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1. The concept of operating leverage involves the use of __________ to magnify returns at high levels of operation. A) fixed costs B) variable costs C) marginal costs D) semi-variable costs

2. In break-even analysis the contribution margin is defined as A) sales minus variable costs. B) sales minus fixed costs. C) variable costs minus fixed costs. D) fixed costs minus variable costs.

3. At the break-even point, a firm's profits are A) greater than zero. B) less than zero. C) equal to zero. D) Not enough information to tell

4. If a firm has a break-even point of 20,000 units and the contribution margin on the firm's single product is $3.00 per unit and fixed costs are $60,000, what will the firm's net income be at sales of 30,000 units? A) $90,000 B) $30,000 C) $15,000 D) $45,000

5. If sales volume exceeds the break-even point, the firm will experience A) an operating loss. B) an operating profit. C) an increase in plant and equipment. D) an increase in stock price.

6. The break-even point can be calculated as A) variable costs divided by contribution margin. B) total costs divided by contribution margin. C) variable cost times contribution margin. D) fixed cost divided by contribution margin.

7. A highly automated plant would generally have A) more variable than fixed costs. B) more fixed than variable costs. C) all fixed costs. D) all variable costs.

8. The degree of operating leverage is computed as A) percent change in operating profit divided by percent change in net income. B) percent change in volume divided by percent change in operating profit. C) percent change in EPS divided by percent change in operating income. D) percent change in operating income divided by percent change in volume.

9. Firms with a high degree of operating leverage are A) easily capable of surviving large changes in sales volume B) usually trading off lower levels of risk for higher profits. C) significantly affected by changes in interest rates. D) trading off higher fixed costs for lower per-unit variable costs.

10. Financial leverage is concerned with the relation between A) changes in volume and changes in EPS. B) changes in volume and changes in EBIT. C) changes in EBIT and changes in EPS. D) changes in EBIT and changes in operating income.

11. Heavy use of long-term debt may be beneficial in an inflationary economy because A) the debt may be repaid in more "expensive" dollars. B) nominal interest rates exceed real interest rates. C) inflation is associated with the peak of a business cycle. D) the debt may be repaid in "cheaper" dollars.

12. Working capital management is primarily concerned with the management and financing of A) cash and inventory. B) current assets and current liabilities. C) current assets. D) receivables and payables.

13. A financial executive devotes the most time to A) Long-range planning. B) Capital budgeting. C) Short-term financing. D) Working capital management.

14. Pressure for current asset buildup often results from A) decline in sales growth. B) rapidly expanding sales. C) increased demands of short-term creditors. D) none of the above.

15. The term "permanent current assets" implies A) the same thing as fixed assets. B) nonmarketable assets. C) some minimum level of current assets that are not self-liquidating. D) inventory.

16. Ideally, which of the following types of assets should be financed with long-term financing? A) Fixed assets only B) Fixed assets and temporary current assets C) Fixed assets and permanent current assets D) Temporary and permanent current assets

17. Generally, more use is made of short-term financing because A) short-term interest rates are generally lower than long-term interest rates. B) most firms do not have easy access to the capital markets. C) short-term financing is usually more predictable than long-term financing. D) a and b above.

18. During tight money periods A) long-term rates are higher than short-term rates. B) short-term rates are higher than long-term rates. C) short-term rates are equal to long-term rates. D) the relationship between short and long-term rates remains unchanged.

19. A "normal" term structure of interest rates would depict A) short-term rates higher than long-term rates. B) long-term rates higher than short-term rates. C) no general relationship between short- and long-term rates. D) medium rates (1-5 years) lower than both short-term and long-term rates.

20. How would electronic funds transfer affect the use of "float"? A) Increase its use somewhat B) Decrease its use somewhat C) Virtually eliminate its use D) Have no effect on its use

22. Probably the safest and most marketable instrument for short-term investment is A) commercial paper. B) large denomination certificates. C) Treasury notes. D) Treasury bills.

23. Which of the following securities trades on a discount basis? A) Treasury notes B) Treasury bills C) Commercial paper D) Certificates of deposit

24. Which of the following securities represents an unsecured promissory note issued by a corporation? A) Certificates of deposit B) Savings accounts C) Commercial paper D) Money market fund

25. A firm that wishes to minimize risk when investing idle cash would be least likely to buy A) commercial paper. B) long-term corporate bonds. C) negotiable certificates of deposit. D) Treasury bills of the U.S. government.

26. For a given firm, holding other factors constant, ordering costs per unit generally A) decline as average inventory increases. B) increase in proportion to increases in inventory. C) are considered fixed costs. D) are negotiated.

27. Which of the following is not a valid quantitative measure for accounts receivable collection policies. A) average collection period B) aging of accounts receivables C) ratio of debt to equity D) ratio of bad debts to credit sales

28. What is generally the largest source of short-term credit small firms? A) Bank loans B) Commercial paper C) Installment loans D) Trade credit

29. LIBOR is A) a resource used in production. B) an interest rate paid on Eurodollar deposits in the London market. C) an interest rate paid by European firms when they borrow Eurodollar deposits from U.S. banks. D) the interest rate paid by the British government on its long-term bonds.

30. A large manufacturing firm has been selling on a 3/10, net 30 basis. The firm changes its credit terms to 2/20, net 90. What change might be expected on the balance sheets of its customers? A) Decreased receivables and increased bank loans B) Increased receivables and increased bank loans C) Increased payables and decreased bank loans D) Increased payables and increased bank loans

31. From the banker's point of view, short-term bank credit an excellent way of financing A) fixed assets. B) permanent working capital needs. C) repayment of long-term debt. D) seasonal bulges in inventory and receivables.

