Chapter 8: Financial and Operating Leverages (CAIIB – Paper 3)

1. Financial leverage primarily arises due to the use of:

  • A. Equity capital
  • B. Preference shares
  • C. Fixed cost debt financing
  • D. Variable operating expenses
Financial leverage arises when a firm uses fixed-cost sources of funds such as debt or preference capital. This amplifies the effect of changes in EBIT on EPS.

2. Which of the following best defines Operating Leverage?

  • A. Sensitivity of EBIT to changes in sales
  • B. Sensitivity of EPS to changes in EBIT
  • C. Sensitivity of sales to changes in EPS
  • D. Sensitivity of capital structure to sales
Operating leverage shows how a percentage change in sales results in a larger percentage change in EBIT due to the presence of fixed operating costs.

3. A firm has EBIT of ₹10,00,000, interest of ₹2,00,000, and preference dividend of ₹1,00,000. What is the financial leverage (at EBIT level)?

  • A. 1.5
  • B. 3.0
  • C. 2.0
  • D. 1.25
Financial leverage (EBIT/EBT) = EBIT ÷ (EBIT - Interest). = 10,00,000 ÷ (10,00,000 - 2,00,000) = 10,00,000 ÷ 8,00,000 = 1.25

4. Combined leverage is defined as:

  • A. Degree of financial leverage ÷ Degree of operating leverage
  • B. Degree of operating leverage × Degree of financial leverage
  • C. EBIT ÷ EBT
  • D. Contribution ÷ EBIT
Combined leverage = Operating leverage × Financial leverage. It shows the sensitivity of EPS to changes in sales.

5. If a company has a high degree of financial leverage, it indicates:

  • A. Low fixed financial costs
  • B. Low impact of EBIT changes on EPS
  • C. High risk and higher variability in EPS
  • D. Stability in EPS despite EBIT changes
High financial leverage means heavy use of debt, which magnifies EPS fluctuations with changes in EBIT, increasing financial risk.

6. Degree of Financial Leverage (DFL) at a given EBIT level is calculated as:

  • A. EBIT ÷ Contribution
  • B. EBIT ÷ (EBIT – Interest)
  • C. Contribution ÷ EBIT
  • D. EBIT ÷ EBT
DFL = EBIT ÷ (EBIT – Interest). It measures the percentage change in EPS for a given percentage change in EBIT.

7. A company has EBIT of ₹5,00,000 and interest of ₹1,00,000. What is its Degree of Financial Leverage?

  • A. 5.0
  • B. 2.5
  • C. 1.25
  • D. 4.0
DFL = EBIT ÷ (EBIT – Interest) = 5,00,000 ÷ (5,00,000 – 1,00,000) = 5,00,000 ÷ 4,00,000 = 1.25

8. As EBIT increases substantially, the Degree of Financial Leverage tends to:

  • A. Remain constant
  • B. Increase continuously
  • C. Fluctuate randomly
  • D. Decline gradually
As EBIT rises, the fixed interest cost becomes relatively less significant. Hence, DFL decreases gradually with higher EBIT levels.

9. If a firm has no debt in its capital structure, its Degree of Financial Leverage will be:

  • A. 1
  • B. 0
  • C. Infinity
  • D. Depends on EBIT level
If no debt exists, interest = 0. DFL = EBIT ÷ (EBIT – 0) = EBIT ÷ EBIT = 1. So, financial leverage effect disappears in an all-equity firm.

10. Which of the following statements about the behaviour of DFL is correct?

  • A. DFL increases with higher EBIT
  • B. DFL decreases as EBIT rises and increases as EBIT falls
  • C. DFL remains fixed irrespective of EBIT
  • D. DFL is always more than 2
DFL behaves inversely with EBIT: - When EBIT rises, DFL decreases (interest is less significant). - When EBIT falls closer to interest level, DFL rises sharply.

11. Operating leverage arises mainly due to the presence of:

  • A. Variable operating costs
  • B. Financial charges
  • C. Fixed operating costs
  • D. Equity capital
Operating leverage is caused by the existence of fixed operating costs (like rent, depreciation, salaries), which magnify the effect of sales changes on EBIT.

12. Degree of Operating Leverage (DOL) is calculated as:

  • A. EBIT ÷ Contribution
  • B. Sales ÷ EBIT
  • C. EBIT ÷ Sales
  • D. Contribution ÷ EBIT
DOL = Contribution ÷ EBIT. It measures the percentage change in EBIT for a given percentage change in sales.

13. A company has Sales ₹20,00,000, Variable cost ₹12,00,000, and Fixed costs ₹4,00,000. What is its Degree of Operating Leverage?

