# MCQs on Financial and Strategic Management | Leverage

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• Last Updated on 19 October, 2021

1. Practical Problem & Solution

1.1 MCQs ON THEORY

2. MCQs ON THEORY ( With Answer Key )

2.1 PRACTICAL MCQs

2.3 HINTS FOR IMPORTANT PRACTICAL MCQs

## 1. Practical Problem & Solution

Problem No. 1] Prepare the income statement and calculate the degree of operating leverage, degree of financial leverage, and the degree of combined leverage for the following companies:

 Company P Q R Output (units) 3,00,000 75,000 5,00,000 Fixed costs (Rs.) 3,50,000 7,00,000 75,000 Unit variable cost (Rs.) 1.00 7.50 0.10 Interest expenses (Rs.) 25,000 40,000 25,000 Unit selling price (Rs.) 3.00 25.00 0.50

Applicable tax rate is 35%.

Ans.: Statement showing income & leverage of each company:

 Particulars P Q R Output (units) 3,00,000 75,000 5,00,000 Sales 9,00,000 18,75,000 2,50,000 Variable cost (3,00,000) (5,62,500) (50,000) Contribution 6,00,000 13,12,500 2,00,000 (-) Fixed cost (3,50,000) (7,00,000) (75,000) Earnings before interest & tax (EBIT) 2,50,000 6,12,500 1,25,000 (-) Interest (25,000) (40,000) (25,000) Earnings before tax (EBT) 2,25,000 5,72,500 1,00,000 (-) Tax @ 35% (78,750) (2,00,375) (35,000) Profit after tax (PAT) 1,46,250 3,72,125 65,000 Operating Leverage = 2.40 2.1429 1.60 Financial Leverage = 1.11 1.0699 1.25 Combined Leverage = 2.67 2.2926 2.00 Or (Operating Leverage × Financial Leverage)

Problem No. 2] The capital structure of a company consists of the following securities.

 Rs. 10% Preference Share Capital 1,00,000 Equity Share Capital (Rs. 10 Shares) 1,00,000 12% Debenture 75,000

The amount of operating profit is Rs. 69,000. The company is in 35% tax bracket.

You are required to calculate the financial leverage of the company.

Ans.:

 Operating Profit (EBIT) 69,000 (-) Interest (9,000) Earnings before tax (EBT) 60,000 (-) Tax @ 35% (21,000) Profit after tax (PAT) 39,000

If there are preference shares in capital structure then following formula has to be used to calculate the financial leverage.

= 1.5466

Problem No. 3] A company has the following capital structure

 Rs. 10,000 Equity Share of Rs. 10 each 1,00,000 2,000 10% Preference Share of Rs. 100 each 2,00,000 2,000 10% Debentures of Rs. 100 each 2,00,000

Calculate the EPS for each of the following levels of EBIT:

(i)   ` 1,00,000

(ii)   ` 60,000 and

(iii)   ` 1,40,000

The company in 50% tax bracket.

Calculate the financial leverage taking EBIT level under (i) base.

Ans.:

 Particulars I II III EBIT 1,00,000 60,000 1,40,000 (-) Interest (20,000) (20,000) (20,000) Earnings before tax (EBT) 80,000 40,000 1,20,000 (-) Tax @ 50% (40,000) (20,000) (60,000) Profit after tax (PAT) 40,000 20,000 60,000 (-) Preference dividend (20,000) (20,000) (20,000) Profit available for equity shareholders 20,000 – 40,000 No. of equity shares 10,000 10,000 10,000 EPS (Profit available for equity shareholders/No. of shares) × 100 2 – 4

Computation of financial leverage under different level of EBIT:

Problem No. 4] The following data relate of company XYZ Ltd.

 Rs. Sales 2,00,000 Less: Variable expenses (30%) (60,000) Contribution 1,40,000 Fixed operating expenses (1,00,000) EBIT 40,000 Less: Interest (5,000) Taxable income 35,000

(a) Using the concept of operating leverage state by what percentage will EBIT increase if there is a 10 per cent increase in sales?

(b) Using the concept of financial leverage, state by what percentage will taxable income increase if EBIT increases by 6%?

(c) Using the concept of combined leverage, State by what percentage taxable income will increase if sales increase by 6%.

Ans.:

 Operating Leverage = = = 3.5 Financial Leverage = = = 1.1429 Combined Leverage = = = 4.0

(1) Operating leverage is 3.5, this means that 1% change in sales will cause 3.5% change in EBIT.

(2) Financial leverage is 1.1429, this means that 1% change in EBIT will cause 1.1429% change in EBT.

(3) Combined leverage is 4, this means that 1% change in sales will cause 4% change in PAT/EPS.

(a) If there is a 10% increase in sale, EBIT increase by 35% (10 × 3.5). Concept of operating leverage applied.

(b) If EBIT increases by 6% taxable income increase by 6.9% (6 × 1.15). Concept of financial leverage applied.

(c) If sales increase by 6% taxable income will increase by 24% (6 × 4). Concept of combined leverage applied.

Problem No. 5] The balance sheet of Alpha Company is given below:

 Liabilities Rs. Assets Rs. Equity Capital (Rs. 10 per share) 90,000 Net Fixed Assets 2,25,000 10% Long Term Debt 1,20,000 Current Assets 75,000 Retained Earnings 30,000 Current Liabilities 60,000 3,00,000 3,00,000

The company’s total assets turnover ratio is 3, its fixed operating cost is Rs. 1,50,000 and its variable operating cost ratio is 50%. The income-tax rate is 50%.

Required to:

(i) Calculate the different type of leverages for the company.

