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CFA 1 Crash Course Corporate Finance
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www.edupristine.com
Crash Course for
Corporate Finance
CFA Level-I Exam
www.edupristine.com © Neev Knowledge Management – Pristine
• Corporate Finance
www.edupristine.com © Neev Knowledge Management – Pristine
10 yrs AAA rated bond 8.5% Expected market return 20%
Beta of market 1.0 Debt/equity ratio 0.8
1 yr market returns 12% Credit spread (BB bond) 2.17%
Credit rating of XYZ BB 10 yrs Govt. Bond 7.33%
Beta of a stock XYZ 1.2 Tax rate 40%
Expected dividend $ 5 Dividends growth 10%
Corporate Finance
Weighted
Average Cost
of Capital
Cost of
Equity
Capital
Extended
DuPont
Expression
Corporate
Governance
Cost of
Preference
Stock
Capital
Budgeting
Pro Forma
Financial
Statements
WACC=(wd)*kd*(1-t)
+ wpskps+ weke
Cost of Equity using
CAPM:
ke=Rf+ β*(Rmkt- Rf)
Q. Tax rate 35%, before
tax cost of debt:6.5%,
Capital Structure is 50:50
Cost of equity: 10.55%
Ans.WACC=(0.5)*6.5%*(
1-0.35) + 0.5*10.55
WACC = 7.4%
Working
Capital
Mgmt
Q. Calculate the weighted average cost of capital using above information?
a) 15% b) 17.5% c) 20%
Ans. 15%
Q. Which of the following will be a fair market price of stock according to
Gordon’s formula?
a) $ 25 b) $ 40 c) $ 30
Ans. $40
Q. Which of the following is most likely to be true, if there
are no outstanding convertible securities?
• EPS <= Diluted EPS
• EPS => Diluted EPS
• EPS=Diluted EPS
Ans. EPS=Diluted EPS
Measure of
Leverage
Dividend
and Share
Repurchases
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kP=DPS/P
Q. Preference dividend = $2,
Price of preference share = $20
Ans. Kp= 2/20 = 10%
Corporate Finance
Weighted
Average Cost
of Capital
Cost of
Equity
Capital
Extended
DuPont
Expression
Corporate
Governance
Cost of
Preference
Stock
Capital
Budgeting
Pro Forma
Financial
Statements
Working
Capital
Mgmt
Measure of
Leverage
Dividend
and Share
Repurchases
www.edupristine.com © Neev Knowledge Management – Pristine
Ke= (D1/P0) + g or
Ke= Rf + β*(Rmkt - Rf + CRP)
Country risk premium (CRP) =
sovereign yield spread *
(σ of developing country equity
index / σ of developed country
sovereign bond)
βlevered= βunlevered*(1+debt/equity)
Q. Stock is quoting at $ 20, expected
dividend is $ 2, Growth rate = 5%
Ans. cost of equity= 2/20+5%=15%
Q. A company has been paying a dividend of $ 15 for each stock held.
What shall be the stock price of the company if this dividend is expected to
be received till infinity and expected rate of return by the investor is 10%?
a) $ 15 b) $ 150 c) $ 100
Ans. P0 = 15 / 10% = $150
Q. If the difference between the
yields of Govt. of India bonds
denominated in Rupee and the
treasury bonds of USA having
same maturity, increases. What
will be the effect on the cost of
equity of a firm in India?
Ans. Increases
Corporate Finance
Weighted
Average Cost
of Capital
Cost of
Equity
Capital
Extended
DuPont
Expression
Corporate
Governance
Cost of
Preference
Stock
Capital
Budgeting
Pro Forma
Financial
Statements
Working
Capital
Mgmt
Measure of
Leverage
Dividend
and Share
Repurchases
www.edupristine.com © Neev Knowledge Management – Pristine
NPV & IRR Profitability index
NPV =CF0+ [CF1/
(1+k)]+[CF2/(1+k)2]+
….+[CFn/ /(1+k)n]
IRR: discount rate
that makes NPV
equal to 0.
PI = 1 + NPV/CF0
If PI > 0, accept project
If PI < 0, reject project
Avg accounting rate of
return (AAR)
AAR= avg NI / avg BV
Payback period
Payback period is no. of
years it takes to recover
initial project cost
Discount payback uses
present values of cash
flows
Treatment of Floatation Costs:
• Increase in Initial Cost of Project
(Preferred)
• Incorporate Floatation Costs in
discount rate (not preferred)
Corporate Finance
Weighted
Average Cost
of Capital
Cost of
Equity
Capital
Extended
DuPont
Expression
Corporate
Governance
Cost of
Preference
Stock
Capital
Budgeting
Pro Forma
Financial
Statements
Working
Capital
Mgmt
Measure of
Leverage
Dividend
and Share
Repurchases
www.edupristine.com © Neev Knowledge Management – Pristine
Receivables
Turnover =
Credit Sales /
Average
Receivables
Inventory
Turnover =
COGS /
Average
Inventory
Payables
Turnover =
Purchases /
Average Trade
Payables
Cash Management
Bond Equivalent Yield
= [(face value –
price)/ price] *
(365/days to maturity)
Money Market Yield
= [(face value –
price)/ price] *
(360/day to maturity)
% Discount =
(face value –
price) / face
value
Q. Which of the following ratios
cannot be directly observed in the
common size statements?
