CFA 2020 Level I Measures of Leverage Answers

Question #1 of 39 Question ID: 1205850 All else equal, which of the following statements about operating leverage is least accurate? A) Firms with high operating leverage experience greater variance in operating income. B) Lower operating leverage generally results in a higher expected rate of return. C) Operating leverage re ects the tradeo between variable costs and xed costs. Explanation Operating leverage is the trade o between xed and variable costs. Higher operating leverage typically is indicative of a rm with higher levels of risk (greater income variance). Given the positive risk/return relationship, higher operating leverage rms are expected to have a higher rate of return. And, lower operating leverage rms are expected to have a lower rate of return. (Study Session 11, Module 34.1, LOS 34.b) Question #2 of 39 Question ID: 1205865 Jayco, Inc., sells blue ink for $4.00 a bottle. The ink's variable cost per bottle is $2.00. Ink has xed cost of $10,000. What is Jayco's breakeven point in units? A) 6,000. B) 5,000. C) 2,500. Explanation QBE = [FC] / (P - V) QBE = [10,000] / (4.00 - 2.00) = 5,000 (Study Session 11, Module 34.1, LOS 34.d) Question #3 of 39 Financial leverage magni es: A) operating income variability. B) earnings per share variability. C) taxes. Explanation Question ID: 1205857 Financial leverage results in the existence of required interest payments and, hence, increased earnings per share variability. Higher debt ratios, given a xed asset base, result in a greater earnings per share variability. Operating income is based on the products and assets of the rm and not on the rm's nancing and, hence, has no impact on nancial leverage. Greater nancial leverage is likely to reduce taxes due to the tax deductibility of interest payments. (Study Session 11, Module 34.1, LOS 34.c) Question #4 of 39 Question ID: 1205844 Which of the following statements about leverage is most accurate? A) A decrease in interest expense will increase the company's degree of total leverage. B) If the company has no debt outstanding, then its degree of total leverage equals its degree of operating leverage. C) An increase in xed costs (holding sales and variable costs constant) will reduce the company's degree of operating leverage. Explanation If debt = 0 then DFL = 1 because DFL = EBIT/(EBIT - I) If debt = 0 then I = 0 and DFL = EBIT/(EBIT - 0) = EBIT/EBIT = 1 DTL = (DOL)(DFL) If DFL = 1 then DTL = (DOL)(1) which complies to DTL = DOL A decrease in interest expense will decrease DFL, which will decrease DTL. An increase in xed costs will increase the company's DOL. (Study Session 11, Module 34.1, LOS 34.b) Question #5 of 39 Question ID: 1205855 Given the following information on the annual operating results for ArtFrames, a producer of quality metal picture frames: Sales of $3,500,000. Variable costs at 45% of sales. Fixed costs of $1,050,000. Debt interest payments on $750,000 issued at par with an annual 9.0% coupon; market yield is currently 7.0%. ArtFrames's degree of operating leverage (DOL) and degree of nancial leverage (DFL) are closest to: DOL DFL A) 3.00 1.50 B) 2.20 1.08 C) 2.20 1.50 Explanation DOL = (sales – variable costs) / (sales – variable costs – xed costs) Variable costs = $3,500,000 × 45% = $1,575,000 Fixed costs = $1,050,000 DOL = ($3,500,000 – $1,575,000) / ($3,500,000 – $1,575,000 – $1,050,000) = 2.20 DFL = EBIT / (EBIT – interest) Interest = $750,000 × 9% = $67,500 EBIT = sales – variable costs – xed costs = $3,500,000 – $1,575,000 – $1,050,000 = $875,000 DFL = $875,000 / ($875,000 – $67,500) = 1.08 (Study Session 11, Module 34.1, LOS 34.b) Question #6 of 39 Question ID: 1205852 Jayco, Inc. sells 10,000 units at a price of $5 per unit. Jayco's xed costs are $8,000, interest expense is $2,000, variable costs are $3 per unit, and earnings before interest and taxes (EBIT) is $12,000. What is Jayco's degree of nancial leverage (DFL) and