1
Learning Goal: 2
Topic: Total Leverage

21. The relationship between operating and financial leverage is additive rather than multiplicative.
Answer: FALSE
Level of Difficulty: 1
Learning Goal: 2
Topic: Total Leverage

22. Operating leverage results from the existence of operating costs in the firm’s income stream.
Answer: FALSE
Level of Difficulty: 1
Learning Goal: 2
Topic: Operating Leverage

23. The total leverage measures the combined effect of operating and financial leverage on the firm’s risk.
Answer: TRUE
Level of Difficulty: 1
Learning Goal: 2
Topic: Total Leverage

24. Operating leverage may be defined as the potential use of fixed operating costs to magnify the
effects of changes in sales on the firm’s earnings before interest and taxes (EBIT).
Answer: TRUE
Level of Difficulty: 2
Learning Goal: 2
Topic: Operating Leverage

25. Operating leverage is present when a firm has fixed operating cost.
Answer: TRUE
Level of Difficulty: 2
Learning Goal: 2
 Chapter 11 Leverage and Capital Structure 441

Topic: Operating Leverage

442 Gitman • Principles of Finance, Brief Fourth Edition

26. Financial leverage results from the presence of variable financial costs in the firm’s income stream.
Answer: FALSE
Level of Difficulty: 2
Learning Goal: 2
Topic: Financial Leverage

27. Financial leverage may be defined as the potential use of variable financial costs to magnify the
effects of changes in earnings before interest and taxes (EBIT) on the firm’s earnings per share
(EPS).
Answer: FALSE
Level of Difficulty: 2
Learning Goal: 2
Topic: Financial Leverage

28. Whenever the percentage change in earnings before interest and taxes resulting from a given
percentage change in sales is greater than the percentage change in sales, operating leverage exists.
Answer: TRUE
Level of Difficulty: 2
Learning Goal: 2
Topic: Operating Leverage

29. The effect of financial leverage is such that an increase in the firm’s earnings before interest and
taxes (EBIT) results in a more than proportional increase in the firm’s earnings per share (EPS),
while a decrease in the firm’s EBIT results in a less than proportional decrease in EPS.
Answer: FALSE
Level of Difficulty: 2
Learning Goal: 2
Topic: Financial Leverage

30. Whenever the percentage change in earnings per share (EPS) resulting from a given percentage
change in sales is greater than the percentage change in sales, financial leverage exists.
Answer: FALSE
Level of Difficulty: 2
Learning Goal: 2
Topic: Financial Leverage

31. Total leverage exists whenever the percentage change in earnings per share (EPS) resulting from a
given percentage change in sales is greater than the percentage change in sales.
Answer: TRUE
Level of Difficulty: 2
Learning Goal: 2
Topic: Total Leverage

32. When a firm has fixed operating costs, operating leverage is present. In that case, an increase in
sales results in a more-than-proportional increase in EBIT, and a decrease in sales results in a more-
than-proportional decrease in EBIT.
Answer: TRUE
Level of Difficulty: 2
Learning Goal: 2
Topic: Operating Leverage
 Chapter 11 Leverage and Capital Structure 443

33. Whenever the percentage change in EBIT resulting from a given percentage change in sales is
greater than the percentage change in sales, operating leverage exists.
Answer: TRUE
Level of Difficulty: 2
Learning Goal: 2
Topic: Operating Leverage

34. The closer the base sales level used is to the operating breakeven point, the smaller the operating
leverage.
Answer: FALSE
Level of Difficulty: 3
Learning Goal: 2
Topic: Operating Leverage

35. The base level of EBIT must be held constant to compare the financial leverage associated with
different levels of fixed financial costs.
Answer: TRUE
Level of Difficulty: 3
Learning Goal: 2
Topic: Financial Leverage

36. The base level of sales must be held constant to compare the total leverage associated with different
levels of fixed costs.
Answer: TRUE
Level of Difficulty: 3
Learning Goal: 2
Topic: Total Leverage

37. The degree of operating leverage will increase if a firm decides to compensate its sales
representatives with a fixed salary and bonus rather than with a pure percent-of-sales commission.
Answer: TRUE
Level of Difficulty: 3
Learning Goal: 2
Topic: Operating Leverage

38. Comparison of the degree of operating leverage of two firms is valid only when the base level of
sales used for each firm is the same.
Answer: TRUE
Level of Difficulty: 4
Learning Goal: 2
Topic: Operating Leverage

39. The degree of operating leverage depends on the base level of sales used as a point of reference. The
closer the base sales level used is to the operating breakeven point, the greater the operating
leverage.
Answer: TRUE
Level of Difficulty: 4
Learning Goal: 2
Topic: Operating Leverage
444 Gitman • Principles of Finance, Brief Fourth Edition

40. In general, the greater the firm’s operating leverage, the higher its business risk.
Answer: TRUE
Level of Difficulty: 1
Learning Goal: 3
Topic: Operating Leverage

41. The probability that a firm will become bankrupt is largely dependent on its level of both business
risk and financial risk.
Answer: TRUE
Level of Difficulty: 1
Learning Goal: 3
Topic: Business Risk and Financial Risk

42. The firm’s capital structure is the mix of short-term and long-term debt and equity maintained by the
firm.
Answer: FALSE
Level of Difficulty: 1
Learning Goal: 3
Topic: Capital Structure Basics

43. The firm’s capital structure can significantly affect the firm’s value by affecting its risk and return.
Answer: TRUE
Level of Difficulty: 1
Learning Goal: 3
Topic: Capital Structure Basics

44. All items on the right-hand side of the firm’s balance sheet, excluding current liabilities are called
capital.
Answer: TRUE
Level of Difficulty: 1
Learning Goal: 3
Topic: Capital Structure Basics

45. In general, low debt-payment ratios are associated with high degrees of financial leverage.
Answer: TRUE
Level of Difficulty: 2
Learning Goal: 3
Topic: Financial Leverage

46. The more fixed cost financing a firm has in its capital structure, the greater its financial leverage and
risk.
Answer: TRUE
Level of Difficulty: 2
Learning Goal: 3
Topic: Financial Leverage

47. Symmetric information results when managers of a firm have more information about operations
and future prospects than do investors.
Answer: TRUE
Level of Difficulty: 2
Learning Goal: 3
 Chapter 11 Leverage and Capital Structure 445

Topic: Asymmetric Information

446 Gitman • Principles of Finance, Brief Fourth Edition

48. In general, non-U.S. companies have much higher debt ratios than do their U.S. counterparts
because financial markets are much more developed in the United States than elsewhere and have
played a much greater role in corporate financing than has been the case in other countries.
Answer: TRUE
Level of Difficulty: 2
Learning Goal: 3
Topic: International Aspects of Capital Structure

49. Effective capital structure decisions can lower the cost of capital, resulting in higher NPVs and more
acceptable projects, thereby increasing the value of the firm.
Answer: TRUE
Level of Difficulty: 2
Learning Goal: 3
Topic: Capital Structure Basics

50. Pecking order is a hierarchy of financing beginning with retained earnings followed by debt
financing and finally external equity financing.
Answer: TRUE
Level of Difficulty: 2
Learning Goal: 3
Topic: Pecking Order Theory

51. The relative inexpensiveness of debt capital is due to the fact that the lenders take the least risk of
any long-term contributors of capital.
Answer: TRUE
Level of Difficulty: 2
Learning Goal: 3
Topic: Capital Structure Basics

52. Poor capital structure decisions can result in a high cost of capital, thereby making some
unacceptable investments acceptable.
Answer: FALSE
Level of Difficulty: 3
Learning Goal: 3
Topic: Capital Structure Basics

53. The debt capital has a lower risk because the lenders have a far stronger legal pressure against the
company to make payment than do preferred or common stockholders.
Answer: TRUE
Level of Difficulty: 3
Learning Goal: 3
Topic: Capital Structure Basics

54. Due to its secondary position relative to equity, suppliers of debt capital take greater risk and
therefore must be compensated with higher expected returns than suppliers of equity capital.
Answer: FALSE
Level of Difficulty: 3
Learning Goal: 3
Topic: Capital Structure Basics
 Chapter 11 Leverage and Capital Structure 447