  • A. 2.0
  • B. 1.5
  • C. 3.0
  • D. 1.25
Contribution = Sales – Variable cost = 20,00,000 – 12,00,000 = 8,00,000. EBIT = Contribution – Fixed cost = 8,00,000 – 4,00,000 = 4,00,000. DOL = Contribution ÷ EBIT = 8,00,000 ÷ 4,00,000 = 2.0

14. If sales volume increases, the Degree of Operating Leverage will:

  • A. Decrease
  • B. Increase
  • C. Remain constant
  • D. Fluctuate irregularly
As sales rise, EBIT grows faster than contribution. This reduces the impact of fixed costs, leading to a decline in the Degree of Operating Leverage.

15. Which of the following statements about Operating Leverage is correct?

  • A. It increases with higher EBIT
  • B. It is caused by financial expenses
  • C. It remains constant for all firms
  • D. It is higher when fixed operating costs are high
Operating leverage is higher when fixed operating costs form a large portion of total costs, as this magnifies the effect of sales changes on EBIT.

16. The Degree of Operating Leverage (DOL) explains the relationship between:

  • A. EPS and EBIT
  • B. Sales and EBIT
  • C. Sales and EPS
  • D. Contribution and Sales
DOL shows the sensitivity of EBIT to changes in Sales. A higher DOL means a small change in sales produces a larger change in EBIT.

17. A firm has Sales ₹30,00,000, Variable Cost ₹18,00,000, and Fixed Costs ₹6,00,000. What is the DOL?

  • A. 3.0
  • B. 1.67
  • C. 1.5
  • D. 2.0
Contribution = Sales – Variable cost = 30,00,000 – 18,00,000 = 12,00,000. EBIT = Contribution – Fixed cost = 12,00,000 – 6,00,000 = 6,00,000. DOL = Contribution ÷ EBIT = 12,00,000 ÷ 6,00,000 = 2.0

18. When EBIT is very low and just above breakeven point, the Degree of Operating Leverage will be:

  • A. Very high
  • B. Moderate
  • C. Constant
  • D. Very low
Near breakeven, EBIT is very small. Since DOL = Contribution ÷ EBIT, the ratio becomes very high, reflecting extreme sensitivity of EBIT to sales.

19. As sales volume increases significantly above breakeven point, the Degree of Operating Leverage tends to:

  • A. Rise continuously
  • B. Stay constant
  • C. Decline gradually
  • D. Fluctuate irregularly
With higher sales, EBIT rises faster than fixed costs. As a result, DOL declines since the impact of fixed operating costs becomes less significant.

20. Which of the following is a correct interpretation of DOL = 2.5?

  • A. EBIT will fall to 40% of sales
  • B. EPS will increase by 2.5% for 1% change in EBIT
  • C. EBIT will be 2.5 times contribution
  • D. EBIT will change by 2.5% for every 1% change in Sales
DOL = 2.5 means that a 1% change in Sales leads to a 2.5% change in EBIT. It measures the sensitivity of EBIT to changes in Sales.

21. Combined leverage is defined as the relationship between:

  • A. Sales and EBIT
  • B. Sales and EPS
  • C. EBIT and EPS
  • D. Contribution and Sales
Combined leverage shows the sensitivity of EPS to changes in Sales. It combines the effects of operating leverage and financial leverage.

22. The formula for Combined Leverage is:

  • A. Contribution ÷ Sales
  • B. EBIT ÷ (EBIT – Interest)
  • C. Degree of Operating Leverage × Degree of Financial Leverage
  • D. EBIT ÷ Sales
Combined Leverage = Operating Leverage × Financial Leverage. It indicates the combined effect of fixed operating and fixed financial costs on EPS.

23. A company has Contribution of ₹12,00,000, EBIT of ₹6,00,000 and Interest of ₹2,00,000. What is the Combined Leverage?

  • A. 4.0
  • B. 2.0
  • C. 3.0
  • D. 1.5
DOL = Contribution ÷ EBIT = 12,00,000 ÷ 6,00,000 = 2. DFL = EBIT ÷ (EBIT – Interest) = 6,00,000 ÷ (6,00,000 – 2,00,000) = 6,00,000 ÷ 4,00,000 = 1.5. Combined Leverage = 2 × 1.5 = 3.0.

24. If a firm has no fixed operating costs but has debt in its capital structure, its Combined Leverage will be:

  • A. More than Financial Leverage
  • B. Equal to Operating Leverage
  • C. Always more than 2
  • D. Equal to Financial Leverage
With no fixed operating costs, DOL = 1. Hence, Combined Leverage = DOL × DFL = 1 × DFL = Financial Leverage.

25. A high Combined Leverage indicates:

  • A. Low risk, high stability
  • B. Operating risk is high but financial risk is low
  • C. High business risk as well as high financial risk
  • D. No impact on EPS variability
High Combined Leverage means both operating and financial risks are high. This magnifies EPS changes with even small sales changes, leading to high risk.

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