(ii) Determine the likely level of sales & EBIT if EPS is:

(a)   Rs. 1            (b)  Rs. 2               (c) Rs. 0

Ans.:

Assets Turnover Ratio =

3 =

Sales = 9,00,000

 Sales 9,00,000 (-) Variable cost (4,50,000) Contribution 4,50,000 (-) Fixed cost (1,50,000) Earnings before interest & tax (EBIT) 3,00,000 (-) Interest (12,000) Earnings before tax (EBT) 2,88,000 (-) Tax @ 50% (1,44,000) Profit after Tax (PAT) 1,44,000

 Operating Leverage = Contribution/EBIT = 4,50,000/3,00,000 = 1.5 Financial Leverage = Contribution/EBIT = 3,00,000/2,88,000 = 1.042 Combined Leverage = Contribution/EBIT = 4,50,000/2,88,000 = 1.5625

Statement showing the likely level of sales & EBIT if EPS is 1, 2 & 0:

 Sales 3,60,000 3,96,000 3,24,000 (-) Variable cost (@ 50% of sales) (1,80,000) (1,98,000) (1,62,000) Contribution 1,80,000 1,98,000 1,62,000 (-) Fixed cost (1,50,000) (1,50,000) (1,50,000) Earnings before interest & tax (EBIT) 30,000 48,000 12,000 (-) Interest (12,000) (12,000) (12,000) Earnings before tax (EBT) 18,000 36,000 0 (-) Tax @ 50% (9,000) (18,000) 0 Profit after tax (PAT) 9,000 18,000 0 No. of shares 9,000 9,000 9,000 EPS 1 2 0

Perform reverse working downward to upward.

Problem No. 6] Calculate operating leverage and financial leverage under situations A, B and C and financial Plans I, II, and III respectively from the following information relating to the operating and capital structure of XYZ Co. Also find out the combinations of operating and financial leverages which give the highest value and the least value. How are these calculations useful to the financial manager in a company?

 Installed capacity 1,200 units Actual production & sales 800 units Selling price per unit Rs. 15 Variable cost per unit Rs. 10 Fixed Cost: Situation A Rs. 1,000 Situation B Rs. 2,000 Situation C Rs. 3,000

 Capital Structure: Financial Plan I Financial Plan II Financial Plan III Equity Rs. 5,000 Rs. 7,500 Rs. 2,500 Debt Rs. 5,000 Rs. 2,500 Rs. 7,500 Cost of debt 12% 12% 12%

Ans.: Sales – Variable Cost = Contribution; 15 – 10 = 5

 Particulars Situation A Situation B Situation C Plan I Plan II Plan III Plan I Plan II Plan III Plan I Plan II Plan III Contribution 4,000 4,000 4,000 4,000 4,000 4,000 4,000 4,000 4,000 (-) Fixed cost (1,000) (1,000) (1,000) (2,000) (2,000) (2,000) (3,000) (3,000) (3,000) EBIT 3,000 3,000 3,000 2,000 2,000 2,000 1,000 1,000 1,000 (-) Interest (600) (300) (900) (600) (300) (900) (600) (300) (900) EBT 2,400 2,700 2,100 1,400 1,700 1,100 400 700 100 Operating Leverage 1.33 2 4 Financial Leverage 1.25 1.11 1.43 1.43 1.18 1.82 2.5 1.43 10 Combined Leverage 1.66 1.48 1.90 2.86 2.36 3.64 10 5.72 40

Problem No. 7] If the combined leverage and operating leverage figures of a company are 2.5 and 1.25 respectively, find the financial leverage and P/V ratio, given that the equity dividend per share is Rs. 2, interest payable per year is Rs. 1 lakh, total fixed cost Rs. 0.5 lakh and sales Rs. 10 lakhs.

Ans.: Operating Leverage × Financial Leverage = Combined Leverage

1.25 × Financial Leverage = 2.5

Financial Leverage = 2

Let the EBIT be ‘x

2x – 2,00,000 = x

2xx = 2,00,000

EBIT = x = 2,00,000

EBT = 2,00,000 – 1,00,000 = 1,00,000

Let the Contribution be ‘x

Operating Leverage = Contribution/EBIT

1.25 = x/2,00,000

Contribution = x = 2,50,000

With the help of above computation know following income statement can be prepared.

 Sales 10,00,000 (-) Variable cost (7,50,000) Contribution 2,50,000 (-) Fixed cost (50,000) Earnings before interest & tax (EBIT) 2,00,000 (-) Interest (1,00,000) Earnings before tax (EBT) 1,00,000

Problem No. 8] A firm has sales of Rs. 75,00,000, variable cost of Rs. 42,00,000 and fixed cost of Rs. 6,00,000. It has a debt of Rs. 45,00,000 at 9% and equity of Rs. 55,00,000.

(i) What is the firm’s ROI?

(ii) Does it have favourable financial leverage?

(iii) If the firm belongs to an industry whose asset turnover is 3, does it have a high or low asset leverage?

(iv) What are the operating, financial and combined leverages of the firm?

(v) At what level of sales the EBT of the firm will be equal to zero?

Ans.: Income Statement

 Particulars Rs. Sales 75,00,000 (-) Variable cost (42,00,000) Contribution 33,00,000 (-) Fixed cost (6,00,000) EBIT 27,00,000 (-) Interest (4,05,000) EBT 22,95,000

Calculation of total investment:

 Particulars Rs. Equity Share Capital 55,00,000 10% Loan 45,00,000 Total Investment 1,00,00,000

(ii)   Return on Investment (ROI) is 27% whereas interest on loan funds is 9% which is less than ROI and hence firm has favourable financial leverage.

(iii)   Calculation of asset turnover ratio and comparison with industry:

Industry asset turnover ratio is 3 whereas firm has asset turnover ratio 0.75 which is low as compared to industry. This means that either firm has low sales as compared to industry or its assets are high and not effectively utilized towards sales.

(iv)   Computation of leverages:

(v)   Calculation of level of sales when EBT of the firm will be equal to zero:

 Particulars Rs. Sales 22,84,091 Variable cost (12,79,091) Contribution 10,05,000 (-) Fixed cost (6,00,000) EBIT 4,05,000 (-) Interest (4,05,000) EBT Nil

Perform reverse working downward to upward. Calculate P/v ratio from existing income statement which is 44% and then calculate sales as shown below.

Sales = 22,84,091

Problem No. 9] From the following details prepare income statement and calculate leverages.

 Company A B C Financial Leverage 3:1 4:1 2:1 Interest Rs. 2,000 Rs. 3,000 Rs. 10,000 Operating Leverage 4:1 5:1 3:1 Variable cost as a percentage to sales 66.67% 75% 50% Income Tax Rate 45% 45% 45%

Ans.: Income statement of company A, B & C:

 Particulars A B C Sales 36,000 80,000 1,20,000 (-) Variable cost (24,000) (60,000) (60,000) Contribution 12,000 20,000 60,000 (-) Fixed cost (9,000) (16,000) (40,000) Earnings before interest & tax (EBIT) 3,000 4,000 20,000 (-) Interest (2,000) (3,000) (10,000) Earnings before tax (EBT) 1,000 1,000 10,000 (-) Tax @ 45% (450) (450) (4,500) Profit after tax (PAT) 550 550 5,500

Problem No. 10] The following summarizes the percentage changes in operating income, percentage changes in revenues, and betas for four pharmaceutical firms.