55. In default, debtholders and preferred stockholders may receive a voice in management; otherwise,
only common stockholders have voting rights.
Answer: TRUE
Level of Difficulty: 3
Learning Goal: 3
Topic: Capital Structure Basics

56. A shift toward more fixed costs increases business risk, which in turn causes earnings before interest
and taxes to increase by less for a given increase in sales.
Answer: FALSE
Level of Difficulty: 4
Learning Goal: 3
Topic: Business Risk

57. When considering fixed operating cost increases, the financial manager must weigh the increased
financial risk associated with greater operating leverage against the expected increase in returns.
Answer: FALSE
Level of Difficulty: 4
Learning Goal: 3
Topic: Business Risk and Financial Risk

58. Business risk is the risk to the firm of being unable to cover operating costs.
Answer: TRUE
Level of Difficulty: 1
Learning Goal: 4
Topic: Business Risk

59. Minimizing the weighted average cost of capital allows management to undertake a larger number
of profitable projects, thereby further increasing the value of the firm.
Answer: TRUE
Level of Difficulty: 2
Learning Goal: 4
Topic: Optimal Capital Structure

60. Optimal capital structure is the capital structure at which the weighted average cost of capital is
minimized, thereby maximizing the firm’s value.
Answer: TRUE
Level of Difficulty: 2
Learning Goal: 4
Topic: Optimal Capital Structure

61. With increasing costs, especially fixed operating and financial cost—comes increasing risk, since
the firm will have to achieve a higher level of sales just to break even.
Answer: TRUE
Level of Difficulty: 3
Learning Goal: 4
Topic: Business Risk and Financial Risk
448 Gitman • Principles of Finance, Brief Fourth Edition

62. The cost of equity is greater than the cost of debt and increases with increasing financial leverage,
but generally less rapidly than the cost of debt.
Answer: FALSE
Level of Difficulty: 3
Learning Goal: 4
Topic: Cost of Equity and Financial Leverage

63. The cost of equity increases with increasing financial leverage in order to compensate the
stockholders for the higher degree of financial risk.
Answer: TRUE
Level of Difficulty: 3
Learning Goal: 4
Topic: Cost of Equity and Financial Leverage

64. As financial leverage increases, the cost of debt remains constant and then rises, while the cost of
equity always rises.
Answer: TRUE
Level of Difficulty: 3
Learning Goal: 4
Topic: Cost of Debt and Financial Leverage

65. If we assume that EBIT is constant, the value of the firm is maximized by minimizing the weighted
average cost of capital.
Answer: TRUE
Level of Difficulty: 3
Learning Goal: 4
Topic: Capital Structure and Firm Value

66. The EBIT-EPS approach to capital structure involves selecting the capital structure that maximizes
earnings before interest and taxes (EBIT) over the expected range of earnings per share (EPS).
Answer: FALSE
Level of Difficulty: 2
Learning Goal: 5
Topic: EBIT-EPS Approach

67. The EBIT-EPS analysis tends to concentrate on maximization of earnings rather than maximization
of owners’ wealth.
Answer: TRUE
Level of Difficulty: 2
Learning Goal: 5
Topic: EBIT-EPS Approach

68. The higher the financial breakeven point and the steeper the slope of the capital structure line, the
greater the financial risk.
Answer: TRUE
Level of Difficulty: 3
Learning Goal: 5
Topic: EBIT-EPS Approach
 Chapter 11 Leverage and Capital Structure 449

69. Because risk premiums increase with increases in financial leverage, the maximization of EPS does
not assure owners’ wealth maximization.
Answer: TRUE
Level of Difficulty: 3
Learning Goal: 5
Topic: EBIT-EPS Approach

70. The higher the degree of financial leverage (DFL), the greater the leverage a plan has, and the
steeper its slope when plotted on EBIT-EPS axes.
Answer: TRUE
Level of Difficulty: 3
Learning Goal: 5
Topic: EBIT-EPS Approach

71. The steeper the slope of the EBIT-EPS capital structure line, the lower the financial risk.
Answer: FALSE
Level of Difficulty: 3
Learning Goal: 5
Topic: EBIT-EPS Approach

72. Financial breakeven point represents the level of earnings before interest and taxes necessary for the
firm to cover its fixed operating and financial changes—that is, the point at which earnings per share
(EPS) is equal to zero.
Answer: FALSE
Level of Difficulty: 3
Learning Goal: 5
Topic: EBIT-EPS Approach

73. Firms having stable and predictable revenues can more safely undertake highly leveraged capital
structures than can firms with volatile patterns of sales revenue.
Answer: TRUE
Level of Difficulty: 1
Learning Goal: 6
Topic: Business Risk and Capital Structure

74. The operating breakeven point can be found by solving for the sales level that just covers total fixed
and variable costs.
Answer: TRUE
Level of Difficulty: 2
Learning Goal: 1
Topic: Operating Breakeven point

75. Both operating and financial leverage result in the magnification of return as well as risk.
Answer: TRUE
Level of Difficulty: 2
Learning Goal: 1
Topic: Operating and Financial Leverage
450 Gitman • Principles of Finance, Brief Fourth Edition

76. While operating leverage results only in a magnification of returns, financial leverage results only in
a magnification of risk.
Answer: FALSE
Level of Difficulty: 2
Learning Goal: 1
Topic: Operating and Financial Leverage

77. The dollar breakeven sales level can be solved for by dividing fixed costs by the contribution margin
ratio.
Answer: TRUE
Level of Difficulty: 3
Learning Goal: 1
Topic: Operating Breakeven point

78. The dollar breakeven sales level can be solved for by dividing fixed costs by the dollar contribution
margin.
Answer: FALSE
Level of Difficulty: 3
Learning Goal: 1
Topic: Operating Breakeven point

79. Holding all other factors constant, a firm that is subject to a greater level of business risk should
employ less operating leverage than an otherwise equivalent firm that is subject to a lesser level of
business risk.
Answer: TRUE
Level of Difficulty: 3
Learning Goal: 2
Topic: Business Risk and Operating Leverage

80. Holding all other factors constant, a firm that is subject to a greater level of business risk should
employ more operating leverage than an otherwise equivalent firm that is subject to a lesser level of
business risk.
Answer: FALSE
Level of Difficulty: 3
Learning Goal: 2
Topic: Business Risk and Operating Leverage

81. Holding all other factors constant, a firm that is subject to a greater level of business risk should
employ less financial leverage than an otherwise equivalent firm that is subject to a lesser level of
business risk.
Answer: TRUE
Level of Difficulty: 3
Learning Goal: 2
Topic: Business Risk and Financial Leverage

82. Holding all other factors constant, a firm that is subject to a greater level of business risk should
employ more financial leverage than an otherwise equivalent firm that is subject to a lesser level of
business risk.
Answer: FALSE
Level of Difficulty: 3
Learning Goal: 2
 Chapter 11 Leverage and Capital Structure 451

Topic: Business Risk and Financial Leverage

452 Gitman • Principles of Finance, Brief Fourth Edition

83. Holding all other factors constant, a firm that is subject to a greater level of business risk should
employ less total leverage than an otherwise equivalent firm that is subject to a lesser level of
business risk.
Answer: TRUE
Level of Difficulty: 3
Learning Goal: 2
Topic: Business Risk and Total Leverage

84. Holding all other factors constant, a firm that is subject to a greater level of business risk should
employ more total leverage than an otherwise equivalent firm that is subject to a lesser level of
business risk.
Answer: FALSE
Level of Difficulty: 3
Learning Goal: 2
Topic: Business Risk and Total Leverage

85. Because of the extensive research conducted in recent years in the area of capital structure theory, it is
now possible for financial managers to pinpoint with great accuracy a firm’s optimal capital structure.
Answer: FALSE
Level of Difficulty: 3
Learning Goal: 3
Topic: Capital Structure Theory

86. Despite the extensive research conducted in recent years in the area of capital structure theory, it is
not yet possible to provide financial managers with a specified methodology for use in determining a
firm’s optimal capital structure.
Answer: TRUE
Level of Difficulty: 3
Learning Goal: 3
Topic: Capital Structure Theory

