D. RISK AND LEVERAGE
THEORIES:
Risk
Business risk
Financial risk
12. Financial risk refers to the:
A. risk of owning equity securities
B. risk faced by equity holders when debt is used
C. general business risk of the firm
D. possibility that interest rates will increase
Market risk
Comprehensive
5. A decrease in the debt ratio will least likely affect:
A. Financial risk C. Systematic or market risk
B. Business risk D. Total risk
14. Which of the following situations is likely to have the highest combined business and financial risk impact
upon a business?
A. A new labor-intensive operation is funded with operating cash flows
B. A fully automated plant is completed, funded with retained earnings
C. A fully automated plant is completed, funded with the issuance of 10-year bonds
D. An automated, but dated plant in the southern region is closed and operations are resumed in a
labor-intensive plant in Central Luzon
Operating Leverage
2. Which of the following is a key determinant of operating leverage?
A. Level of debt C. Technology
B. Cost of debt D. Capital structure
3. The degree of operating leverage for Alabang Company is 3.5, and the degree of operating leverage for
Paranaque Corporation is 7.0. According to this information, which firm is considered to have greater
business risk?
A. Alabang Company.
B. Paranaque Corporation.
C. The degree of operating leverage is not a measure of business risk, so it is not possible to tell which
firm has the greater business risk given the above information.
D. To determine which firm has the greater business risk, we need to know the operating income (NOI
or EBIT) of each firm. Paranaque Corporation would have less business risk if its operating income is
at least twice that of Alabang Company.
9. Which of the following is incorrect regarding operating leverage?
A. Operating leverage is the degree to which costs are fixed.
B. A project's break-even point will be affected by the extent to which costs can be reduced as sales
decline.
C. If the project has mostly variable costs, it is said to have high operating leverage.
D. High operating leverage implies that profits are more sensitive to changes in sales.
11. The extent to which fixed costs are used in a firm’s operations is called its:
A. financial leverage. C. financial leverage.
B. operating leverage. D. foreign risk exposure.
Financial Leverage
4. It refers to management strategy of financing assets with borrowed capital; such an extensive use raise the
entity risk thereby impacting on the return on common stockholders’ equity to be above or below the rate of
return on total assets.
A. Factoring C. Mortgage.
B. Leverage. D. Restructuring
1. The use of financial leverage by the firm has a potential impact on which of the following?
(1) The risk associated with the firm
(2) The return experienced by the shareholder
(3) The variability of net income
(4) The degree of operating leverage
(5) The degree of financial leverage
A. 1, 3, 5 C. 1, 2, 3, 5
B. 2, 3, 4, 5 D. 1, 2, 5
16. The degree of financial leverage for April Company is 3.0, and the degree of financial leverage for August
Corporation is 6.2. According to this information, which firm is considered to have greater overall (total)
risk?
A. April Company.
B. August Corporation.
C. The degree of financial leverage is a measure of financial risk, so the only conclusion that can be
made with the information given is that August Corporation has greater financial risk than April
Company -- we cannot tell which firm has greater total risk.
D. To determine which firm has the greater total risk, we need to know the financial breakeven point of
each firm.
Weighted average Cost of capital
6. Which of the following changes would tend to decrease the company cost of capital for a traditional firm?
A. Decrease the proportion of equity financing.
B. Increase the market value of the d ebt.
C. Decrease the pro portion of debt financing.
D. Decrease the market value of the equity.
15. The most commonly held view of capital structure is that the weighted average cost of capital:
A. falls first with moderate levels of leverage and then increases.
B. does not change with leverage.
C. increases proportionately with increases in leverage.
D. increases with moderate amounts of leverage and then falls.
Target capital structure
10. The mix of debt, preferred stock, and common equity with which the firm plans to raise capital is called the:
A. financial risk C. business risk