 Firm Change in revenue Change in operating income Beta PQR Ltd. 27% 25% 1.00 RST Ltd. 25% 32% 1.15 TUV Ltd. 23% 36% 1.30 WXY Ltd. 21% 40% 1.40

Required:

(i) Calculate the degree of operating leverage for each of these firms. Comment also.

(ii) Use the operating leverage to explain why these firms have different beta.

Ans.:

 PQR Ltd. = 25%/27% = 0.93 RST Ltd. = 32%/25% = 1.28 TUV Ltd. = 36%/23% = 1.57 WXY Ltd. = 40%/21% = 1.91

Why these firms have different beta: Operating leverage is directly linked to fixed cost. High operating leverage indicated higher level of burden of fixed cost. Thus, two companies with identical revenue may have different operating leverage because of different fixed cost. In such case company having higher fixed cost has high operating leverage as compared to other and consequently has high business risk.

Beta is measure of non-diversifiable risk. It measures the sensitivity of stock with market. Beta of market itself is always one. If company has beta of 1.2 it indicate that it is 20% more risky than market. On the other hand if company has 0.9 beta then it indicates that is 10% less risky than market. To conclude high beta indicates more risk as compared to market.

In relation to given problem with the increase in operating leverage beta is also increasing hence it indicates that more risk is involved in subsequent company than previous one.

Problem No. 11] The following details of Alpha Ltd. for the year ended 2010 are furnished:

 Financial leverage 2:1 Operating leverage 3:1. Interest charges per annum Rs. 20 lakh Corporate tax rate 40% Variable cost as percentage of sales 60%

Prepare income statement of the company.

[CS (Professional) – June 2011] (6 Marks)

Ans.:

Income statement of Alpha Ltd.:

 Particulars Rs. Sales 100% 3,00,00,000 Variable cost (60%) (1,80,00,000) Contribution 40% 1,20,00,000 (-) Fixed cost (80,00,000) EBIT 40,00,000 (-) Interest (20,00,000) EBT 20,00,000 (-) Tax @ 40% (8,00,000) Profit after tax (PAT) 12,00,000

### 1.1 MCQs ON THEORY

1. The term Leverage in general refers to a –

(A)  Relationship between fixed cost and profit.

(B)  Relationship between sales and fixed cost.

(C)  Relationship  between  two  inter- related variables.

(D)  Relationship between two unrelated variables.

1. In financial analysis Leverage represents the influence of one ______ over some other related ________

(A)  Non-financial variable; financial variable

(B)  Financial variable; financial variable

(C)  Financial variable; non-financial variable

(D)  Variable relating to revenue; financial variable

1. Which of the following is not commonly used measures of leverage in financial analysis?

(A)  Operating Leverage

(B)  Financial Leverage

(C)  Combined Leverage

(D)  Matrix Leverage

1. _______ is the ratio of net operating income before fixed charges to net operating income after fixed charges.

(A)  Financial Leverage

(B)  Operating Leverage

(C)  Operation Leverage

(D)  Fiscal Leverage

1. Operating leverage indicates the tendency of operating profits (EBIT) to vary disproportionately with –

(A)  Profit

(B)  Fixed cost

(C)  Sales

(D)  EPS

1. Degree of ______ is the ratio of the percentage increase in earning per share (EPS) to the percentage increase in earnings before interest and taxes (EBIT).

(A)  Operating Leverage

(B)  Combined Leverage

(C)  Working Capital Leverage

(D)  Financial Leverage

1. There is no operating leverage if there is no _______

(A)  Profit

(B)  Sales

(C)  Fixed cost

(D)  EPS

1. EBIT is usually the same thing as:

(A)  Funds provided by operations

(B)  Earnings before taxes

(C)  Net income

(D)  Operating profit

1. Which of the following is correct formula to calculate Operating Leverage?

(A)  Operating Leverage = Contribution/EBIT

(B)  Operating Leverage = Contribution/EBIT

(C)  Operating Leverage = Contribution/EBIT

(D)  Operating Leverage = Contribution/EBIT

1. In the context of operating leverage break-even analysis, if selling price per unit rises and all other variables remain constant, the operating break-even point in units will:

(A)  Fall

(B)  Rise

(C)  Stay the same

(D)  Still be indeterminate until interest and preferred dividends paid are known

1. Which of the following is correct formula to calculate Operating Leverage?

(A)

(B)

(C)

(D)

1. A firm’s degree of total leverage (DTL) is equal to its degree of operating leverage ……….. its degree of financial leverage (DFL).

(A)   Plus

(B)   Minus

(C)   Divided by

(D)   Multiplied by

1. If operating leverage is 4, this means that –

(A)   4% change in sales will cause 1% change in EBIT.

(B)   1% change in sales will cause 4% change in EBIT.

(C)   1% change in sales will cause 4% change in EPS.

(D)   4% change in sales will cause 1% change in EPS.

1. Degree of total leverage can applied in measuring change in –

(A)   EBIT to a percentage change in sales

(B)   EPS to a percentage change in EBIT

(C)   EPS to a percentage change in sales

(D)   Sales to a percentage change in EBIT

1. If the fixed costs are high, the operating leverage will also be –

(A)   Low

(B)   High

(C)   Zero

(D)   Negative

1. Measure of business risk is –

(A)   Operating leverage

(B)   Financial leverage

(C)   Combines leverage

(D)   Working capital leverage

1. The presence of fixed costs in the total cost structure of a firm results into –

(A)   Financial Leverage

(B)   Operating Leverage

(C)   Super Leverage

(D)   Progressive leverage

1. A high operating leverage indicates –

(A)   Highly favourable situation as it consists of low fixed costs.

(B)   Highly risky situation as it consists of large interest costs.

(C)   Highly favourable situation as it consists of higher EPS.

(D)   Highly risky situation as it consists of large fixed costs.