87. In general, a firm’s theoretical optimal capital structure is that which balances the tax benefits of
debt financing against the increase probability of bankruptcy that result from its use.
Answer: TRUE
Level of Difficulty: 3
Learning Goal: 3
Topic: Capital Structure Theory

88. In general, a firm’s theoretical optimal capital structure is that which balances the tax disadvantage
of debt financing against the increase probability of bankruptcy that results from its use.
Answer: FALSE
Level of Difficulty: 3
Learning Goal: 3
Topic: Capital Structure Theory

89. The pecking order explanation of capital structure states that a hierarchy of financing exists for firms
in which retained earnings are employed first, followed by debt financing and finally by external
equity financing.
Answer: TRUE
Level of Difficulty: 3
Learning Goal: 3
 Chapter 11 Leverage and Capital Structure 453

Topic: Pecking Order Theory

454 Gitman • Principles of Finance, Brief Fourth Edition

90. The pecking order explanation of capital structure states that a hierarchy of financing exists for firms
in which new external debt financing is employed first, followed by retained earnings and finally by
external equity financing.
Answer: FALSE
Level of Difficulty: 3
Learning Goal: 3
Topic: Pecking Order Theory

91. The asymmetric information explanation of capital structure suggests that firms will issue new
equity only when the managers believe the firm’s stock is overvalued; as a result, issuing new equity
is considered a negative signal that will result in a decline in share price.
Answer: TRUE
Level of Difficulty: 4
Learning Goal: 3
Topic: Asymmetric Information

92. The asymmetric information explanation of capital structure suggests that firms will issue new debt
only when the managers believe the firm’s stock is overvalued; as a result, issuing new debt is
considered a negative signal that will result in a decline in share price.
Answer: FALSE
Level of Difficulty: 4
Learning Goal: 3
Topic: Asymmetric Information

93. In theory, a firm’s optimal capital structure is that which minimized the firm’s overall cost of capital
resulting in a maximization of the market value of the firm.
Answer: TRUE
Level of Difficulty: 3
Learning Goal: 4
Topic: Optimal Capital Structure

94. The basic shortcoming of EBIT-EPS analysis is that this model focuses on the maximization of
earnings rather than on the maximization of share price.
Answer: TRUE
Level of Difficulty: 3
Learning Goal: 5
Topic: EBIT-EPS Analysis

95. The basic shortcoming of EBIT-EPS analysis is that this model focuses on the maximization of
stock returns rather than on the maximization of share price.
Answer: FALSE
Level of Difficulty: 3
Learning Goal: 5
Topic: EBIT-EPS Analysis

96. The overriding objective of the capital structure decision should be to choose the level of debt that
results in the largest possible share price.
Answer: TRUE
Level of Difficulty: 3
Learning Goal: 4
Topic: Optimal Capital Structure
 Chapter 11 Leverage and Capital Structure 455

 Multiple Choice Questions

1. _________ analysis is a technique used to assess the returns associated with various cost structures
and levels of sales.
(a) Time-series
(b) Marginal
(c) Breakeven
(d) Ratio
Answer: C
Level of Difficulty: 1
Learning Goal: 1
Topic: Breakeven Analysis

2. Earnings before interest and taxes (EBIT) is a descriptive label for

(a) operating profits.
(b) net profits before taxes.
(c) earnings per share.
(d) gross profits.
Answer: A
Level of Difficulty: 1
Learning Goal: 1
Topic: EBIT-EPS Analysis

3. _________ costs are a function of time, not sales, and are typically contractual.
(a) Fixed
(b) Semi-variable
(c) Variable
(d) Operating
Answer: A
Level of Difficulty: 1
Learning Goal: 1
Topic: Operating Leverage

4. _________ costs are a function of volume, not time.

(a) Fixed operating
(b) Semi-variable
(c) Variable
(d) Fixed financial
Answer: C
Level of Difficulty: 1
Learning Goal: 1
Topic: Operating Leverage
456 Gitman • Principles of Finance, Brief Fourth Edition

5. The firm’s _________ is the level of sales necessary to cover all operating costs, i.e., the point at
which EBIT  $0.
(a) cash breakeven point
(b) financial breakeven point
(c) operating breakeven point
(d) total breakeven point
Answer: C
Level of Difficulty: 1
Learning Goal: 1
Topic: Operating Breakeven Point
6. Which of the following is NOT a variable cost?
(a) Materials used.
(b) Rent.
(c) Delivery costs.
(d) Direct labor.
Answer: B
Level of Difficulty: 1
Learning Goal: 1
Topic: Operating Leverage
7. _________ costs require the payment of a specified amount in each accounting period.
(a) Operating
(b) Variable
(c) Semi-variable
(d) Fixed
Answer: D
Level of Difficulty: 1
Learning Goal: 1
Topic: Operating Leverage
8. At the operating breakeven point, _________ equals zero.
(a) sales revenue
(b) fixed operating costs
(c) variable operating costs
(d) earnings before interest and taxes
Answer: D
Level of Difficulty: 1
Learning Goal: 1
Topic: Operating Breakeven Point
9. A firm’s operating breakeven point is sensitive to all of the following variables EXCEPT
(a) fixed operating costs.
(b) sales price per unit.
(c) interest payment.
(d) variable operating cost per unit.
Answer: C
Level of Difficulty: 1
 Chapter 11 Leverage and Capital Structure 457

Learning Goal: 1
Topic: Operating Breakeven Point
458 Gitman • Principles of Finance, Brief Fourth Edition

10. Breakeven analysis is used by the firm

(a) to determine the level of operations necessary to cover all operating costs.
(b) to evaluate the profitability associated with various levels of sales.
(c) Both (a) and (b).
(d) none of the above.
Answer: C
Level of Difficulty: 2
Learning Goal: 1
Topic: Breakeven Analysis

11. If a firm’s fixed operating costs decrease, the firm’s operating breakeven point will
(a) decrease.
(b) increase.
(c) remain unchanged.
(d) change in an undetermined direction.
Answer: A
Level of Difficulty: 2
Learning Goal: 1
Topic: Operating Breakeven Point

12. If a firm’s variable costs per unit increase, the firm’s operating breakeven point will
(a) decrease.
(b) increase.
(c) remain unchanged.
(d) change in an undetermined direction.
Answer: B
Level of Difficulty: 2
Learning Goal: 1
Topic: Operating Breakeven Point

13. If a firm’s sale price per unit decreases, the firm’s operating breakeven point will
(a) decrease.
(b) increase.
(c) remain unchanged.
(d) change in an undetermined direction.
Answer: B
Level of Difficulty: 2
Learning Goal: 1
Topic: Operating Breakeven Point

14. If a firm’s fixed financial costs decrease, the firm’s operating breakeven point will
(a) decrease.
(b) increase.
(c) remain unchanged.
(d) change in an undetermined direction.
Answer: C
Level of Difficulty: 2
 Chapter 11 Leverage and Capital Structure 459

Learning Goal: 1
Topic: Operating Breakeven Point
460 Gitman • Principles of Finance, Brief Fourth Edition

15. The firm’s operating breakeven point is the point at which

(a) total operating costs equal total fixed costs.
(b) total operating costs are zero.
(c) EBIT is less than sales.
(d) EBIT is zero.
Answer: D
Level of Difficulty: 2
Learning Goal: 1
Topic: Operating Breakeven Point

16. Noncash charges such as depreciation and amortization _________ the firm’s breakeven point.
(a) do not affect
(b) overstate
(c) understate
(d) decrease
Answer: B
Level of Difficulty: 4
Learning Goal: 1
Topic: Operating Breakeven Point

17. Which one of the following is (are) considered as limitations of breakeven analysis?
(a) It assumes that the firm faces linear, or nonvarying, sales revenue and total operating cost
functions.
(b) It is difficult to break semivariable costs into fixed and variable components.
(c) It has a short-term time horizon.
(d) All of the above.
Answer: D
Level of Difficulty: 4
Learning Goal: 1
Topic: Limitations of Breakeven Analysis

18. A major assumption of breakeven analysis and one which causes severe limitations in its use is that
(a) fixed costs really are fixed.
(b) total revenue is nonlinear.
(c) revenues and operating costs are linear.
(d) all costs are really semi-variable.
Answer: C
Level of Difficulty: 4
Learning Goal: 1
Topic: Limitations of Breakeven Analysis
 Chapter 11 Leverage and Capital Structure 461

