Question

Bob is the CFO of a small manufacturing firm and he’s running some what if scenarios on the firms business and financial risk. The CEO asks him the following questions and Bob simply says true or false:

1. T/F business risk is the risk to the firm without the use of any debt and financial risk is the additional risk put on by using debt.

2. T/F Operating leverage is essentially how much fixed costs the firm has, and financial leverage is separate from business risk.

He then asks Bob to calculate these risks given the following information:

Sales = $10

Variable costs = $3

Fixed costs = $4

EBIT = $3

Interest expense = $1

# shares outstanding = 2

1. What is the DOL

2. If sales increase by 10% how much will EBIT increase

3. What is the DOL if there are no fixed costs

4. What is the DFL

5. If EBIT drops 10% how much do EPS change

6. What is the DTL

7. If sales increase by 20% how much do EPS change

8. T/F The DOL and SFL magnifies financial numbers in good times but also negatively magnifies financial numbers in bad times.

Answer 1

	1- True because financial risk relates to the risk arises due to the use of debt in capital structure while business risk related to operational efficiency of the business without use of debt
	2-True operational risk relates to how efficiently company is using its fixed cost while financial risk is sperate from operational risk
	sales	10
	less variable cost	3
	contribution	7
	less fixed cost	4
	EBIT	3
	Interest	1
	EBT	2
	No. of shares	2
	EPS = EBT/no. of shares	1
1-	Degree of operating leverage = contribution/EBIT	7/3	2.333333333
2-	If sales increases by 10%, EBIT will increase by = DOL* increase in sales	2.333*10%	23.33%
	new level of EBIT = current EBIT*(1+% increase in EBIT)	3*(1.2333)	3.70
3-	Degree of operating leverage = contribution/EBIT	7/7	1
	contribution	7
	EBIT = contribution-fixed cost = 7-0 =7	7
4-	Degree of financial leverage = EBIT/EBT	3/2	1.5
5-	If EBIT drops by 10% then change in EPS	1.5*-10%	-15%
	new level of EPS = current EPS*(1-%change in EPS)	1*(1-.15)	0.85
6-	Degree of total leverage = contribution/EBT	7/ 2	3.5
7-	if sales increases by 20% then change in EPS =DTL*change in sales	3.5*20%	70%
	new level of EPS = current level ofEPS*(1+%change in EPS)	1*(1.7)	1.7
8-	True because any change in financial variable will change the results of dependable variables like EBIT EPS and EBT in good as well as in bad time