1. Match List-I with List-II and select the correct answer using the codes given below the lists:
 List-I List-II P.   Factoring 1.   Sales Q.   Operating leverage 2.   Fixed interest cost R.   Debtors turnover ratio 3.   Working capital S.   Financial leverage 4.   Break-even point 5.   Fixed cost

Select the correct answer from the options given below:

 P Q R S (A) 4 5 1 2 (B) 3 5 2 1 (C) 3 5 1 2 (D) 4 2 3 5

1. Operating leverage depends on –

I. Contribution

II. Interest cost

III.   Fixed cost

IV. Volume of sales

V. EPS

VI. Profit after tax (PAT)

Select correct answer from the options given below:

(A)   I, IV, III

(B)   II, V, VI

(C)   I, III, V

(D)   VI, I, III

1. Which of the following is correct formula to calculate Financial Leverage?

(A)   Financial Leverage = EBT/EBIT

(B)   Financial Leverage = EBIT/EPS

(C)   Financial Leverage = EPS/EBIT

(D)   Financial Leverage = EBIT/EBT

1. A firm has a DOL of 4.5 at Q units. What does this tell us about the firm?

(A)   If sales rise by 4.5%, then EBIT will rise by 1%.

(B)   If EBIT rises by 4.5%, then EPS will rise by 1%.

(C)   If EBIT rises by 1%, then EPS will rise by 4.5%.

(D)   If sales rise by 1%, then EBIT will rise by 4.5%

1. High operating leverage shows –

(A)   Higher burden of fixed cost and high EBIT.

(B)   Low burden of fixed cost and high EBIT.

(C)   Higher burden of fixed cost and low EBIT.

(D)   Low burden of fixed cost and low EBIT.

1. Operating leverage is directly _____ to business risk.

(A)   Proportional

(B)   Not proportional

(C)   Unrelated

(D)   Not related

1. A firm has a DFL of 5.5. What does this tell us about the firm?

(A)   If sales rise by 5.5%, then EBIT will rise by 1%.

(B)   If EBIT rises by 5.5%, then EPS will rise by 1%.

(C)   If EBIT rises by 1%, then EPS will rise by 5.5%.

## 2. MCQs ON THEORY ( With Answer Key )

1. The term Leverage in general refers to a –

(A)   Relationship between fixed cost and profit.

(B)   Relationship between sales and fixed cost.

(C)   Relationship between two interrelated variables.

(D)   Relationship between two unrelated variables.

1. In financial analysis Leverage represents the influence of one ______ over some other related ________

(A)   Non-financial variable; financial variable

(B)   Financial variable; financial variable

(C)   Financial variable; non-financial variable

(D)   Variable relating to revenue; financial variable

1. Which of the following is not commonly used measures of leverage in financial analysis?

(A)   Operating Leverage

(B)   Financial Leverage

(C)   Combined Leverage

(D)   Matrix Leverage

1. _______ is the ratio of net operating income before fixed charges to net operating income after fixed charges.

(A)   Financial Leverage

(B)   Operating Leverage

(C)   Operation Leverage

(D)   Fiscal Leverage

1. Operating leverage indicates the tendency of operating profits (EBIT) to vary disproportionately with –

(A)   Profit

(B)   Fixed cost

(C)   Sales

(D)   EPS

1. Degree of ______ is the ratio of the percentage increase in earning per share (EPS) to the percentage increase in earnings before interest and taxes (EBIT).

(A)   Operating Leverage

(B)   Combined Leverage

(C)   Working Capital Leverage

(D)   Financial Leverage

1. There is no operating leverage if there is no _______

(A)   Profit

(B)   Sales

(C)   Fixed cost

(D)   EPS

1. EBIT is usually the same thing as:

(A)   Funds provided by operations

(B)   Earnings before taxes

(C)   Net income

(D)   Operating profit

1. Which of the following is correct formula to calculate Operating Leverage?
 (A) Operating Leverage = Contribution EBIT (B) Operating Leverage = EBIT Contribution (C) Operating Leverage = EBIT Contribution (D) Operating Leverage = Contribution EBIT
1. In the context of operating leverage break-even analysis, if selling price per unit rises and all other variables remain constant, the operating break-even point in units will:

(A)   Fall

(B)   Rise

(C)   Stay the same

(D)   Still be indeterminate until interest and preferred dividends paid are known

1. Which of the following is correct formula to calculate Operating Leverage?
 (A) % change in EPS % change in Sales (B) % change in EBIT % change in EPS (C) % change in EBIT % change in Sales (D) % change in Sales % change in EBIT
1. A firm’s degree of total leverage (DTL) is equal to its degree of operating leverage ……………… its degree of financial leverage (DFL).

(A)   Plus

(B)   Minus

(C)   Divided by

(D)   Multiplied by

1. If operating leverage is 4, this means that –

(A)   4% change in sales will cause 1% change in EBIT.

(B)   1% change in sales will cause 4% change in EBIT.

(C)   1% change in sales will cause 4% change in EPS.

(D)   4% change in sales will cause 1% change in EPS.

1. Degree of total leverage can applied in measuring change in –

(A)   EBIT to a percentage change in sales

(B)   EPS to a percentage change in EBIT

(C)   EPS to a percentage change in sales

(D)   Sales to a percentage change in EBIT

1. If the fixed costs are high, the operating leverage will also be –

(A)   Low

(B)   High

(C)   Zero

(D)   Negative

1. Measure of business risk is –

(A)   Operating leverage

(B)   Financial leverage

(C)   Combines leverage

(D)   Working capital leverage

1. The presence of fixed costs in the total cost structure of a firm results into –

(A)   Financial Leverage

(B)   Operating Leverage

(C)   Super Leverage

(D)   Progressive leverage

1. A high operating leverage indicates –

(A)   Highly favourable situation as it consists of low fixed costs.

(B)   Highly risky situation as it consists of large interest costs.

(C)   Highly favourable situation as it consists of higher EPS.

(D)   Highly risky situation as it consists of large fixed costs.

1. Match List-I with List-II and select the correct answer using the codes given below the lists:
 List-I List-II P.   Factoring 1.   Sales Q.   Operating leverage 2.   Fixed interest cost R.   Debtors turnover ratio 3.   Working capital S.   Financial leverage 4.   Break- even point 5.   Fixed cost

Select the correct answer from the options given below:

 P Q R S (A) 4 5 1 2 (B) 3 5 2 1 (C) 3 5 1 2 (D) 4 2 3 5
1. Operating leverage depends on –

I. Contribution

II. Interest cost

III.   Fixed cost

IV. Volume of sales

V. EPS

VI. Profit after tax (PAT)

Select correct answer from the options given below:

(A)   I, IV, III

(B)   II, V, VI

(C)   I, III, V

(D)   VI, I, III

1. Which of the following is correct formula to calculate Financial Leverage?
 (A) Financial Leverage = EBT/EBIT (B) Financial Leverage =EBIT/EPS (C) Financial Leverage = EPS/EBIT (D) Financial Leverage = EBIT/EBT

1. A firm has a DOL of 4.5 at Q units. What does this tell us about the firm?

(A)   If sales rise by 4.5%, then EBIT will rise by 1%.