19. The per dollar contribution toward fixed operating costs and profits provided by each dollar of sales
is the
(a) profit margin.
(b) contribution margin.
(c) expense ratio.
(d) fixed coverage ratio.
Answer: B
Level of Difficulty: 4
Learning Goal: 1
Topic: Contribution Margin

20. A firm has fixed operating costs of $10,000, the sale price per unit of its product is $25, and its
variable cost per unit is $15. The firm’s operating breakeven point in units is _________ and its
breakeven point in dollars is _________.
(a) 250; $ 6,250
(b) 400; $10,000
(c) 667; $16,675
(d) 1,000; $25,000
Answer: D
Level of Difficulty: 4
Learning Goal: 1
Topic: Operating Breakeven Point (Equation 12.1, Equation 12.2 and Equation 12.3)

21. A firm has fixed operating costs of $150,000, total sales of $1,500,000, and total variable costs of
$1,275,000. The firm’s operating breakeven point in dollars is
(a) $150,000.
(b) $176,471.
(c) $1,000,000.
(d) $1,425,000.
Answer: C
Level of Difficulty: 4
Learning Goal: 1
Topic: Dollar Operating Breakeven Point (Equation 12.1, Equation 12.2 and Equation 12.3)

22. One function of breakeven analysis is to

(a) create profits.
(b) describe leverage.
(c) evaluate the profitability of various sales levels.
(d) determine the amount of financing needed by the firm.
Answer: C
Level of Difficulty: 4
Learning Goal: 1
Topic: Breakeven Analysis
462 Gitman • Principles of Finance, Brief Fourth Edition

23. A firm has fixed operating costs of $25,000, a per unit sales price of $5, and a variable cost per unit
of $3. What is its operating breakeven point if it desires net operating income of $10,000, not $0
(zero)?
(a) 12,500 units.
(b) 15,000 units.
(c) 17,500 units.
(d) 25,000 units.
Answer: C
Level of Difficulty: 4
Learning Goal: 1
Topic: Operating Breakeven Point (Equation 12.1, Equation 12.2 and Equation 12.3)

24. The long-term funds of the firm are called

(a) debt.
(b) assets.
(c) capital.
(d) equity.
Answer: C
Level of Difficulty: 1
Learning Goal: 2
Topic: Capital Structure Basics

25. _________ results from the use of fixed-cost assets or funds to magnify returns to the firm’s owners.
(a) Long-term debt
(b) Equity
(c) Leverage
(d) Capital structure
Answer: C
Level of Difficulty: 1
Learning Goal: 2
Topic: Capital Structure Basics

26. _________ leverage is concerned with the relationship between sales revenues and earnings before
interest and taxes.
(a) Financial
(b) Operating
(c) Variable
(d) Total
Answer: B
Level of Difficulty: 1
Learning Goal: 2
Topic: Operating Leverage
 Chapter 11 Leverage and Capital Structure 463

27. _________ leverage is concerned with the relationship between sales revenue and earnings per
share.
(a) Financial
(b) Operating
(c) Variable
(d) Total
Answer: D
Level of Difficulty: 1
Learning Goal: 2
Topic: Total Leverage

28. _________ leverage is concerned with the relationship between earnings before interest and taxes
and earnings per share.
(a) Financial
(b) Operating
(c) Variable
(d) Total
Answer: A
Level of Difficulty: 1
Learning Goal: 2
Topic: Financial Leverage

29. _________ is the potential use of fixed operating costs to magnify the effects of changes in sales on
earnings before interest and taxes.
(a) Financial leverage
(b) Operating leverage
(c) Total leverage
(d) Ratio analysis
Answer: B
Level of Difficulty: 1
Learning Goal: 2
Topic: Operating Leverage

30. _________ is the potential use of fixed financial charges to magnify the effects of changes in
earnings before interest and taxes on the firm’s earnings per share.
(a) Financial leverage
(b) Operating leverage
(c) Total leverage
(d) Debt service
Answer: A
Level of Difficulty: 1
Learning Goal: 2
Topic: Financial Leverage
464 Gitman • Principles of Finance, Brief Fourth Edition

31. Fixed financial charges include

(a) common stock dividends and bond interest expense.
(b) common stock dividends and preferred stock dividends.
(c) bond interest expense and preferred stock dividends.
(d) stock repurchase expense.
Answer: C
Level of Difficulty: 1
Learning Goal: 2
Topic: Financial Leverage
32. A decrease in fixed financial costs will result in _________ in financial risk.
(a) an increase
(b) a decrease
(c) no change
(d) an undetermined change
Answer: B
Level of Difficulty: 1
Learning Goal: 2
Topic: Financial Leverage
33. The three basic types of leverage are
(a) operating, production, and financial.
(b) operating, production, and total.
(c) production, financial, and total.
(d) operating, financial, and total.
Answer: D
Level of Difficulty: 1
Learning Goal: 2
Topic: Types of Leverage
34. The higher financial leverage causes _________ to increase more for a given increase in _________.
(a) EBIT; sales
(b) EPS; sales
(c) EPS; EBIT
(d) EBIT; EPS
Answer: C
Level of Difficulty: 1
Learning Goal: 2
Topic: Financial Leverage
35. _________ is the potential use of fixed costs, both operating and financial, to magnify the effect of
changes in sales on the firm’s earnings per share.
(a) Debt service
(b) Total leverage
(c) Operating leverage
(d) Financial leverage
Answer: B
Level of Difficulty: 2
 Chapter 11 Leverage and Capital Structure 465

Learning Goal: 2
Topic: Total Leverage
466 Gitman • Principles of Finance, Brief Fourth Edition

36. As fixed operating costs increase and all other factors are held constant, the degree of operating
leverage will
(a) increase.
(b) decrease.
(c) remain unchanged.
(d) change in an undetermined direction.
Answer: A
Level of Difficulty: 2
Learning Goal: 2
Topic: Operating Leverage

37. Through the effects of financial leverage, when EBIT increases, earnings per share will
(a) increase.
(b) decrease.
(c) remain unchanged.
(d) change in an undetermined direction.
Answer: A
Level of Difficulty: 2
Learning Goal: 2
Topic: Financial Leverage

38. With the existence of fixed operating costs, a decrease in sales will result in _________ in EBIT.
(a) a proportional increase
(b) an equal increase
(c) a less than proportional decrease
(d) a more than proportional decrease
Answer: D
Level of Difficulty: 3
Learning Goal: 2
Topic: Operating Leverage

39. An increase in fixed operating costs will result in _________ in the degree of operating leverage.
(a) a decrease
(b) an increase
(c) no change
(d) an undetermined change
Answer: B
Level of Difficulty: 3
Learning Goal: 2
Topic: Operating Leverage
 Chapter 11 Leverage and Capital Structure 467

40. A firm has fixed operating costs of $650,000, a sales price per unit of $20, and a variable cost
per unit of $13. At a base sales level of 500,000 units, the firm’s degree of operating leverage
is _________.
(a) 1.07
(b) 1.11
(c) 1.18
(d) 1.23
Answer: D
Level of Difficulty: 3
Learning Goal: 2
Topic: Degree of Operating Leverage (Equation 12.4 and Equation 12.5)

41. A firm has fixed operating costs of $175,000, total sales revenue of $3,000,000 and total variable
costs of $2,250,000. The firm’s degree of operating leverage is _________.
(a) 0.77
(b) 1.30
(c) 0.81
(d) 4.29
Answer: B
Level of Difficulty: 3
Learning Goal: 2
Topic: Degree of Operating Leverage (Equation 12.4 and Equation 12.5)

42. A firm has EBIT of $375,000, interest expense of $75,000, preferred dividends of $6,000 and a
tax rate of 40 percent. The firm’s degree of financial leverage at a base EBIT level of $375,000
is _________.
(a) 0.97
(b) 1.29
(c) 1.27
(d) 1.09
Answer: B
Level of Difficulty: 3
Learning Goal: 2
Topic: Degree of Financial Leverage (Equation 12.6 and 12.7)