32. Compensating balances A) are used by banks as a substitute for charging service fees. B) are created by having a sweep account. C) generate returns to customers from interest bearing accounts. D) are used to reward new accounts

Extra Credit:

What is the current federal discount rate (the rate that bank can borrow money from the Federal Reserve)?

Paper For Above instruction

Operating leverage plays a crucial role in how a firm can magnify its returns when operating at high levels of activity. It primarily involves the use of fixed costs in a company's cost structure, allowing small changes in sales volume to result in larger swings in operating income. This concept is fundamental to managerial finance because it impacts profitability and risk management. In this paper, we examine the concept of operating leverage, break-even analysis, the role of fixed and variable costs, and related financial metrics such as the degree of operating leverage and financial leverage.

Understanding Operating Leverage

Operating leverage refers to the degree to which a company's operating income is affected by changes in sales volume. It is closely linked to the proportion of fixed costs within total costs. A firm with high operating leverage has a larger proportion of fixed costs relative to variable costs. When sales increase, the fixed costs are spread over a larger sales base, leading to disproportionately higher profits, but conversely, during sales decline, losses can be amplified. This dynamic underscores the importance of understanding fixed and variable cost structures in strategic planning.

Break-Even Analysis and Contribution Margin

Break-even analysis is a vital tool in financial management that helps determine the sales level at which a company's total revenues equal total costs, resulting in zero profit. The contribution margin, a key component of this analysis, is calculated as sales minus variable costs. It measures the amount remaining from sales after variable costs are deducted and contributes toward covering fixed costs. Once fixed costs are covered, additional sales contribute directly to profit, making the contribution margin a crucial indicator of profitability.

Calculating the Break-Even Point

The break-even point (BEP) can be computed using the fixed costs divided by the contribution margin per unit. This figure indicates how many units must be sold to cover all costs. For example, if fixed costs are $60,000, and the contribution margin per unit is $3, the BEP is 20,000 units. Once this level is exceeded, the firm begins to generate profit. It is essential for managers to understand this relationship to set sales targets and formulate pricing strategies effectively.

Impacts of Sales Volume on Profitability

When sales surpass the break-even point, companies move into profitability, experiencing operating profits. Conversely, falling below this point results in losses. Therefore, the capacity to analyze and forecast sales relative to the break-even volume is fundamental for operational planning. Companies often seek to increase the contribution margin through cost control or price adjustments to improve their break-even point or profit margins.

Fixed Costs, Variable Costs, and Automation

The structure of costs significantly influences the degree of operating leverage. High automation in production facilities tends to increase fixed costs because investments in machinery and technology are substantial and largely fixed in nature. This shift towards more fixed costs elevates operating leverage, making the firm more sensitive to sales fluctuations, yet capable of higher returns when sales are strong. Manual, less automated plants typically have more variable costs, providing flexibility but potentially limiting profit margins in high-volume scenarios.

Measuring Operating and Financial Leverage

The degree of operating leverage (DOL) quantifies the sensitivity of operating income to changes in sales. It is calculated as the percentage change in operating profit divided by the percentage change in sales volume. A high DOL indicates that a small percentage change in sales will produce a larger change in operating income, which is advantageous during periods of rising sales but riskier in downturns. Similarly, financial leverage examines the impact of debt financing on earnings per share (EPS), where increased debt amplifies the effects of changes in operating income on net income.

Risks and Benefits of Leverage

Heavy use of fixed costs or debt introduces both opportunities and risks. The advantage of operating leverage is the potential for higher profits; however, the downside is increased financial risk. In inflationary periods, long-term debt may be advantageous since it can be repaid with devalued dollars, reducing real costs. Conversely, excessive leverage can compromise financial stability, especially if sales decline or economic conditions deteriorate.

Working Capital Management and Financing Options

Effective working capital management involves managing short-term assets and liabilities to ensure liquidity and operational efficiency. Maintaining optimal levels of cash, inventory, receivables, and payables is fundamental. Firms often rely on short-term financing sources such as bank loans, commercial paper, and trade credit, which are more accessible and typically cheaper than long-term debt. The choice of financing depends on the company's cash flow needs, cost considerations, and risk tolerance.

Impact of Credit Terms and Short-term Financing

Adjusting credit terms can influence customer behavior and cash flow. For example, changing credit terms to more lenient ones might increase receivables, temporarily affecting liquidity. Small firms depend heavily on trade credit and bank loans for short-term funding, with LIBOR serving as a benchmark interest rate in international markets. Effective management of these sources is essential for maintaining liquidity while minimizing costs.

Investment and Risk Management in Short-term Instruments

When investing idle cash, firms prioritize safety and liquidity. Instruments like Treasury bills, which are backed by the U.S. government and traded at a discount, are highly marketable and secure. Commercial paper, unsecured promissory notes issued by corporations, offers short-term investment opportunities, albeit with slightly higher risk. Assets such as long-term bonds carry higher risk and are less suitable for short-term investment strategies aimed at preserving capital and liquidity.

Conclusion

In conclusion, understanding concepts such as operating leverage, break-even analysis, and the distinctions between fixed and variable costs is essential for effective financial management. Firms must balance leveraging fixed costs to maximize returns while managing associated risks through prudent financing strategies. Maintaining optimal working capital, selecting appropriate short-term financing options, and managing investments in short-term instruments are integral to operational success and financial stability. These principles collectively enable firms to navigate economic fluctuations and competitive landscapes effectively.

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