(B)   If EBIT rises by 4.5%, then EPS will rise by 1%.

(C)   If EBIT rises by 1%, then EPS will rise by 4.5%.

(D)   If sales rise by 1%, then EBIT will rise by 4.5%

1. High operating leverage shows –

(A)   Higher burden of fixed cost and high EBIT.

(B)   Low burden of fixed cost and high EBIT.

(C)   Higher burden of fixed cost and low EBIT.

(D)   Low burden of fixed cost and low EBIT.

1. Operating leverage is directly _____ to business risk.

(A)   Proportional

(B)   Not proportional

(C)   Unrelated

(D)   Not related

1. A firm has a DFL of 5.5. What does this tell us about the firm?

(A)   If sales rise by 5.5%, then EBIT will rise by 1%.

(B)   If EBIT rises by 5.5%, then EPS will rise by 1%.

(C)   If EBIT rises by 1%, then EPS will rise by 5.5%.

(D)   If sales rise by 1%, then EBIT will rise by 5.5%.

1. More operating leverage leads to –

(A)   Less financial risk

(B)   More financial risk

1. Which of the following is correct formula to calculate Financial Leverage?
 (A) % change in EPS % change in EBIT (B) % change in EBIT % change in EPS (C) % change in EBT % change in EPS (D) % change in Contribution % change in EPS
1. Higher operating leverage is related to the use of additional __________

(A)   Fixed costs

(B)   Variable costs

(C)   Debt financing

(D)   Common equity financing

1. Financial leverage indicates –

(A)   The tendency of profit before tax (PBT) to vary disproportionately with sales.

(B)   The tendency of sales to vary disproportionately with fixed cost.

(C)   The tendency of profit after tax (PAT) to vary disproportionately with fixed cost.

(D)   The tendency of profit before tax (PBT) to vary disproportionately with operating profit (EBIT).

1. Lower financial leverage is related to the use of additional __________

(A)   Fixed costs

(B)   Variable costs

(C)   Debt financing

(D)   Common equity financing

1. The operating leverage indicates the impact of changes in sales on –

(A)   Operating income

(B)   Operating cost

(C)   Operating profit after tax

(D)   Operating sales

1. Match List-I with List-II and select the correct answer using the codes given below the lists:
 List-I List-II T. Matching approach 1. Dividend policy U. Combined leverage 2. Inventory management V. Ordering quantity 3. Working capital W. Bonus shares 4. Should low as compared other industries in firm 5. Authorized capital

Select the correct answer from the options given below:

 T U V W (A) 3 4 1 2 (B) 3 4 4 5 (C) 3 4 2 1 (D) 4 3 2 1
1. If financial leverage is 2.5, this means that –

(A)   2.5% change in EBIT will cause 1% change in EBT

(B)   1% change in sales will cause 2.5% change in EBT

(C)   2.5% change in sales will cause 1% change in EBT

(D)   1% change in EBIT will cause 2.5% change in EBT

1. Which of the following is correct formula to calculate Financial Leverage (FL) when capital structure consists of preference shares and equity shares?
 (A) (B) (C) (D)
1. Which of the following formulas represents a correct calculation of the degree of operating leverage?

(A)   (Q – QBE)/Q

(B)   (EBIT)/(EBIT – FC)

(C)   [Q(P – V) + FC]/[Q(P – V)]

(D)   [Q(P – V)]/[Q(P – V) – FC]

1. Where a company has large amount of fixed interest charges, the financial leverage will be ______

(A)   High

(B)   Low

(C)   Negative

(D)   Unreliable

1. Which of the following formulas represents the correct calculation of the degree of financial leverage?

(A)   [NI + T + I]/[NI – I – PD/(1 – T)]

(B)   EBIT/[EBIT – I – PD/(1 – T)]

(C)   EBIT/[NI – I – PD/(1 – T)]

(D)   All of the above are correct methods to calculate the degree of financial leverage (DFL).

1. The maximum amount of debt (and other fixed-charge financing) that a firm can adequately service is referred to as the __________.

(A)   Debt capacity

(B)   Debt-service burden

(D)   Fixed-charge burden

1. High financial leverage is not good as it indicates the large content of –

(A)   Fixed cost

(B)   Fixed interest charges

(C)   Variable cost charges

(D)   Contribution

1. The cash required during a specific period to meet interest expenses and principal payments is referred to as the:

(A)   Debt capacity

(B)   Debt-service burden

(D)   Fixed-charge burden

1. Earnings to equity shareholders (EPS) will fluctuate violently if –

(A)   Financial leverage is very high

(B)   Operating leverage is very high

(C)   Working capital leverage is very high

(D)   Operating leverage is very low

1. If the Return on Investment (ROI) exceeds the rate of interest on debt, it is _______ financial leverage.

(A)   Unfavourable

(C)   A favourable

(D)   Negative

1. Which one of the following is correct?

(i)   Liquidity ratios measure’s long term solvency of a concern.

(ii)   Inventory is a part of liquidity assets.

(iii)   Financial leverage is related to business risk.

(iv)   The amount of gross assets is equal to net capital employed.

Select the correct answer from the options given below:

(A)   (i), (ii) and (iv)

(B)   (ii), (iii) and (iv)

(C)   (i), (ii), (iii) and (iv)

(D)   None of the above

1. High operating leverage combined with high financial leverage will constitute –

(A)   Favourable situation

(B)   Positive situation

(C)   Less risky situation

(D)   Risky situation

(i)   With the increase in fixed cost operating leverage diminishes.

(ii)   Net working Capital is the excess of current assets over current liabilities.

(iii)   Greater the size of the business unit larger will be the requirement of working capital.

(iv)   Working Capital is also known as circulating capital.

Which of the above statement is correct?