43. A decrease in fixed operating costs will result in _________ in the degree of financial leverage.
(a) a decrease
(b) an increase
(c) no change
(d) an undetermined change
Answer: D
Level of Difficulty: 3
Learning Goal: 2
Topic: Degree of Financial Leverage
468 Gitman • Principles of Finance, Brief Fourth Edition

44. At a base sales level of $400,000, a firm has a degree of operating leverage of 2 and a degree of
financial leverage of 1.5. The firm’s degree of total leverage is _________.
(a) 3.5
(b) 3.0
(c) 0.5
(d) 1.3
Answer: B
Level of Difficulty: 3
Learning Goal: 2
Topic: Degree of Total Leverage (Equation 12.4 and Equation 12.5)

45. Generally, _________ in leverage result in _________ return and _________ risk.
(a) increases; decreased; increased
(b) increases; decreased; decreased
(c) increases; increased; increased
(d) decreases; increased; decreased
Answer: C
Level of Difficulty: 3
Learning Goal: 2
Topic: Leverage, Return and Risk

46. With the existence of fixed operating costs, an increase in sales will result in _________ increase in
EBIT.
(a) a proportional
(b) an equal
(c) a less than proportional
(d) a more than proportional
Answer: D
Level of Difficulty: 3
Learning Goal: 2
Topic: Operating Leverage

47. A firm has interest expense of $145,000, preferred dividends of $25,000, and a tax rate of
40 percent. The firm’s financial breakeven point is
(a) $ 25,000.
(b) $170,000.
(c) $186,667.
(d) $145,000.
Answer: C
Level of Difficulty: 3
Learning Goal: 2
Topic: Financial Breakeven Point
 Chapter 11 Leverage and Capital Structure 469

48. Because the degree of total leverage is multiplicative and not additive, when a firm has very high
operating leverage it can moderate its total risk by
(a) increasing sales.
(b) using more financial leverage.
(c) increasing EBIT.
(d) using a lower level of financial leverage.
Answer: D
Level of Difficulty: 3
Learning Goal: 2
Topic: Degree of Total Leverage

49. The firm’s _________ is the mix of long-term debt and equity utilized by the firm, which may
significantly affect its value by affecting return and risk.
(a) dividend policy
(b) capital budget
(c) capital structure
(d) working capital
Answer: C
Level of Difficulty: 1
Learning Goal: 3
Topic: Capital Structure Basics

50. The basic sources of capital for a firm include all of the following EXCEPT
(a) long-term debt.
(b) preferred stock.
(c) current liabilities.
(d) common stock.
Answer: C
Level of Difficulty: 1
Learning Goal: 3
Topic: Capital Structure Basics

51. In theory, the firm should maintain financial leverage consistent with a capital structure that
(a) meets the industry standard.
(b) maximizes the earnings per share.
(c) maximizes the owner’s wealth.
(d) maximizes dividends.
Answer: C
Level of Difficulty: 1
Learning Goal: 3
Topic: Capital Structure Basics
470 Gitman • Principles of Finance, Brief Fourth Edition

52. _________ risk is the risk of being unable to cover operating costs.
(a) Business
(b) Financial
(c) Leverage
(d) Total
Answer: A
Level of Difficulty: 1
Learning Goal: 3
Topic: Business Risk

53. Business risk is affected by all of the following EXCEPT

(a) revenue stability.
(b) cost stability.
(c) operating leverage.
(d) earnings per share.
Answer: D
Level of Difficulty: 1
Learning Goal: 3
Topic: Business Risk

54. All of the following affect business risk EXCEPT

(a) operating leverage.
(b) interest rate stability.
(c) cost stability.
(d) revenue stability.
Answer: B
Level of Difficulty: 1
Learning Goal: 3
Topic: Business Risk

55. _________ risk is the risk of being unable to cover financial costs.
(a) Business
(b) Financial
(c) Total
(d) Leverage
Answer: B
Level of Difficulty: 1
Learning Goal: 3
Topic: Financial Risk
 Chapter 11 Leverage and Capital Structure 471

56. After satisfying obligations to creditors, the government, and preferred stockholders, any remaining
earnings will most likely be allocated to any of the following EXCEPT
(a) common shareholders as cash dividends.
(b) common shareholders as stock dividends.
(c) retained by the firm for future investment.
(d) a combination of retained earnings and cash dividends.
Answer: B
Level of Difficulty: 2
Learning Goal: 3
Topic: Concept of Capital Structure

57. The lower risk nature of long-term debt in a firm’s capital structure is due to the fact that
(a) the equity holders are the true owners of the firm.
(b) equity capital has a fixed return.
(c) creditors have a higher position in the priority of claims.
(d) dividend payments are tax-deductible.
Answer: C
Level of Difficulty: 2
Learning Goal: 3
Topic: Concept of Capital Structure

58. Which of the following is NOT a reason why debt capital is considered to be the least risky source
of capital?
(a) It has a high priority claim against assets and earnings.
(b) It has a strong legal position.
(c) It is a low cost source of capital because interest payments are tax deductible.
(d) It does not normally have to be repaid at a specific future date.
Answer: D
Level of Difficulty: 2
Learning Goal: 3
Topic: Concept of Capital Structure

59. Probability of bankruptcy is determined by

(a) financial risk.
(b) total risk.
(c) business risk.
(d) interest rate risk.
Answer: B
Level of Difficulty: 2
Learning Goal: 3
Topic: Financial Risk
472 Gitman • Principles of Finance, Brief Fourth Edition

60. The inexpensive nature of long-term debt in a firm’s capital structure is due to the fact that
(a) the equity holders are the true owners of the firm.
(b) equity capital has a fixed return.
(c) creditors have a higher position in the priority of claims.
(d) dividend payments are tax-deductible.
Answer: C
Level of Difficulty: 2
Learning Goal: 3
Topic: Concept of Capital Structure

61. The inexpensive nature of long-term debt in a firm’s capital structure is due to the fact that
(a) the equity holders are the true owners of the firm.
(b) equity capital has a fixed return.
(c) interest payments are tax-deductible.
(d) equity holders have a higher position in the priority of claims.
Answer: C
Level of Difficulty: 2
Learning Goal: 3
Topic: Concept of Capital Structure

62. The key differences between debt and equity capital include all of the following EXCEPT
(a) voice in management.
(b) maturity.
(c) tax treatment.
(d) effect on operating leverage.
Answer: D
Level of Difficulty: 2
Learning Goal: 3
Topic: Concept of Capital Structure

63. The cost of debt financing results from

(a) the increased profitability of bankruptcy caused by debt obligations.
(b) the agency costs of the lender’s monitoring and controlling the firm’s actions.
(c) the costs associated with managers having more information about the firm’s prospects than do
investors.
(d) All of the above.
Answer: D
Level of Difficulty: 3
Learning Goal: 3
Topic: Cost of Debt Financing
 Chapter 11 Leverage and Capital Structure 473

64. A corporation borrows $1,000,000 at 10 percent annual rate of interest. The firm has a 40 percent
tax rate. The yearly, after-tax cost of this debt is
(a) $ 40,000.
(b) $ 60,000.
(c) $100,000.
(d) $166,667.
Answer: B
Level of Difficulty: 3
Learning Goal: 3
Topic: Cost of Debt Financing

65. A corporation has $5,000,000 of 8 percent preferred stock outstanding and a 40 percent tax rate. The
after-tax cost of the preferred stock is
(a) $400,000.
(b) $240,000.
(c) $666,667.
(d) $160,000.
Answer: A
Level of Difficulty: 3
Learning Goal: 3
Topic: Cost of Preferred Stock Financing

66. A corporation has $10,000,000 of 10 percent preferred stock outstanding and a 40 percent tax rate.
The amount of earnings before interest and taxes (EBIT) required to pay the preferred dividends is
(a) $1,000,000.
(b) $ 400,000.
(c) $ 600,000.
(d) $1,666,667.
Answer: D
Level of Difficulty: 3
Learning Goal: 3
Topic: Cost of Preferred Stock Financing

67. A corporation has $5,000,000 of 10 percent bonds and $3,000,000 of 12 percent preferred stock
outstanding. The firm’s financial breakeven (assuming a 40 percent tax rate) is
(a) $860,000.
(b) $716,000.
(c) $1,100,000.
(d) $1,400,000
Answer: C
Level of Difficulty: 3
Learning Goal: 3
Topic: Financial Breakeven Point
474 Gitman • Principles of Finance, Brief Fourth Edition