total leverage (DTL)? DFL DTL A) 1.20 2.00 B) 1.33 1.75 C) 1.33 2.00 Explanation DOL = [Q(P – V)] / [Q(P – V) – F] = [10,000(5 – 3)] / [10,000(5 – 3) – 8,000] = 1.67 DFL = EBIT / (EBIT – I) = 12,000 / (12,000 – 2,000) = 1.2 DTL = DOL × DFL = 1.67 × 1.2 = 2.0 (Study Session 11, Module 34.1, LOS 34.b) Question #7 of 39 Which of the following factors is least likely to a ect business risk? A) Interest rate variability. B) Operating leverage. C) Demand variability. Explanation Question ID: 1205833 Business risk can be de ned as the uncertainty inherent in a rm's return on assets (ROA). While changes in interest rates may impact the demand or input prices, there is a more direct impact on business risk with the other two choices. (Study Session 11, Module 34.1, LOS 34.a) Question #8 of 39 Question ID: 1205847 Given the following information on the annual operating results for ArtFrames, a producer of quality metal picture frames, what is the degree of operating leverage (DOL) and the degree of nancial leverage (DFL)? Sales of $3.5 million Variable Costs at 45% of sales Fixed Costs of $1.05 million Debt interest payments on $750,000 issued at par with an annual 9.0% coupon (current yield is 7.0%) Which of the following choices is closest to the correct answer? ArtFrame's DOL and DFL are: DOL DFL A) 2.20 1.08 B) 3.00 1.50 C) 2.20 1.50 Explanation The calculations are as follows: First, calculate the operating results: ArtFrames Annual Operating ResultsSales$3,500,000Variable Costs11,575,0001,925,000Fixed Costs1,050,000Earnings before interest and taxes (EBIT)875,000Interest Expense267,500807,5001Variable costs = 0.45 × 3,500,0002Interest Expense = 0.09 × 750,000 Second, calculate DOL: DOL = (Sales – Variable Costs) / (Sales – Variable Costs – Fixed Costs) = (3,500,000 – 1,575,000) / (3,500,000 – 1,575,000 – 1,050,000) = 2.20 Third, calculate DFL: DFL = EBIT / (EBIT – I) = 875,000 / 807,500 = 1.08 (Study Session 11, Module 34.1, LOS 34.b) Question #9 of 39 Question ID: 1205848 Which of the following statements regarding leverage is most accurate? A) A rm with high business risk is more likely to increase its use of nancial leverage than a rm with low business risk. B) High levels of nancial leverage increase business risk while high levels of operating leverage will decrease business risk. C) A rm with low operating leverage has a small proportion of its total costs in xed costs. Explanation A rm with high operating leverage has a high percentage of its total costs in xed costs. (Study Session 11, Module 34.1, LOS 34.b) Question #10 of 39 Question ID: 1205837 The uncertainty in return on assets due to the nature of a rm's operations is known as: A) nancial leverage. B) tax e ciency. C) business risk. Explanation Business risk is a function of the rm's revenue and expenses, resulting in operating income, or earnings before interest and taxes (EBIT). The main factors a ecting business risk are demand variability, sales price variability, input price variability, ability to adjust output prices, and operating leverage. Tax e ciency is tied to mutual fund investing, while nancial leverage requires the existence of debt. (Study Session 11, Module 34.1, LOS 34.a) Question #11 of 39 Question ID: 1205849 A rm expects to produce 200,000 units of our that can be sold for $3.00 per bag. The variable costs per unit are $2.00, the xed costs are $75,000, and interest expense is $25,000. The degree of operating leverage (DOL) and the degree of total leverage (DTL) is closest to: DOL DTL A) 1.3 1.3 B) 1.6 1.3 C) 1.6 2.0 Explanation DOL = Q(P – V) / [Q(P – V) – F] DOL = 200,000 (3 – 2) / [200,000(3 – 2) – 75,000] = 1.6 DTL = [Q(P - V) / Q(P - V) - F - I] DTL = 200,000 (3 - 2) / [200,000 (3 - 2) - 75,000 - 25,000] = 2 (Study Session 11, Module 34.1, LOS 34.b) Question #12 of 39 Question ID: 1205834 Hughes Continental is assessing its business risk. Which of the following factors would least likely be considered in the