CA Inter P6 · Chapter 6
Financing Decisions – Leverages MCQs with Answers
9 multiple-choice questions on Financing Decisions – Leverages for CA Inter P6 Financial Management and Strategic Management. Try each one before revealing the answer and explanation.
Practise this chapter interactivelyQuestion 1
Nandini Ltd has a contribution of ₹ 20,00,000 and a degree of operating leverage of 2.5. Its fixed operating costs are:
- A) ₹ 16,00,000
- B) ₹ 12,00,000
- C) ₹ 8,00,000
- D) ₹ 5,00,000
Show answer & explanation
Answer: B) ₹ 12,00,000
DOL = contribution / EBIT, so EBIT = ₹ 20,00,000 / 2.5 = ₹ 8,00,000. Fixed costs = contribution - EBIT = ₹ 20,00,000 - ₹ 8,00,000 = ₹ 12,00,000. The figure ₹ 8,00,000 is EBIT.
Question 2
Annual sales of Mehta Castings are ₹ 40,00,000, variable costs are 60% of sales and fixed operating costs are ₹ 6,00,000. The degree of operating leverage is:
- A) 4.00
- B) 2.67
- C) 1.60
- D) 0.625
Show answer & explanation
Answer: C) 1.60
Contribution = ₹ 40,00,000 x 40% = ₹ 16,00,000. EBIT = ₹ 16,00,000 - ₹ 6,00,000 = ₹ 10,00,000. DOL = contribution / EBIT = ₹ 16,00,000 / ₹ 10,00,000 = 1.60. So a 1% change in sales leads to a 1.6% change in EBIT.
Question 3
A company has EBIT of ₹ 10,00,000, debenture interest of ₹ 2,50,000 and preference dividend of ₹ 1,40,000. The tax rate is 30%. The degree of financial leverage is (to two decimals):
- A) 1.64
- B) 1.82
- C) 1.33
- D) 1.53
Show answer & explanation
Answer: B) 1.82
Preference dividend is paid out of post-tax profit, so it is grossed up: ₹ 1,40,000 / (1 - 0.30) = ₹ 2,00,000. DFL = EBIT / [EBIT - I - PD/(1 - t)] = ₹ 10,00,000 / (₹ 10,00,000 - ₹ 2,50,000 - ₹ 2,00,000) = ₹ 10,00,000 / ₹ 5,50,000 = 1.82. Ignoring preference dividend gives 1.33, and not grossing it up gives 1.64.
Question 4
A firm has a degree of operating leverage of 2 and a degree of financial leverage of 1.5. If sales increase by 10%, earnings per share will increase by:
- A) 20%
- B) 30%
- C) 15%
- D) 35%
Show answer & explanation
Answer: B) 30%
Degree of combined leverage = DOL x DFL = 2 x 1.5 = 3. EPS changes by DCL x % change in sales = 3 x 10% = 30%. A 20% increase would be the change in EBIT only (DOL x 10%). Adding the leverages (3.5 x 10%) gives 35%, which is wrong because they multiply.
Question 5
Sunrise Ltd has a degree of combined leverage of 4 and a degree of operating leverage of 2.5. Its EBIT is ₹ 8,00,000 and it has no preference shares. Its annual interest charge is:
- A) ₹ 2,00,000
- B) ₹ 4,80,000
- C) ₹ 3,00,000
- D) ₹ 5,00,000
Show answer & explanation
Answer: C) ₹ 3,00,000
DFL = DCL / DOL = 4 / 2.5 = 1.6. DFL = EBIT / EBT, so EBT = ₹ 8,00,000 / 1.6 = ₹ 5,00,000. Interest = EBIT - EBT = ₹ 8,00,000 - ₹ 5,00,000 = ₹ 3,00,000. The figure ₹ 5,00,000 is EBT, not interest.
Question 6
Operating leverage arises because of:
- A) Fixed financial charges such as interest
- B) Variable costs that change in proportion to sales
- C) Preference dividend payable before equity dividend
- D) Fixed operating costs in the cost structure
Show answer & explanation
Answer: D) Fixed operating costs in the cost structure
Operating leverage measures how sensitive EBIT is to changes in sales. It exists because fixed operating costs do not change with output, so a change in sales has a more than proportionate effect on EBIT. Fixed financial charges such as interest and preference dividend cause financial leverage.
Question 7
A company pays annual debenture interest of ₹ 3,00,000 and preference dividend of ₹ 70,000. The tax rate is 30%. Its financial break-even point (the EBIT at which EPS is zero) is:
- A) ₹ 4,00,000
- B) ₹ 3,00,000
- C) ₹ 3,70,000
- D) ₹ 5,28,571
Show answer & explanation
Answer: A) ₹ 4,00,000
At the financial break-even point, EBIT just covers interest and the pre-tax profit needed to pay preference dividend. Financial BEP = I + PD/(1 - t) = 3,00,000 + 70,000/0.70 = 3,00,000 + 1,00,000 = ₹ 4,00,000. Simply adding 70,000 ignores that preference dividend is paid out of after-tax profit, and grossing up interest as well is wrong because interest is tax-deductible.
Question 8
When a firm operates exactly at its operating break-even point, its degree of operating leverage is:
- A) Equal to the degree of financial leverage
- B) Exactly zero
- C) Undefined (infinitely large), because EBIT is zero
- D) Exactly 1
Show answer & explanation
Answer: C) Undefined (infinitely large), because EBIT is zero
DOL = contribution / EBIT. At the operating break-even point, contribution exactly equals fixed costs, so EBIT is zero and DOL cannot be defined. It tends to infinity as sales approach break-even. Operating risk is therefore highest near the break-even level.
Question 9
A firm with a high degree of operating leverage and a high degree of financial leverage is best described as:
- A) Very risky, because a small fall in sales can cause a sharp fall in EPS
- B) Certain to earn a higher EPS than an unlevered firm in all conditions
- C) Unaffected by changes in sales volume
- D) Very safe, because the two leverages offset each other
Show answer & explanation
Answer: A) Very risky, because a small fall in sales can cause a sharp fall in EPS
Combined leverage is DOL x DFL, so a high value of both multiplies the effect of a change in sales on EPS. This raises total risk: a small decline in sales can wipe out earnings for equity holders. Firms usually balance a high operating leverage with a low financial leverage, or the reverse.