68. The conflict resulting from a manager’s desire to increase the firm’s risk without increasing current
borrowing costs and lenders’ desire to limit lending is one effect of the _________ problem.
(a) agency
(b) leverage
(c) capital
(d) variable cost
Answer: A
Level of Difficulty: 3
Learning Goal: 3
Topic: Optimal Capital Structure

69. Operating and financial constraints placed on a corporation by loan provision are
(a) agency costs to the lender.
(b) agency costs to the firm.
(c) interest rate costs to the firm.
(d) necessary to control the risk of the firm.
Answer: B
Level of Difficulty: 3
Learning Goal: 3
Topic: Agency Costs and Capital Structure

70. The risk of the debt capital is less than that of other long-term contributors of capital because
(a) they have a higher priority of claim against any earnings or assets available for payment.
(b) they have a far stronger legal pressure against the company to make payment than do preferred
and common stockholders.
(c) the tax-deductibility of interest payments lowers the debt cost to the firm substantially.
(d) all of the above.
Answer: D
Level of Difficulty: 3
Learning Goal: 3
Topic: Cost of Debt Financing

71. Management has just discovered an excellent investment for which it needs additional funding.
Relative to the discussion on asymmetric information the firm should
(a) finance with new common stock if management believes the firm is undervalued.
(b) finance with debt if management believes the firm is undervalued.
(c) finance with debt if management believes the firm is overvalued.
(d) finance with preferred stock if the firm is at value.
Answer: B
Level of Difficulty: 4
Learning Goal: 3
Topic: Asymmetric Information and Capital Structure
 Chapter 11 Leverage and Capital Structure 475

72. In order to enhance the wealth of stockholders and to send positive signals to the market,
corporations generally raise funds using the following order.
(a) Retained earnings, equity, debt.
(b) Retained earnings, debt, equity.
(c) Debt, retained earnings, equity.
(d) Equity, retained earnings, debt.
Answer: B
Level of Difficulty: 3
Learning Goal: 4
Topic: Asymmetric Information and Capital Structure

73. The optimal capital structure is the one that balances

(a) return and risk factors in order to maximize profits.
(b) return and risk factors in order to maximize earnings per share.
(c) return and risk factors in order to maximize market value.
(d) return and risk factors in order to maximize dividends.
Answer: C
Level of Difficulty: 3
Learning Goal: 4
Topic: Optimal Capital Structure

74. As debt is substituted for equity in the capital structure and the debt ratio increases, all of the
following statements about the component costs of capital are true EXCEPT
(a) the cost of equity continually increases.
(b) the cost of debt continually increases.
(c) the overall cost of capital first declines, reaches a minimum, and then rises again.
(d) the overall cost of capital continually increases.
Answer: D
Level of Difficulty: 3
Learning Goal: 4
Topic: Optimal Capital Structure

75. Poor capital structure decisions can result in _________ the cost of capital, resulting in _________
acceptable investments. Effective capital structure decisions can _________ the cost of capital,
resulting in _________ acceptable investments.
(a) increasing; fewer; lower; more
(b) decreasing; more; higher; fewer
(c) increasing; more; lower, fewer
(d) decreasing; fewer; higher; more
Answer: A
Level of Difficulty: 3
Learning Goal: 4
Topic: Optimal Capital Structure
476 Gitman • Principles of Finance, Brief Fourth Edition

76. According to the traditional approach to capital structure, the value of the firm will be maximized
when
(a) the financial leverage is maximized.
(b) the cost of debt is minimized.
(c) the weighted average cost of capital is minimized.
(d) the dividend payout is maximized.
Answer: C
Level of Difficulty: 3
Learning Goal: 4
Topic: Traditional Approach to Capital Structure

77. In the traditional approach to capital structure, as the amount of debt increases in a firm’s capital
structure,
(a) the cost of equity rises faster than the cost of debt.
(b) the cost of debt rises faster than the cost of equity.
(c) debt becomes less risky.
(d) equity cost is unaffected.
Answer: A
Level of Difficulty: 3
Learning Goal: 4
Topic: Traditional Approach to Capital Structure

78. As debt is substituted for equity in the capital structure and the debt ratio increases, the behavior of
the overall cost of capital is partially explained by
(a) the tax-deductibility of interest payments.
(b) the increase in the number of common shares outstanding.
(c) the reduction in risk as perceived by the common shareholders.
(d) the decrease in the cost of equity.
Answer: A
Level of Difficulty: 3
Learning Goal: 4
Topic: Traditional Approach to Capital Structure

79. The controversy over the existence of an optimal capital structure is debated between those
_________ who believe a traditional approach exists and those _________, who do not believe one
exists. In the _________ approach to capital structure, the optimal capital structure occurs where the
_________ is minimized.
(a) supporters of Modigliani and Miller; traditionalists; Modigliani and Miller; degree of financial
leverage.
(b) traditionalists; supporters of Modigliani and Miller; traditional; cost of capital
(c) supporters of Modigliani and Miller; traditionalists; Modigliani and Miller; cost of capital
(d) traditionalists; supporters of Modigliani and Miller; traditional; degree of financial leverage
Answer: B
Level of Difficulty: 4
Learning Goal: 4
Topic: Traditional Approach versus MM Approach to Capital Structure
 Chapter 11 Leverage and Capital Structure 477

80. A firm has an operating profit of $300,000, interest of $35,000, and a tax rate of 40 percent. The
firm has an after-tax cost of debt of 5 percent and a cost of equity of 15 percent. The firm’s target
capital structure is set at a mix of 40 percent debt and 60 percent equity. According to the traditional
approach to capital structure, the value of the firm is
(a) $1.4 million.
(b) $2.0 million.
(c) $2.7 million.
(d) $6.0 million.
Answer: C
Level of Difficulty: 4
Learning Goal: 4
Topic: Traditional Approach to Capital Structure

81. In the EBIT-EPS approach to capital structure, risk is represented by

(a) shifts in the cost of equity capital.
(b) shifts in the cost of debt capital.
(c) the slope of the capital structure line.
(d) shifts in the times-interest-earned ratio.
Answer: C
Level of Difficulty: 2
Learning Goal: 5
Topic: EBIT-EPS Approach to Capital Structure

82. In the EBIT-EPS approach to capital structure, a constant level of EBIT is assumed
(a) to ease the calculations of owners’ equity.
(b) to isolate the impact on returns of the financing costs associated with alternative capital
structures.
(c) to emphasize the relationship between interest expenses and taxes.
(d) to concentrate on the effect of revenue and expense on capital structure decisions.
Answer: B
Level of Difficulty: 3
Learning Goal: 5
Topic: EBIT-EPS Approach to Capital Structure

83. A firm has a current capital structure consisting of $400,000 of 12 percent annual interest debt and
50,000 shares of common stock. The firm’s tax rate is 40 percent on ordinary income. If the EBIT is
expected to be $200,000, the firm’s earnings per share will be _________.
(a) $2.40
(b) $3.04
(c) $7.04
(d) $1.82
Answer: D
Level of Difficulty: 3
Learning Goal: 5
Topic: EBIT-EPS Approach to Capital Structure
478 Gitman • Principles of Finance, Brief Fourth Edition

84. The major shortcoming of the EBIT-EPS approach to capital structure is that
(a) the technique does not promote the maximization of shareholder wealth.
(b) the technique does not consider the cost of capital.
(c) the technique only considers leverage-related risk.
(d) the technique does not maximize earnings per share.
Answer: A
Level of Difficulty: 3
Learning Goal: 5
Topic: EBIT-EPS Approach to Capital Structure

85. The _________ approach to capital structure proposes that an optimal capital structure be selected
which _________.
(a) M and M; maximizes the weighted average cost of capital
(b) traditional; minimizes the cost of debt
(c) EBIT-EPS; maximizes the EPS
(d) residual theory; minimizes dividends
Answer: C
Level of Difficulty: 3
Learning Goal: 5
Topic: EBIT-EPS Approach to Capital Structure