analysis? A) Input price variability. B) Debt-equity ratio. C) Unit sales levels. Explanation The main factors a ecting business risk are demand variability, sales price variability, input price variability, ability to adjust output prices, and operating leverage. Debt levels a ect nancial risk, not business (operating) risk. (Study Session 11, Module 34.1, LOS 34.a) Question #13 of 39 Question ID: 1205836 The two major types of risk a ecting a rm are: A) nancial risk and cash ow risk. B) business risk and nancial risk. C) business risk and collection risk. Explanation Business risk is the uncertainty regarding the operating income of a company. Financial risk refers to the uncertainty caused by the xed cost associated with borrowed money. (Study Session 11, Module 34.1, LOS 34.a) Question #14 of 39 Question ID: 1205861 Wanton's San Y'isidro Co. manufactures custom door knobs for international clients. Average Revenue is $35 per unit, variable costs are $15 per unit, and total costs are $200,000. If sales are 10,000 units, what is the rm's breakeven sales quantity? A) 1,750 units. B) 3,000 units. C) 2,500 units. Explanation For this problem you need 2 equations. Break-even quantity = Fixed Costs / (Price - Variable cost) Q = FC / (P - V) Fixed Costs = Total Costs - Variable Costs FC = TC - VC = 200,000 - 150,000 = 50,000 Q = 50,000 / (35 - 15) = 2,500 (Study Session 11, Module 34.1, LOS 34.d) Question #15 of 39 Question ID: 1205843 If a 10% increase in sales causes EPS to increase from $1.00 to $1.50, and if the rm uses no debt, then what is its degree of operating leverage? A) 5.0. B) 4.2. C) 4.7. Explanation Upon rst glance, it appears there is not enough information to complete the problem. However when one realizes DTL = (DOL)(DFL) it is possible to complete this problem. DTL = %ΔEPS/%ΔSales = 5 DFL = EBIT/(EBIT-I) = 1. (DOL)(1) =5 DOL= 5. (Study Session 11, Module 34.1, LOS 34.b) Question #16 of 39 Question ID: 1205842 As nancial leverage increases, what will be the impact on the expected rate of return and nancial risk? A) Both will rise. B) One will rise while the other falls. C) Both will fall. Explanation A higher breakeven point resulting from increased interest costs associated with debt nancing increases the risk of the company. Since the risk is tied to rm nancing, it is referred to as nancial risk. Given the positive risk-return relationship, the expected return of the company's common stock also rises. (Study Session 11, Module 34.1, LOS 34.b) Question #17 of 39 Question ID: 1205863 Annah Korotkin is the sole proprietor of CoverMeUp, a business that designs and sews outdoor clothing for dogs. Each year, she rents a booth at the regional Pet Expo and sells only blankets. Korotkin views the Expo as primarily a marketing tool and is happy to breakeven (that is, cover her booth rental). For the last 3 years, she has sold exactly enough blankets to cover the $750 booth rental fee. This year, she decided to make all blankets for the Expo out of high-tech waterproof/breathable material that is more expensive to produce, but that she believes she can sell for a higher pro t margin. Information on the two types of blankets is as follows: Per Unit Last Year's (Basic) Blanket This Year's (New) Blanket Sales Price $25 $40 Variable Cost $20 $33 Assuming that Korotkin remains most interested in covering the booth cost (which has increased to $840), how many more or fewer blankets (new style) does she need to sell to cover the booth cost? To cover this year's booth costs, Korotkin needs to sell: A) 42 fewer blankets than last year. B) 30 fewer blankets than last year. C) 42 more blankets than last year. Explanation To obtain this result, we need to calculate Last Year's Breakeven Quantity, This Year's Breakeven Quantity, and calculate the di erence. Step 1: Determine Last Year's (Basic Blanket) breakeven quantity: QBE = (Fixed Costs) / (Sales Price per unit – Variable Cost per unit) = 750 / (25 – 20) = 150 Step 2: Determine This Year's (New Blanket) breakeven quantity: QBE = (Fixed Costs) / (Sales Price per unit – Variable Cost per unit) = 840 / (40 – 33) = 120 Step 3: Determine Change in Units: ΔQ = QThis Year – QLast Year = 120 – 150 = –30. Korotkin needs to sell 30 fewer blankets. (Study Session 11, Module 34.1, LOS 34.d) Question #18 of 39 Question ID: 1205835 Which of the following sources of nancing is least likely to increase a rm's nancial risk? A) Operating leases. B) Fixed-rate debt. C) Common equity. Explanation Financial risk, in the context of a rm's nancing of its operations, results from taking on xed nancial obligations such as debt or operating leases. Common equity nancing does not involve xed obligations. (Study Session 11, Module 34.1, LOS 34.a) Question #19 of 39 Question ID: 1205854 FCO, Inc. (FCO) is comparing EBIT forecasts to help determine the impact its capital structure has on net income. Expected EBIT EBIT + 10% EBIT $80,000 $88,000 Interest expense 15,000 15,000 EBT 65,000 73,000 Taxes 26,000 29,200 Net income 39,000 43,800 Liabilities 200,000 Shareholder equity 250,000 Return on equity 15.60% FCO's degree of nancial leverage is closest to: A) 0.60. B) 0.80. C) 1.25. Explanation The degree of nancial leverage (DFL) is interpreted as the ratio of the percentage change in net income to the percentage change in EBIT. FCO can compare two EBIT forecasts to determine how net income is being driven by nancial leverage. DFL=(NI1−NI0)/NI0(EBIT1−EBIT0)/EBIT0DFL= (43,800−39,000)/39,000(88,000−80,000)/80,000=0.1230.100=1.23 (Study Session 11, Module 34.1, LOS 34.b) Question #20 of 39 A company's use of nancial leverage: A) increases default risk and decreases potential return on equity. B) decreases default risk and decreases potential return on equity. C) increases default risk and increases potential return on equity. Explanation Question ID: 1205860 Issuing debt introduces default risk. The interest expense associated with using debt represents a xed cost that reduces net income. However, compared to nancing entirely with equity, the lower net income is spread over a smaller base of shareholders' equity. This nancing structure increases the potential return on equity. (Study Session 11, Module 34.1, LOS 34.c) Question #21 of 39 Question ID: 1205846 Stromburg Corporation's sales are $75,000,000. Fixed costs, including research and development, are $40,000,000, while variable costs amount to 30% of sales. Stromburg plans an expansion which will generate additional xed costs of $15,000,000, decrease variable costs to 25% of sales, and permit sales to increase to $100,000,000. What is Stromburg's degree of operating leverage at the new projected sales level? A) 4.20. B) 3.50. C) 3.75. Explanation Sales = $100,000,000 VC of 25% of sales = 25,000,000 FC of 40,000,000 + 15,000,000 = 55,000,000 DOL= [100,000,000 – 25,000,000] / [100,000,000 – 25,000,000 – 55,000,000] = 3.75 (Study Session 11, Module 34.1, LOS 34.b) Question #22 of 39 Question ID: 1205830 All else equal, a rm's business risk is higher when: A) variable costs are the highest portion of its expense. B) the rm has low operating leverage. C) xed costs are the highest portion of its expense. Explanation The higher the percentage of a rm's costs that are xed, the higher the operating leverage, and the greater the rm's business risk and the more susceptible it is to business cycle uctuations. (Study Session 11, Module 34.1, LOS 34.a) Question #23 of 39 Question ID: 1205862 Jayco, Inc. has a division that makes red ink for the accounting industry. The unit has xed costs of $10,000 per month, and is expected to sell 40,000 bottles of ink per month. If the variable cost per bottle is $2.00 what price must the division charge in order to breakeven? A) $2.75. B) $2.50. C) $2.25. Explanation 40,000 = $10,000/(P - $2) 40,000P – $80,000 = $10,000 P = $90,000/40,000 = $2.25. (Study Session 11, Module 34.1, LOS 34.d) Question #24 of 39 Question ID: 1205856 Additional debt should be used in the rm's capital structure if it increases: A) earnings per share. B) rm earnings. C) the value of the rm. Explanation The key to nding the optimal capital structure is identifying the level of debt that will maximize rm value. Earnings and earnings per share are not critical in and of themselves when assessing rm value, because they do not consider risk. (Study Session 11, Module 34.1, LOS 34.c) Question #25 of 39 Question ID: 1205859 Which of the following statements regarding the impact of nancial leverage on a company's net income and return on equity (ROE) is most accurate? A) Using nancial leverage increases the volatility of ROE for a level of volatility in operating income. B) If a rm has a positive operating pro t margin, using nancial leverage will always increase ROE. C) Increasing nancial leverage increases both risk and potential return of existing bondholders. Explanation If a rm is nanced with 100% equity, there is a direct relationship between changes in the rm's ROE and changes in operating income. Adding nancial leverage (debt) to the rm's capital structure will cause ROE to become much more volatile and ROE will change more rapidly for a given change in operating income. The increased volatility in ROE re ects an increase in both risk and potential return for equity holders. Note that nancial leverage results in increased default risk, but since existing bond holders are compensated by coupon interest and return of principal, their potential return is unchanged. Although nancial leverage will generally increase ROE if a rm has a positive operating margin (EBIT/Sales), if the operating margin were small, the added interest expense could turn the rm's net pro t margin negative, which would in turn make ROE negative. (Study Session 11, Module 34.1, LOS 34.c) Question #26 of 39 Question ID: 1205839 The combination of operating risk and sales risk is known as: A) gearing risk. B) business risk. C) nancial risk. Explanation Business risk is the combination of sales risk and operating risk. Business risk refers to the risk associated with a rm's operating income and is the result of uncertainty about a rm's revenues and the expenditures necessary to produce those revenues. Sales risk is the uncertainty about the rm's sales. Operating risk refers to the additional uncertainty about operating earnings caused by xed operating costs. The greater the proportion of xed costs to variable costs, the greater a rm's operating risk. Financial risk refers to the additional risk that the rm's common stockholders must bear when a rm uses xed cost (debt) nancing. Gearing is a British term that refers to leverage. (Study Session 11, Module 34.1, LOS 34.a) Question #27 of 39 Question ID: 1205868 Steven's Bakery produces snack cakes and bread. Listed below are the operating costs for the snack cakes division and the bread division. Snack cakes Bread Price per package $2.00 $2.50 Variable cost per package $1.00 $1.30 Fixed operating costs $25,000 $30,000 Fixed nancing costs $10,000 $10,000 Compared to the snack cakes division, the operating breakeven quantity for the bread division is: A) greater. B) the same. C) less. Explanation The operating breakeven quantity for the snack cakes division is $25,000/($2.00 – $1.00) = 25,000. The operating breakeven quantity for the bread division is $30,000/($2.50 – $1.30) = 25,000. (Study Session 11, Module 34.1, LOS 34.e) Question #28 of 39 Question ID: 1205841 During a period of expansion in the economy, compared to rms with lower operating leverage, earnings growth for rms with high operating leverage will be: A) una ected. B) higher. C) lower. Explanation If a high percentage of a rm's total costs are xed, the rm is said to have high operating leverage. High operating leverage, other things held constant, means that a relatively small change in sales will result in a large change in operating