(A)   (i), (ii) and (iii)

(B)   (ii), (iii) and (iv)

(C)   (iii), (iv) and (i)

(D)   (i), (ii) and (iv)

1. Which of the following can be treated as ‘Ideal Situation’?

(A)   High operating cost and low financial leverage.

(B)   Low operating leverage and high financial leverage.

(C)   Operating & financial leverage both should be low.

(D)   Operating & financial leverage both should be high.

1. Assertion (A):

High operating leverage shows higher burden of fixed cost.

Reason (R):

As fixed cost goes on increasing EBIT reduces.

Select the correct answer from the options given below:

(A)   (A) is correct but (R) is incorrect.

(B)   (A) is incorrect but (R) is correct.

(C)   Both (A) and (R) are not correct.

(D)   (A) is correct and (R) is correct explanation of (A)

1. Which of the following statement is correct?

(A)   If a business firm has a lot of variable costs as compared to fixed costs, then the firm is said to have high operating leverage.

(B)   Combined Leverage = % change in EPS multiplied by % change in Sales

(C)   If a business firm has a lot of fixed costs as compared to variable costs, then the firm is said to have high operating leverage.

(D)   If contribution is less than fixed cost, operating leverage will be favourable and vice versa.

1. Operating leverage may be defined as:

(A)   The degree to which debt is used in financing the firm

(B)   The difference between price and variable costs

(C)   The extent to which capital assets and fixed costs are utilized

(D)   The difference between fixed costs and the contribution margin

1. Degree of ______ is the ratio of percentage change in earning per share to the percentage change in sales.

(A)   Financial leverage

(B)   Operating leverage

(C)   Combined leverage

(D)   Working leverage

### 2.1 PRACTICAL MCQs

1. Output (units) = 3,00,000

Fixed cost = ` 3,50,000

Unit variable cost = ` 1.00

Interest expenses = ` 25,000

Unit selling price = ` 3.00

Applicable tax rate is 35%

Calculate Operating Leverage.

(A)   1.11

(B)   2.40

(C)   2.67

(D)   1.07

1. Output (units) = 3,00,000

Fixed cost = ` 3,50,000

Unit variable cost = ` 1.00

Interest expenses = ` 25,000

Unit selling price = ` 3.00

Applicable tax rate is 35%

Calculate Financial Leverage.

(A)   1.11

(B)   2.40

(C)   2.67

(D)   1.07

1. Output (units) = 3,00,000

Fixed cost = ` 3,50,000

Unit variable cost = ` 1.00

Interest expenses = ` 25,000

Unit selling price = ` 3.00

Applicable tax rate is 35%

Calculate Combined Leverage.

(A)   2.67

(B)   2.30

(C)   2.00

(D)   2.15

1. If operating leverage is 2.1429 and financial leverage is 1.0699 then combined leverage will be –

(A)   2.2927

(B)   2.0029

(C)   0.4993

(D)   Data given is not sufficient

1. If combined leverage is 2 and financial leverage is 1.25 then operating leverage will be –

(A)   0.625

(B)   2.50

(C)   1.60

(D)   Data given is not sufficient

1. If combined leverage is 2.2926 and operating leverage is 2.1429 then financial leverage will be –

(A)   1.0699

(B)   0.9347

(C)   4.9128

(D)   Data given is not sufficient

1. A company has sales of ` 1 lakh. The variable costs are 40% of the sales while the fixed operating costs amount to ` 30,000. The amount of interest on long-term debts is ` 10,000. You are required to calculate the combined leverage.

(A)   4

(B)   2

(C)   3

(D)   5

1. Operating leverage is 4. This means 10% change in sales will cause –

(A)   4% change in variable cost

(B)   40% change in EPS

(C)   4% change in EBIT

(D)   40% change in EBIT

1. Financial leverage is 2.5. This means 10% change in EBIT will cause –

(A)   2.5% change in EBT

(B)   2.5% change in EPS

(C)   25% change in sales

(D)   25% change in EBT and EPS

1. Combined leverage is 3.125. This means 10% change in Sales will cause –

(A)   31.25% change in PAT

(B)   31.25% change in EPS

(C)   31.25% change in capital employed

(D)   Both (A) and (B)

1. If there is a 10% increase in sale, EBIT increase by 35% and if sales increase by 6%, taxable income will increase by 24%. Operating leverage must be –

(A)   1.15

(B)   3.50

(C)   4.00

(D)   2.67

1. If EBIT increases by 6%, taxable income increases by 6.9%. If sales increase by 6%, taxable income will increase by 24%.

Financial leverage must be –

(A)   1.19

(B)   1.13

(C)   1.12

(D)   1.15

1. If sales increase by 6% taxable income i.e. PAT and EPS will increase by 24%.

Combined leverage must be –

(A)   3

(B)   4

(C)   5

(D)   6

1. The capital structure of a company consists of the following securities.
 ` 10% Preference Share Capital 1,00,000 Equity Share Capital (` 10 Shares) 1,00,000 12% Debenture 75,000

The amount of operating profit is ` 69,000. The company is in 35% tax bracket. You are required to calculate the financial leverage of the company.

(A)   1.1500

(B)   1.5466

(C)   1.1566

(D)   1.1554

1. Operating leverage is 7 and financial leverage is 2.2858. How much change in sales will be required to bring 70% change in EBIT?

(A)   10%

(B)   70%

(C)   11.429%

(D)   30%

1. Financial leverage = 1.5465

EBIT = ` 1,38,000

Interest = ` 18,000

Tax rate = 35%.

Capital structure of the company consists of equity shares and preference shares.

Amount of Preference Dividend = ?

(A)   ` 19,950

(B)   ` 19,898

(C)   ` 20,000

(D)   ` 19,899

1. Total assets of Alpha Company are ` 3,00,000. The company’s total assets turnover ratio is 3, its fixed operating cost is ` 1,50,000 and its variable operating cost ratio is 50%. The income-tax rate is 50%. It also has long term debts of ` 1,20,000 on which interest @ 10% is payable. Operating, Financial & Combined Leverages of the company are –

(A)   1.5; 1.042; 1.563 respectively

(B)   1.05; 1.42; 1.05625 respectively

(C)   1.50; 1.42; 2.13 respectively

(D)   1.55; 1.042; 1.6151 respectively

1. Contribution = ` 4,00,000

EBIT = ` 3,00,000

10% Debenture = ` 6,00,000

Combined leverage = ?