86. A firm has a current capital structure consisting of $400,000 of 12 percent annual interest debt and
50,000 shares of common stock. The firm’s tax rate is 40 percent on ordinary income. If the EBIT is
expected to be $200,000, two EBIT-EPS coordinates for the firm’s existing capital structure are
(a) ($36,000, $0) and ($200,000, $3.04).
(b) ($48,000, $0) and ($200,000, $1.82).
(c) ($0, $48,000) and ($200,000, $1.82).
(d) ($152,000, $3.50) and ($150,000, $1.82).
Answer: B
Level of Difficulty: 3
Learning Goal: 5
Topic: EBIT-EPS Approach to Capital Structure

87. The basic shortcoming of the EBIT-EPS approach to capital structure is

(a) that the optimal capital structure is difficult to compute.
(b) its disregard for the presence of preferred stock in the capital structure.
(c) its disregard for the firm’s dividend policy.
(d) that it concentrates on the maximization of EPS rather than the maximization of owner’s wealth.
Answer: D
Level of Difficulty: 3
Learning Goal: 5
Topic: EBIT-EPS Approach to Capital Structure
 Chapter 11 Leverage and Capital Structure 479

88. A firm is analyzing two possible capital structures—30 and 50 percent debt ratios. The firm has total
assets of $5,000,000 and common stock valued at $50 per share. The firm has a marginal tax rate of
40 percent on ordinary income. The number of common shares outstanding for each of the capital
structures would be
(a) 30 percent debt ratio: 30,000 shares and 50 percent debt ratio: 50,000 shares.
(b) 30 percent debt ratio: 50,000 shares and 50 percent debt ratio: 70,000 shares.
(c) 30 percent debt ratio: 70,000 shares and 50 percent debt ratio: 100,000 shares.
(d) 30 percent debt ratio: 70,000 shares and 50 percent debt ratio: 50,000 shares.
Answer: D
Level of Difficulty: 4
Learning Goal: 5
Topic: Capital Structure Analysis

89. A firm is analyzing two possible capital structures—30 and 50 percent debt ratios. The firm has total
assets of $5,000,000 and common stock valued at $50 per share. The firm has a marginal tax rate of
40 percent on ordinary income. If the interest rate on debt is 7 percent and 9 percent for the 30
percent and the 50 percent debt ratios, respectively, the amount of interest on the debt under each of
the capital structures being considered would be
(a) 30 percent debt ratio: $105,000 and 50 percent debt ratio: $225,000.
(b) 30 percent debt ratio: $245,000 and 50 percent debt ratio: $225,000.
(c) 30 percent debt ratio: $105,000 and 50 percent debt ratio: $250,000.
(d) 30 percent debt ratio: $135,000 and 50 percent debt ratio: $175,000.
Answer: A
Level of Difficulty: 4
Learning Goal: 5
Topic: Capital Structure Analysis

90. Financial leverage measures the effect of fixed financing costs on the relationship between
(a) Sales and EBIT.
(b) Sales and EPS.
(c) EBIT and EPS.
(d) none of the above.
Answer: C
Level of Difficulty: 2
Learning Goal: 2
Topic: Financial Leverage

91. Operating leverage measures the effect of fixed financing costs on the relationship between
(a) Sales and EBIT.
(b) Sales and EPS.
(c) EBIT and EPS.
(d) none of the above.
Answer: D
Level of Difficulty: 3
Learning Goal: 2
Topic: Operating Leverage
480 Gitman • Principles of Finance, Brief Fourth Edition

92. Operating leverage measures the effect of fixed operating costs on the relationship between
(a) Sales and EBIT.
(b) Sales and EPS.
(c) EBIT and EPS.
(d) none of the above.
Answer: A
Level of Difficulty: 2
Learning Goal: 2
Topic: Operating Leverage

93. Financial leverage measures the effect of fixed operating costs on the relationship between
(a) Sales and EBIT.
(b) Sales and EPS.
(c) EBIT and EPS.
(d) none of the above.
Answer: D
Level of Difficulty: 3
Learning Goal: 2
Topic: Financial Leverage

94. Total leverage measures the effect of fixed costs on the relationship between
(a) Sales and EBIT.
(b) Sales and EPS.
(c) EBIT and EPS.
(d) none of the above.
Answer: B
Level of Difficulty: 2
Learning Goal: 2
Topic: Total Leverage

95. Tony’s Beach T-Shirts has fixed annual operating costs of $75,000. Tony retails his T-shirts for
$14.99 each and the variable cost per T-shirt is $4.99. Based on this information, the breakeven sales
level in dollars is
(a) $125,495.
(b) $112,425.
(c) $108,995.
(d) none of the above.
Answer: B
Level of Difficulty: 3
Learning Goal: 1
Topic: Dollar Operating Breakeven Point (Equation 12.1, Equation 12.2 and Equation 12.3)
 Chapter 11 Leverage and Capital Structure 481

96. Tony’s Beach T-Shirts has fixed annual operating costs of $75,000. Tony retails his T-shirts for
$14.99 each and the variable cost per T-shirt is $4.99. Based on this information, the breakeven sales
level in units is
(a) 7,500.
(b) 15,030.
(c) 5,003.
(d) none of the above.
Answer: A
Level of Difficulty: 2
Learning Goal: 1
Topic: Operating Breakeven Point (Equation 12.1, Equation 12.2 and Equation 12.3)

97. Nico Trading Company must choose its optimal capital structure. Currently, the firm has a 20
percent debt ratio and the firm expects to generate a dividend next year of $5.44 per share.
Dividends are expected to remain at this level indefinitely. Stockholders currently require a
12.1 percent return on their investment. Nico is considering changing its capital structure if it would
benefit shareholders. The firm estimates that if it increases the debt ratio to 30 percent, it will
increase its expected dividend to $5.82 per share. Again, dividends are expected to remain at this
new level indefinitely. However, because of the added risk, the required return demanded by
stockholders will increase to 12.6 percent. Based on this information, should Nico make the change?
(a) Yes.
(b) No.
(c) It’s irrelevant.
(d) Not enough information.
Answer: A
Level of Difficulty: 4
Learning Goal: 6
Topic: Optimal Capital Structure and Shareholder Wealth Maximization (Equation 12.12)

 Essay Questions
1. The Majestic Blind Co. sells its finished product for an average of $35 per unit with a variable cost
per unit of $21. The company has fixed operating costs of $1,050,000.
(a) Calculate the firm’s operating breakeven point in units.
(b) Calculate the firm’s operating breakeven point in dollars.
(c) Using 100,000 units as a base, what is the firm’s degree of operating leverage?
482 Gitman • Principles of Finance, Brief Fourth Edition

Answers:
FC $1,050,000
(a) Q    75,000 units
P  VC $35  $21
FC $1,050,000
(b) D    $2,625,000
(1  TVC/TR) (1  $21/35)
Q(P  VC)
(c) DOL at base sales level of 100,000 units. 
Q(P  VC)  FC
100,000($35  $21)

100,000($35  21)  $1,050,000
 4.0
Level of Difficulty: 3
Learning Goal: 2
Topic: Operating Breakeven Analysis (Equation 12.1, Equation 12.2 and Equation 12.3)

2. RMM, Inc. is considering purchasing a small firm in the same line of business. The purchase would
be financed by the sale of common stock or a bond issue. The financial manager needs to evaluate
how the two alternative financing plans will affect the earnings potential of the firm. Total financing
required is $4.5 million. The firm currently has $20,000,000 of 12 percent bonds and 600,000
common shares outstanding. The firm can arrange financing of the $4.5 million through a 14 percent
bond issue or the sale of 100,000 shares of common stock. The firm has a 40 percent tax rate.
(a) What is the degree of financial leverage for each plan at $7,000,000 of EBIT?
(b) What is the financial breakeven point for each plan?
Answers:
7,000,000
(a) DFL at base level EBIT (Bond Issue)   1.76
7,000,000  3,030,000
7,000,000
DFL at base level EBIT (stock Issue)   1.52
7,000,000  2,400,000
(b) Financial Breakeven Point (Bond Issue)  $3,030,000
Financial Breakeven Point (Stock Issue)  $2,400,000
Level of Difficulty: 3
Learning Goal: 2
Topic: Financial Leverage and Financial Breakeven (Equation 12.6 and Equation 12.7)