income. Therefore, during an expansionary phase in the economy a highly leveraged rm will have higher earnings growth than a lesser leveraged rm. The opposite will happen during an economic contraction. (Study Session 11, Module 34.1, LOS 34.b) Question #29 of 39 Question ID: 1205858 Which of the following is a key determinant of operating leverage? A) Level and cost of debt. B) The competitive nature of the business. C) The tradeo between xed and variable costs. Explanation Operating leverage can be de ned as the trade o between variable and xed costs. (Study Session 11, Module 34.1, LOS 34.c) Question #30 of 39 Question ID: 1205864 Annual xed costs at King Mattress amount to $325,000. The variable cost of raw materials and labor is $120 for the typical mattress. Sales prices for mattresses average $160. How many units must King Mattress sell to break even? A) 2,708. B) 40. C) 8,125. Explanation QBreakeven = Fixed Cost / (Price – Variable Cost) QBreakeven = $325,000 / (160 – 120) = 8,125 (Study Session 11, Module 34.1, LOS 34.d) Question #31 of 39 Question ID: 1205851 An analyst has gathered the following expenditure information for three di erent rms, each of which has a sales level of $4 million. Costs for rms under consideration (in millions) Firm A Firm B Firm C Variable Costs $2.00 $2.60 $2.40 Fixed Costs $1.00 $1.30 $1.40 Interest Expense $0.20 $0.00 $0.20 Which rm has the highest degree of operating leverage (DOL)? A) Firm A. B) Firm C. C) Firm B. Explanation The DOL for the three companies is as follows: DOL = (Total Revenue - Total Variable Costs) / (TR – TVC – Total Fixed Costs) Firm A: ($4.00 – $2.00) / ($4.00 – $2.00 – $1.00) = 2 Firm B: ($4.00 – $2.60) / ($4.00 – $2.60 – $1.30) = 14 Firm C: ($4.00 – $2.40) / ($4.00 – $2.40 – $1.40) = 8 (Note: Interest expense does not a ect operating leverage.) (Study Session 11, Module 34.1, LOS 34.b) Question #32 of 39 Question ID: 1205853 Which of the following best describes a rm with low operating leverage? A large change in: A) sales result in a small change in net income. B) earnings before interest and taxes result in a small change in net income. C) the number of units a rm produces and sells result in a similar change in the rm’s earnings before interest and taxes. Explanation Operating leverage is the result of a greater proportion of xed costs compared to variable costs in a rm's capital structure and is characterized by the sensitivity in operating income (earnings before interest and taxes) to change in sales. A rm that has equal changes in sales and operating income would have low operating leverage (the least it can be is one). Note that the relationship between operating income and net income is impacted by the degree of nancial leverage, and the relationship between sales and net income is impacted by the degree of total leverage. (Study Session 11, Module 34.1, LOS 34.b) Question #33 of 39 Question ID: 1205866 Yangtze Delta High Technology produces multimedia-enabled wireless phones. The factory incurs rent, depreciation, salary, and other xed costs totaling RMB 10 million per year. Also, the company incurs annual interest of RMB 3 million on debt. Each phone sold by Yangtze Delta sells for RMB 200. The variable cost per phone is RMB 150. Yangtze Delta's operating breakeven quantity of sales is closest to: A) 260,000. B) 65,000. C) 200,000. Explanation The operating breakeven point is the quantity of product sold at which operating income is zero (revenue equals operating cost). F = Fixed operating cost = RMB 10,000,000 P = Price per unit = RMB 200 V = Variable cost per unit = RMB 150 Operating breakeven quantity = F / (P – V) = 10,000,000 / (200 – 150) = 200,000. (Study Session 11, Module 34.1, LOS 34.e) Question #34 of 39 Question ID: 1205845 The following information re ects the projected operating results for Opstalan, a catalog printer. Sales of $5.0 million. Variable Costs at 40% of sales. Fixed Costs of $1.0 million. Debt