(A)   1.63

(B)   1.66

(C)   1.68

(D)   1.62

1. Operating leverage = 2

Combined leverage = 3.5

EBIT = ` 2,80,000

Interest = ` 40,000

Tax rate = 50%.

Capital structure of the company consists of equity shares and preference shares.

Amount of Preference Dividend = ?

(A)   ` 39,967

(B)   ` 39,970

(C)   ` 39,000

(D)   ` 40,000

1. EBIT = ` 4,00,000

Fixed cost = ` 6,00,000

Interest = ` 80,000

Combined leverage = ?

(A)   Sufficient data is not given

(B)   3.12

(C)   3.215

(D)   3.125

1. EBIT = ` 40,000

Variable cost = ` 2,40,000

Sales = ` 4,00,000

Operating leverage = ?

(A)   3.5

(B)   4.125

(C)   4.0

(D)   3.125

1. Contribution = ` 7,00,000

Fixed cost = ` 2,00,000

Interest = ` 3,00,000

Financial leverage = ?

(A)   2.0

(B)   1.5

(C)   2.5

(D)   1.0

1. Contribution of a firm is ` 4,000.
 Fixed Cost: Situation A ` 1,000 Situation B ` 2,000 Situation C ` 3,000

Compute the operating leverage for the three situations.

(A)   1.33; 1.18; 1.82

(B)   1.33; 2.36; 2.86

(C)   2.86; 2.00; 3.64

(D)   1.33; 2.00; 4.00

1. EBIT of a firm is ` 3,000.
 Financial Plan Plan I Plan II Plan III Equity ` 5,000 ` 7,500 ` 2,500 Debt ` 5,000 ` 2,500 ` 7,500 Cost of debt 12% 12% 12%

Compute the financial leverage for the three plans respectively.

(A)   1.33; 1.11; 1.43

(B)   1.25; 1.18; 1.43

(C)   1.66; 1.48; 1.90

(D)   1.25; 1.11; 1.43

1. Calculate Financial Leverage & EPS assuming 20% before tax rate of return on assets. Other data:
 (`  in Lakhs) Particulars Solid Ltd. Sound Ltd. Assets 100 100 12% Debt – 50 Equity (` 10 each) 100 50

Applicable tax rate firm is 50%.

Select the correct answer from the options given below:

 Solid Ltd. Sound Ltd. EPS FL EPS FL (A) 0.50 1.00 0.40 2.50 (B) 1.00 1.40 1.00 1.43 (C) 1.00 1.00 1.40 1.43 (D) 1.40 1.43 1.00 1.00
1. From the following data of Abhishek Ltd., compute the operating leverage, financial leverage, combined leverage.
 ` EBIT 10 lakh Profit before tax (PBT) 4 lakh Fixed cost 6 lakh

(A)   1.6; 2.5, 4.0

(B)   2.5; 1.6; 4.0

(C)   4.0; 2.5; 1.6

(D)   4.0; 1.5; 2.5

1. From the following data of Tanishka Ltd., compute the percentage change in earnings per share (EPS), if sales are expected to increase by 5%:
 ` EBIT 16.00 lakh Profit before tax (PBT) 6.40 lakh Fixed cost 9.60 lakh

(A)   5%

(B)   10%

(C)   4%

(D)   20%

1. Following data is available for Alpha Ltd.
 Financial leverage 2:1 Operating leverage 3:1 Interest charges ` 20 lakh Corporate tax rate 40% Variable (% of sales) 60%

Sales = ?

(A)   ` 1,00,00,000

(B)   ` 1,20,00,000

(C)   ` 2,00,00,000

(D)   ` 3,00,00,000

1. Following data is available for X Ltd.
 Variable cost (% of sales) 70% Interest expense ` 20,000 DOL 5:1 DFL 3:1 Corporate tax rate 30%

EBIT = ?

(A)   ` 30,000

(B)   ` 20,000

(C)   ` 60,000

(D)   ` 15,000

1. Following data is available for Y Ltd.
 Variable cost (% of sales) 75% Interest expense ` 30,000 DOL 6:1 DFL 4:1 Corporate tax rate 30%

Contribution = ?

(A)   ` 9,60,000

(B)   ` 2,40,000

(C)   ` 3,00,000

(D)   ` 7,80,000

1. Following data is available for Z Ltd.
 Variable cost (% of sales) 50% Interest expense ` 1,00,000 DOL 2:1 DFL 2:1 Corporate tax rate 30%

Sales = ?

(A)   ` 4,00,000

(B)   ` 6,00,000

(C)   ` 8,00,000

(D)   ` 9,00,000

From the following information answer next 3 questions:

 Sales 4,00,000 Less: Variable expenses 1,40,000 Contribution 2,60,000 Less: Fixed expenses 1,80,000 EBIT 80,000 Less: Interest 10,000 Taxable income 70,000
1. What percentage will EBIT increase, if there is a 10% increase in sales?

(A)   32.0%

(B)   31.14%

(C)   33.71%

(D)   32.5%

1. What percentage will taxable income increase, if EBIT increases by 6%?

(A)   6.86%

(B)   6.67%

(C)   6.33%

(D)   6.22%

1. What percentage will taxable income increase, if the sales increase by 6%

(A)   22.29%

(B)   22.92%

(C)   22.78%

(D)   22.87%

From the following information answer next 3 questions:

Following information relating to the operations and capital structure of Swadeshi Ltd. is available:

Installed capacity: 2,000 units

Production & sales: 50% of installed capacity

Selling price per unit: ` 20

Variable cost per unit: ` 10.

Fixed costs:

Situation-1: ` 4,000

Situation-2: ` 5,000

Capital structure:

 Financial Plan A B Equity capital 5,000 15,000 10% Debt capital 15,000 5,000 20,000 20,000
1. What is the Operating Leverage?
 Situation 1 Situation 2 (A) 2.00 1.67 (B) 1.67 1.33 (C) 1.67 2.00 (D) 1.33 1.67
1. What is the Financial Leverage?
 Situation 1 Situation 2 Plan A Plan B Plan A Plan B (A) 1.33 1.43 1.09 1.11 (B) 1.33 1.43 1.11 1.09 (C) 1.33 1.09 1.43 1.11 (D) 1.09 1.33 1.43 1.11
1. What is the Combined Leverage?
 Situation 1 Situation 2 Plan A Plan B Plan A Plan B (A) 2.22 1.81 2.22 2.86 (B) 2.22 2.86 1.81 2.22 (C) 2.22 1.82 2.86 2.22 (D) 1.81 2.22 2.86 2.22
1. Total assets of Honey Well Ltd. are ` 6,00,000. Total assets turnover ratio is 2.5 times. The fixed operating costs are ` 2,00,000 and variable operating cost ratio is 40%. Income tax rate is 30%. Calculate operating, financial and combined leverage?

