Leverage

Southwestern College is planning to hold a fundraising banquet at one of the local country clubs. It has
two options for the banquet:

OPTION 1: Crestview Country Club

a. Fixed rental cost of $1,000
b. $12 per person for food

OPTION 2: Tallgrass Country Club

a. Fixed rental cost of $3,000
b. A caterer who charges $8.00 per person for food

Southwestern College has budgeted $1,800 for administrative and marketing expenses. It plans to hire a
band which will cost another $800. Tickets are expected to be $30 per person. Local business supporters
will donate any other items required for the event.

1. Which option provides the least amount of risk?

A) Option one
B) Option two
C) Both options provide the same amount of risk.
D) Neither option has risks.

2. Which option has the lowest breakeven point?

A) Option one
B) Option two
C) Both options have the same breakeven point.
D) The lowest breakeven point cannot be determined.

3. Which option provides the greatest operating income if 600 people attend?
A) Option one
B) Option two
C) Operating incomes are identical.
D) Operating income is indeterminable.

4. Which option provides the greatest degree of operating leverage if 600 people attend?
A) Option one
B) Option two
C) Both options provide equal degrees of operating leverage.
D) Operating leverage is indeterminable.

5. Option 1: Fixed costs of $10,000 and a breakeven point of 500 units.

Option 2: Fixed costs of $20,000 and a breakeven point of 700 units.
Which option should you choose if you are expecting to produce 600 units?
A) Option one
B) Option two
C) Both options are equally desirable.
D) The best option is indeterminable.

6. Mrs. Tannenbaum is going to sell Christmas tree lights for $40 a box. The lights cost Mrs. Tannenbaum $10 a box and any
unsold lights can be returned for a full refund. She is planning to rent a booth at the upcoming Happy Holidays Convention,
which offers three options:
1. paying a fixed fee of $3,000, or
2. paying a $1,000 fee plus 10% of revenues made at the convention, or
3. paying 25% of revenues made at the convention.
Which of the following statements is FALSE?
A) Her decision will determine the risk she faces.
B) Contribution margin will vary depending upon the option chosen.
C) One of the options will allow Mrs. Tannenbaum to break even, even if she doesn't sell any lights.
D) Operating income will be the greatest for Option 3.

7. In a company with low operating leverage:

A) fixed costs are high and variable costs are low
 B) large changes in sales volume result in small changes in net income
C) there is a higher possibility of net loss than a higher-leveraged firm
D) less risk is assumed than in a highly leveraged firm

The top management at Groundsource Company, a manufacturer of lawn and garden equipment, is attempting to recover from
a fire that destroyed some of their accounting records. The main computer system was also severely damaged. The following
information was salvaged:

8. What were the sales for the Tiller Division?

A) $9,600,000
B) $12,000,000
C) $15,000,000
D) $15,500,000

9. What is the value of the operating assets belonging to the Tractor Division?
A) $ 3,500,000
B) $4,000,000
C) $4,500,000
D) $5,000,000

10. What is the value of the operating assets belonging to the Tiller Division?
A) $10,000,000
B) $ 12,000,000
C) $ 14,400,000
D) $ 15,000,000

11. What is the Digger Division's return on investment?

A) .25
B) .30
C) .45
D) .60

12. What is the Tractor Division's return on sales?

A) 0.10
B) 0.12
C) 0.15
D) 0.20

13. What is the Tractor Division's investment turnover?

A) .50
B) 1.0
C) 2.0
D) 2.5

14. What is the Tiller Division's investment turnover?

A) .50
B) .833
C) 1.2
D) 1.5

15. Which of the following is the correct formula for return on sales?
A) Income / Investment
B) Investment / Income
 C) Income / Revenue
D) Revenue / Investment
The Bandage Medical Supply Company has two divisions that operate independently of one another.
The financial data for the year 2012 reported the following results:

16. What are the respective return-on-investment ratios for the North and South Divisions?
A) 0.110 and 0.125
B) 0.108 and 0.075
C) 0.125 and 0.110
D) 0.125 and 0.150

17. What are the respective residual incomes for the North and South Divisions?
A) $60,000 and $100,000
B) $300,000 and $60,000
C) $300,000 and $100,000
D) $100,000 and a negative $300,000

18. Which division has the best return on investment and which division has the best residual income figure, respectively?
A) North, North
B) South, South
C) North, South
D) South, North

19. Blair Company has $5 million in total assets. The company’s assets are financed with $1 million of debt and $4 million of
common equity. The company’s income statement is summarized below:

Operating income (EBIT) $ 1,000,000

Interest 100,000
Earnings before taxes (EBT) $ 900,000
Taxes (40%) 360,000
Net income $ 540,000

The company wants to increase its assets by $1 million, and it plans to finance this increase by issuing $1 million in new debt.
This action will double the company’s interest expense but its operating income will remain at 20 percent of its total assets, and
its average tax rate will remain at 40 percent. If the company takes this action, which of the following will occur:
A) The company’s net income will increase.
B) The company’s return on assets will fall.
C) The company’s return on equity will remain the same.
D) Statements a and b are correct.

20. Some key financial data and ratios are reported in the table below for Hemmingway Hotels and for its competitor,
Fitzgerald Hotels:

On the basis of the information above, which of the following statements is most correct?
A) Hemmingway has a higher total assets turnover than Fitzgerald.
B) Hemmingway has a higher debt ratio than Fitzgerald.
C) Hemmingway has higher net income than Fitzgerald.
D) Statements a and b are correct.
21. Company A and Company B have the same total assets, tax rate, and net income. Company A, however, has a lower profit
margin than Company B. Company A also has a higher debt ratio and, therefore, higher interest expense than Company B.
Which of the following statements is most correct?
A) Company A has a higher total assets turnover.
B) Company A has a higher return on equity.
C) Company A has a higher basic earning power ratio.
D) All of the statements above are correct.

22. Company A and Company B have the same tax rate, total assets, and basic earning power. Both companies have positive
net incomes. Company A has a higher debt ratio, and therefore, higher interest expense than Company B. Which of the
following statements is true?
A) Company A has a higher ROA than Company B.
B) Company A has a higher times interest earned (TIE) ratio than Company B.
C) Company A has a higher net income than Company B.
D) Company A pays less in taxes than Company B.

23. Hanson Corporation's present year ROE remained at last year's 14% level, while the profit margin was reduced from 8% to
4% and the leverage ratio increased from 1.2 to 1.5. The effects on asset turnover were to
A) Remain constant.
B) Increase from 1.46 to 2.33.
C) Decease from 14.58 to 2.33.
D) Increase from 4.76 to 9.60.

24. Deb & Co. has a debt ratio of 0.50, a total assets turnover of 0.25, and a profit margin of 10%. The president is unhappy
with the current return on equity, and he thinks it could be doubled. This could be accomplished (1) by increasing the profit
margin to 14% and (2) increasing debt utilization. Total assets turnover will not change. What new debt ratio, along with
the 14% profit margin, is required to double the return on equity?
A) 0.75
B) 0.70
C) 0.65
D) 0.55

25. A fire has destroyed many of the financial records of R. Son & Co. You are assigned to put together a financial report. You
have found the return on equity to be 12% and the debt ratio was 0.40. What was the return on assets?
A) 5.35%
B) 8.40%
C) 6.60%
D) 7.20%
.
end