interest payments on $1.5 million issued with an annual 7.0% coupon (current yield is 8.0%). Tax Rate of 0.0%. Opstalan's degree of total leverage (DTL) is closest to: A) 2.58. B) 1.41. C) 1.59. Explanation First, calculate the operating results: Opstalan Annual Operating Results Sales $5,000,000 Variable Costs1 2,000,000 3,000,000 Fixed Costs 1,000,000 EBIT 2,000,000 Interest Expense2 105,000 1,895,000 1Variable costs = 0.40 × 5,000,000 2Interest Expense = 0.07 × 1,500,000 Second, calculate DOL = (Sales – Variable Costs) / (Sales – Variable Costs – Fixed Costs) = 3,000,000 / 2,000,000 = 1.50 Third, calculate DFL = EBIT / (EBIT – I) = 2,000,000 / 1,895,000 = 1.06. Finally, calculate DTL = DOL × DFL = 1.50 × 1.06 = 1.59. (Study Session 11, Module 34.1, LOS 34.b) Question #35 of 39 Question ID: 1205867 Nelson, Inc. has xed nancing costs of $3 million, xed operating costs of $5 million, and variable costs of $2.00 per unit. If the price of Nelson's product is $4.00, Nelson's operating breakeven quantity of sales is: A) 2.5 million units. B) 4.0 million units. C) 1.0 million units. Explanation Operating breakeven quantity = xed operating costs / (price – variable cost per unit) = $5 million / ($4.00 – $2.00) = 2,500,000 units. (Study Session 11, Module 34.1, LOS 34.e) Question #36 of 39 Question ID: 1205840 Myron Jackson is a private equity fund manager specializing in distressed companies. His investment philosophy is based on the principle that capital structure problems can be xed, but industry characteristics dictate business models. Jackson would most likely be interested in distressed rms with which of the following characteristics? A) High operating risk and low nancial risk. B) High operating risk and high nancial risk. C) High nancial risk and low operating risk. Explanation Financial risk refers to the capital structure, while operating risk refers to the operating cost structure. A rm's capital structure is well within the control of management as to how much debt to assume. In contrast, a rm's operating cost structure is usually driven by industry characteristics. This distressed rm's specialist would be looking for rms with capital structure problems that can be solved with an increase in equity capital and a reduction in debt nancing. Changing the operating characteristics of the industry is far more challenging. (Study Session 11, Module 34.1, LOS 34.a) Question #37 of 39 Question ID: 1205832 Variability in a rm's operating income is most closely related to its: A) internal risk. B) nancial risk. C) business risk. Explanation Business risk is the uncertainty regarding the operating income of a company. Financial risk refers to the uncertainty caused by the xed cost associated with borrowed money. (Study Session 11, Module 34.1, LOS 34.a) Question #38 of 39 Question ID: 1205838 The additional risk a rm's common shareholders must bear when a rm uses xed cost nancing is best described as: A) nancial risk. B) business risk. C) operating risk. Explanation When a company nances its operations with xed cost nancing (debt), it takes on xed expenses in the form of interest payments. The greater the proportion of debt in a rm's capital structure, the greater the rm's nancial risk. Business risk refers to the risk associated with a rm's operating income. Operating risk refers to the additional uncertainty about operating earnings caused by xed operating costs. (Study Session 11, Module 34.1, LOS 34.a) Question #39 of 39 Question ID: 1205831 Which of the following statements about business risk and nancial risk is least accurate? A) Factors that a ect business risk are demand, sales price, and input price variability. B) The greater a company's business risk, the higher its optimal debt ratio. C) Business risk is the riskiness of the company's assets if it uses no debt. Explanation The greater a company's business risk, the lower its optimal debt ratio. (Study Session 11, Module 34.1, LOS 34.a)