Operating and Financial Leverage

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  • Topic: Fixed cost, Costs, Variable cost
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Chapter 5

Operating and Financial Leverage

Discussion Questions

|5-1. |Discuss the various uses for break-even analysis. | | | | | |Such analysis allows the firm to determine at what level of operations it will break even (earn zero profit) | | |and to explore the relationship between volume, costs, and profits. | | | | |5-2. |What factors would cause a difference in the use of financial leverage for a utility company and an automobile | | |company? | | | | | |A utility is in a stable, predictable industry and therefore can afford to use more financial leverage than an | | |automobile company, which is generally subject to the influences of the business cycle. An automobile | | |manufacturer may not be able to service a large amount of debt when there is a downturn in the economy. | | | | |5-3. |Explain how the break-even point and operating leverage are affected by the choice of manufacturing facilities | | |(labor intensive versus capital intensive). | | | | | |A labor-intensive company will have low fixed costs and a correspondingly low break-even point. However, the | | |impact of operating leverage on the firm is small and there will be little magnification of profits as volume | | |increases. A capital-intensive firm, on the other hand, will have a higher break-even point and enjoy the | | |positive influences of operating leverage as volume increases. | | | | |5-4. |What role does depreciation play in break-even analysis based on accounting flows? Based on cash flows? Which | | |perspective is longer term in nature? | | | | | |For break-even analysis based on accounting flows, depreciation is considered part of fixed costs. For cash | | |flow purposes, it is eliminated from fixed costs. | | | | | |The accounting flows perspective is longer-term in nature because we must consider the problems of equipment | | |replacement. | | | |

|5-5. |What does...
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