3. Little LAM, Inc. has decided to invest $10,000,000 in a new headquarters and needs to determine
the best way to finance the construction. The firm currently has $50,000,000 of 10 percent bonds
and 4,000,000 common shares outstanding. The firm can obtain the $10,000,000 of financing
through a 10 percent bond issue or the sale of 1,000,000 shares of common stock. The firm has a
40 percent tax rate.
(a) What is the degree of financial leverage for each plan at $25,000,000 of EBIT?
(b) What is the financial breakeven point for each plan?
 Chapter 11 Leverage and Capital Structure 483

Answers:
(a) Bond issue interest  10,000,000(0.10)  $1,000,000
5,000,000
Current interest  50,000,000(0.10) 
$6,000,000

25,000,000
DFL at base level EBIT (Bond Issue)   1.32
25,000,000  6,000,000
25,000,000
DFL at base level EBIT (stock Issue)   1.25
25,000,000  5,000,000
(b) Financial Breakeven Point (Bond Issue)  $6,000,000
Financial Breakeven Point (Stock Issue)  $5,000,000
Level of Difficulty: 3
Learning Goal: 2
Topic: Financial Leverage and Financial Breakeven (Equation 12.6 and Equation 12.7)

4. Tri-Star Productions, Inc. is evaluating two different operating structures which are described below.
The firm has annual interest expense of $250, common shares outstanding of 1,000, and a tax rate of
40 percent.

Fixed Price Variable Cost

Costs per Unit per Unit
operating structure 1: $500 $1 $0.75
operating structure 2: $1,200 $1 $0.70

(a) For each operating structure, calculate

(a1) EBIT and EPS at 10,000, 20,000, and 30,000 units.
(a2) the degree of operating leverage (DOL) and degree of total leverage (DTL) using 20,000
units as a base sales level.
(a3) the operating breakeven point in units.
(b) Which operating structure has greater operating leverage and business risk?
(c) If Tri-Star Productions, Inc. projects sales of 20,000 units, which operating structure is
recommended?
Answers:
(a1)

EBIT EPS
Operating
Structure 10,000 20,000 30,000 10,000 20,000 30,000
#1 $2,000 $4,500 $7,000 $1.05 $2.55 $4.05
#2 1,800 4,800 7,800 0.93 2.73 4.53

(a2) and (a3)

Operating Operating Breakeven

Structure DOL DTL Point in Units
#1 1.11 1.18 2,000 units
#2 1.25 1.32 4,000 units
484 Gitman • Principles of Finance, Brief Fourth Edition

(b) Operating structure 2 has greater fixed costs, greater operating leverage, and greater
business risk than operating structure 1.
(c) If sales are projected at 20,000 units, Tri-Star Production, Inc. should choose
operating structure 2 because it results in a higher EBIT and EPS for the firm.
Operating structure 2 has a higher operating breakeven point, but with sales estimated
at 20,000 units versus a breakeven point of 4,000 units, the firm should take
advantage of the added leverage.
Level of Difficulty: 4
Learning Goal: 2
Topic: Leverage, Return, and Risk (Equation 12.1, Equation 12.2, Equation 12.3, Equation 12.4,
Equation 12.5, Equation 12.8, Equation 12.9, and Equation 12.10)
Table 12.1
Plan 1 Plan 2
Interest Expense $25,000 $50,000
Preferred Dividend $3,000 $1,500
Common Shares Outstanding 200,000 100,000

5. Assuming a 40 percent tax rate, what is the financial breakeven point for each plan? (See
Table 12.1.)
Answer: Financial breakeven point $Interest  Preferred Dividends/(1 – t)
Financing Plan 1: FBP  $25,000  3,000/(1 – 0.40)  $30,000
Financing Plan 2: FBP  $50,000  1,500/(1 – 0.40)  $52,500
Level of Difficulty: 3
Learning Goal: 5
Topic: Financial Breakeven Point

6. What is the degree of financial leverage at a base level EBIT of $120,000 for both financing plans?
The firm has a 40 percent tax rate. (See Table 12.1.)
Answer: Degree of financial leverage for Plan 1 at base level of EBIT
$120,000
  1.33
$120,000  $25,000  $3,000 /(1  0.40)
Degree of financial leverage for Plan 2 at base level of EBIT
$120,000
  1.78
$120,000  $50,000  $1,500 /(1  0.40)
Level of Difficulty: 3
Learning Goal: 5
Topic: Degree of Financial Leverage (Equation 12.6 and Equation 12.7)
 Chapter 11 Leverage and Capital Structure 485

7. What is the EPS under Financing Plan 1, if the firm projects EBIT of $200,000 and has a tax rate of
40 percent? (See Table 12.1.)
Answer: Calculate the EPS with the formula:
(EBIT  Interest)(1  tax rate)  PD
EPS 
# of common shares outstanding
($200,000  $25,000)(1  0.40)  $3,000
EPS   0.51
200,000
Level of Difficulty: 3
Learning Goal: 5
Topic: Financial Breakeven

8. At about what EBIT level should the financial manager be indifferent to either plan? (See
Table 12.1.)
Answer:
(EBIT  25,000)(1  0.40)  3,000 (EBIT  50,000)(1  0.40)  1,500

200,000 100,000
At EBIT  $75,000.
Level of Difficulty: 3
Learning Goal: 5
Topic: Financial Breakeven

9. Which plan has a higher degree of financial leverage and financial risk? (See Table 12.1.)
Answer: Financing Plan 2
Level of Difficulty: 3
Learning Goal: 5
Topic: Financial Leverage and Financial Risk (Equation 12.6 and Equation 12.7)

10. Frankline Coin, Inc. is considering two capital structures. The key information follows. Assume a
40 percent tax rate and expected EBIT of $50,000.

Source of Capital Structure 1 Structure 2

Long-term debt $500,000 @ 8% $350,000 @ 7%
Common stock 10,000 shares 20,000 shares

(a) Calculate two EBIT-EPS coordinates for each of the structures.

(b) Indicate over what EBIT range, if any, each structure is preferred.
486 Gitman • Principles of Finance, Brief Fourth Edition

Answers:
(a)

Structure 1 Structure 2
EBIT EPS EBIT EPS
Coordinates 40,000; 0 24,500; 0
50,000; 0.60 50,000; 0.77
60,000; 1.20 60,000; 1.07

(b) Calculation of indifference point

EPS (Structure 1)  EPS (Structure 2)
(EBIT – $40,000)(1 – 0.40)/10,000 (EBIT – $24,500)(1 – 0.40)/20,000
If EBIT is expected to be less than $55,500, structure 2 will maximize EPS. If EBIT
is expected to be greater than $55,500, Structure 1 will maximize EPS.
Level of Difficulty: 4
Learning Goal: 5
Topic: EBIT-EPS Approach to Capital Structure

11. Tangshan Mining Company must choose its optimal capital structure. Currently, the firm has a 40
percent debt ratio and the firm expects to generate a dividend next year of $4.89 per share and
dividends are expected to grow at a constant rate of 5 percent for the foreseeable future.
Stockholders currently require a 10.89 percent return on their investment. Tangshan Mining is
considering changing its capital structure if it would benefit shareholders. The firm estimates that if
it increases the debt ratio to 50 percent, it will increase its expected dividend to $5.24 per share.
Because of the additional leverage, dividend growth is expected to increase to 6 percent and this
growth will be sustained indefinitely. However, because of the added risk, the required return
demanded by stockholders will increase to 11.34 percent.
(a) What is the value per share for Tangshan Mining under the current capital structure?
(b) What is the value per share for Tangshan Mining under the proposed capital structure?
(c) Should Tangshan Mining make the capital structure change? Explain.
Answers:
(a) The current price of Tangshan Mining stock is:
P  $4.89/(0.1089 – 0.05)  $83.02
(b) The price of Tangshan Mining stock if the capital structure change is made is
expected to be:
P  $5.24/(0.1134 – 0.065)  $108.26
(c) Yes. Tangshan Mining should make the change because it will maximize share price.
Level of Difficulty: 4
Learning Goal: 6
Topic: Optimal Capital Structure and Shareholder Wealth Maximization (Equation 12.12)