• Inventory turnover
• Profit Margin
• Debt /Asset Ratio
Ans. Inventory turnover ratio Q. Which of the following is least likely
to be bond with modifying maturity?
• Callable bonds
• Putable bonds
• Treasury bonds
Ans. Treasury bonds
Q. A bond matures in one year and pays interest at
maturity. If the face value of the bond and coupon rate is
$500,000 & 9% respectively, and the required rate of
return is 8%, what should be the present value?
• >$500,000
• <$500,000
• $500,000
Ans. >$500,000
Corporate Finance
Weighted
Average Cost
of Capital
Cost of
Equity
Capital
Extended
DuPont
Expression
Corporate
Governance
Cost of
Preference
Stock
Capital
Budgeting
Pro Forma
Financial
Statements
Working
Capital
Mgmt
Measure of
Leverage
Dividend
and Share
Repurchases
www.edupristine.com © Neev Knowledge Management – Pristine
2010 2011 2012
Operating Margin 78% 78% 78%
Effects of nonoperating
items
0.80 0.77 0.72
Tax Effect 0.65 0.65 0.65
Total asset turnover ratio 0.20 0.19 0.18
Financial leverage 2.50 2.86 3.37
ROE 20% 21% 22%
ROE= [O/P Income/Revenue] * [PBT/ (O/p Income)] *
[PAT/PBT] * [Revenue / avg. total assets] * [avg. total assets/ avg. equity]
Corporate Finance
Weighted
Average Cost
of Capital
Cost of
Equity
Capital
Extended
DuPont
Expression
Corporate
Governance
Cost of
Preference
Stock
Capital
Budgeting
Pro Forma
Financial
Statements
Working
Capital
Mgmt
Measure of
Leverage
Dividend
and Share
Repurchases
www.edupristine.com © Neev Knowledge Management – Pristine
1. Estimate the relations b/w changes in sales and changes in
income statement & balance sheet items
2. Estimate future tax rate, interest rates on debt, lease payments
etc.
3. Forecast sales
4. Estimate fixed operating and financial costs
5. Integrate these estimates into pro forma financial statements
Corporate Finance
Weighted
Average Cost
of Capital
Cost of
Equity
Capital
Extended
DuPont
Expression
Corporate
Governance
Cost of
Preference
Stock
Capital
Budgeting
Pro Forma
Financial
Statements
Working
Capital
Mgmt
Measure of
Leverage
Dividend
and Share
Repurchases
www.edupristine.com © Neev Knowledge Management – Pristine
Favor Shareholder
Interests
Harm Shareholder
Interests
• Independent board.
• Strong code of ethics
• Confidential voting
• Management-
aligned board
• Voting restrictions
• Takeover defenses
Corporate Finance
Weighted
Average Cost
of Capital
Cost of
Equity
Capital
Extended
DuPont
Expression
Corporate
Governance
Cost of
Preference
Stock
Capital
Budgeting
Pro Forma
Financial
Statements
Working
Capital
Mgmt
Measure of
Leverage
Dividend
and Share
Repurchases
www.edupristine.com © Neev Knowledge Management – Pristine
Leverage is present
because of:
• Fixed Operating Costs
• Use of Debt in capital
structure z
Degree of Operating Leverage
Degree of Financial Leverage
Degree of Total Leverage = DOL
*DFL
FVPQ
VPQDOL
)(
)(
CFVPQ
FVPQDFL
)(
)(
Breakeven: When Profit = 0 and
Revenue = Costs
Breakeven Points
Operating Break Even:
VP
CFQBE
VP
FQOBE
Corporate Finance
Weighted
Average Cost
of Capital
Cost of
Equity
Capital
Extended
DuPont
Expression
Corporate
Governance
Cost of
Preference
Stock
Capital
Budgeting
Pro Forma
Financial
Statements
Working
Capital
Mgmt
Measure of
Leverage
Dividend
and Share
Repurchases
www.edupristine.com © Neev Knowledge Management – Pristine
Regular Cash
Dividends
Dividend
Reinvestment Plan
(DRP)
No floatation costs
Special Dividends
Used especially by
cyclical companies
in periods of strong
earnings
Liquidating
Dividends
Company goes
out of business
Stock
Splits
Reverse
Stock
Splits
Share
Repurchases
• Earning yield > Cost of debt
then EPS increases
• Earning yield < Cost of Debt
then EPS is reduced
• If market price > BVPS then
book value per share reduces
after repurchase
• If market price < BVPS then
book value per share
increases after repurchase
For equal taxation and
information content
cash dividends = share
repurchases
• EPS and other per market
data decline by half
• P/E, Dividend Yield are
same
• Wealth remains same
Corporate Finance
Weighted
Average Cost
of Capital
Cost of
Equity
Capital
Extended
DuPont
Expression
Corporate
Governance
Cost of
Preference
Stock
Capital
Budgeting
Pro Forma
Financial
Statements
Working
Capital
Mgmt
Measure of
Leverage
Dividend
and Share
Repurchases
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Question 1
Sigma Corporation is planning to launch a new product in the market for which it has
paid Xylus Consultants a fee of $4000 to do a market survey to gauge the demand for
the product. The new product is expected to cause a 5% decline in the market share of
its existing brands. Also the facilities for the manufacturing of the project could earn a
lease rent of $1500 per month, if the project were not to be undertaken. Which of the
following regarding the project cash flow is least likely true?