(A)   1.2857; 1.0355; 1.3314

(B)   1.0355; 1.2857; 1.3314

(C)   1.3314; 1.0355; 1.2857

(D)   1.2857; 1.3314; 1.2857

1. Total assets of Q Ltd. are ` 6,00,000. Total assets turnover ratio is 2.5 times. The fixed operating costs are ` 2,00,000 and variable operating cost ratio is 40%. Income tax rate is 30%. No. of equity shares are 18,000. Determine the likely level of EBIT if EPS is ` 6.

(A)   ` 1,54,286

(B)   ` 1,78,286

(C)   ` 1,54,682

(D)   ` 1,78,862

1. Which of the following company has greater business risk?
 (`  in lakhs) Particulars A Ltd. B Ltd. C Ltd. D Ltd. Sales 40 50 80 100 Variable cost (16) (15) (32) (30) Contribution 24 35 48 70 Fixed cost (10) (20) (30) (50) EBIT 14 15 18 20

(A)   A Ltd.

(B)   B Ltd.

(C)   C Ltd.

(D)   D Ltd.

1. ABC Ltd. has an average selling price of ` 10 per unit. Its variable unit costs are ` 7 and fixed costs amount to ` 1,70,000. It finances all its assets by equity funds. It pays 30% tax on its income. PQR Ltd. is identical to ABC Ltd. except in respect of the pattern of financing. The latter finances its assets 50% by equity and 50% by debt, the interest on which amounts to ` 20,000.

Which of the following statement is correct?

(A)   Both companies have similar business risk.

(B)   PQR Ltd. has high financial risk as compared to ABC Ltd.

(C)   PQR Ltd. has high business risk & financial risk as compared to ABC Ltd.

(D)   All of the above

1. Bling Ltd. supplies following data:

Operating leverage 2.5; financial leverage 3; EPS ` 30; market price per share ` 225; and capital 20,000 shares. It is proposed to raise a loan of ` 50,00,000 @ 18% for expansion. After expansion, sales will increase by 25% and fixed cost by ` 3,00,000.

Work out the market price per share after expansion, assuming tax rate @ 50%.

(A)   25.56

(B)   52.56

(C)   56.25

(D)   65.52

1. A firm has a DOL of 3.5 at Q units. What does this tell us about the firm?

(A)   If sales rise by 3.5% at the firm, then EBIT will rise by 1%.

(B)   If EBIT rises by 3.5% at the firm, then EPS will rise by 1%.

(C)   If EBIT rises by 1% at the firm, then EPS will rise by 3.5%.

(D)   If sales rise by 1% at the firm, then EBIT will rise by 3.5%

1. A firm has a DFL of 3.5. What does this tell us about the firm?

(A)   If sales rise by 3.5%, then EBIT will rise by 1%.

(B)   If EBIT rises by 3.5%, then EPS will rise by 1%.

(C)   If EBIT rises by 1%, then EPS will rise by 3.5%.

(D)   If sales rise by 1% at the firm, then EBIT will rise by 3.5%.

1. Calculate the degree of financial leverage (DFL) for a firm when its EBIT is ` 20,00,000. The firm has ` 30,00,000 in debt that costs 10% annually. The firm also has a 9%, ` 10,00,000 preferred stock issue outstanding. The firm pays 40% in taxes.

(A)   0.78

(B)   0.80

(C)   1.24

(D)   1.29

 1 (C) 2 (B) 3 (D) 4 (B) 5. (C) 6. (D) 7. (C) 8 (D) 9 (A) 10 (A) 11 (C) 12. (D) 13. (B) 14 (C) 15 (B) 16 (A) 17 (B) 18 (D) 19. (C) 20. (A) 21. (D) 22 (D) 23 (C) 24 (A) 25 (C) 26. (C) 27. (A) 28. (A) 29 (D) 30 (D) 31 (A) 32 (C) 33. (D) 34. (C) 35. (D) 36 (A) 37 (B) 38 (A) 39 (B) 40. (B) 41. (A) 42. (C) 43 (D) 44 (D) 45 (B) 46 (C) 47. (D) 48. (C) 49. (C) 50 (C) 51 (B) 52 (A) 53 (A) 54. (A) 55. (C) 56. (A) 57 (C) 58 (D) 59 (D) 60 (D) 61. (B) 62. (D) 63. (B) 64 (B) 65 (A) 66 (C) 67 (A) 68. (B) 69. (D) 70. (D) 71 (C) 72 (C) 73 (D) 74 (D) 75. (C) 76. (A) 77. (D) 78 (D) 79 (A) 80 (B) 81 (C) 82. (D) 83. (A) 84. (A) 85 (C) 86 (C) 87 (C) 88 (A) 89. (B) 90. (D) 91. (D) 92 (C) 93 (D) 94 (C) 95 (A)

2.3 HINTS FOR IMPORTANT PRACTICAL MCQs

1. Combined Leverage = 2.1429 × 1.0699 = 2.2927
2. Combined Leverage = Operating Leverage × Financial Leverage

2 = x × 1.25

x = Operating Leverage = 2/1.25 = 1.6

1. Use hint of 55 and solve accordingly.
 Sales 1,00,000 (-) Variable cost (40,000) Contribution 60,000 (-) Fixed cost (30,000) Earnings before interest & tax (EBIT) 30,000 (-) Interest (10,000) Earnings before tax (EBT) 20,000

 Combined Leverage = Contribution = 60,000 = 3 EBT 20,000
1. Financial Leverage =

1.5465 =

 1.5465 = 1,38,000 1,20,000 – 1.5385x

1,85,580 – 2.3792x = 1,38,000

2.3792x = 47,580

x = DP = 19,998 say 20,000

1. Operating leverage = 4,00,000/3,00,000 = 1.33

Financial leverage = 3,00,000/2,40,000 = 1.25

Combined leverage = 1.33 × 1.25 = 1.66

1. Financial Leverage = 3.5/2 = 1.75

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