A. The cash flows should not take into account the consultants fee
B. The loss in lease rent is relevant to the decision making
C. The loss of sale of existing product is irrelevant to the decision making
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Answer 1
C.
The cost of cannibalisation should be considered in the incremental cash flows
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Question 2
Company A's stock is selling for $120 and the expected return on equity is 10%.
Dividend planned for next year is $6 and the company plans to pay out 30% of its
earnings. What is the cost of retained earnings for Company A using the discounted
cash flow approach?
A. 12.5%
B. 15%
C. 10%
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Answer 2
A.
Kre = D1/P0 + g where g = (1-payout ratio) x ROE, P0 = Current price and D1 =
Dividend expected. Hence, Kre = 6/120 + (1-0.3) x 0.1 = 0.125 i.e. 12.5%
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Question 3
A company is considering a project with future cash flows:
Year Cash flow
0 -1500
1 450
2 400
3 513
4 580
The firm plans to invest in another project after its maximum payback period of 3 years.
The WACC of the firm is 10%. Which of the following is least likely the company’s
decision regarding the two projects?
A. The first project is least likely to be profitable within the maximum payback period
B. The first project should not have been accepted by the company in the first place
C. The firm’s major concern is profitability and not liquidity as evident from the capital
budgeting methods followed by it
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Answer 3
C.
The maximum payback period method followed reflects that the firm is more concerned
about the liquidity from the project as the payback period method is not appropriate to
calculate the profitability of the project.
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Question 4
Rio Inc has invested $650 million in a real estate project. The present value of the after
tax future cash flows from the project is $900 million, as estimated by the company. If
Rio at present has 100 million shares outstanding trading at $50 per share, what
should an analyst analysing Rio recommend to his clients about this company after
receiving and analysing this information?
A. Buy as the stock price is expected to rise to $52.5
B. Cannot be said with certainty
C. Buy as the stock price is expected to rise to $59
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Answer 4
B.
The analyst may expect a lower level of profitability than that estimated by the
company
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Question 5
A firm has a target equity share capital of $400 million and debt of $100 million. It
raises another $120 million from the market through a rights issue. If the cost of equity
is 13% and the after tax cost of debt is 8%, what is most likely the WACC of the firm
after the additional fund raised?
A. 12%
B. 12.19%
C. 11.27%
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Answer 5
A.
The WACC is calculated based on the target capital structure of the firm which is
80:20. Hence, WACC is 0.8*0.13+0.2*0.08= 0.12
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Question 6
Plasma Inc is considering the purchase of an automatic capping machine to reduce
labor costs. The machine is projected to save Plasma $5,000 per year. The machine
costs $40,000 and is expected to last for 15 years. Plasma has estimated that their
cost of capital for such an investment is 10%. For an extra $750 per year, Plasma can
get a “Good As New” service contract. The contract keeps the machine in new
condition forever. Net of the cost of the service contract, the machine would produce
cash flows of $4250 per year in perpetuity. Which of the following decisions is the most
appropriate?
A. Plasma should not avail of the service contract
B. Plasma’s profitability would increase if it accepts the service contract
C. Plasma should not accept the entire project in the first place
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Answer 6
B.
The NPV for purchase of machine only is negative (-$1970), however with the service
contract the NPV is positive $2500 and the IRR is more than the WACC of the firm
(10.81%).
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Question 7
What is a firm's weighted-average cost of capital if the stock has a beta of 1.45,
Treasury bills yield 5%, and the market portfolio offers an expected return of 14%? In
addition to equity, the firm finances 30% of its assets with debt that has a yield to
maturity of 9%. The firm is in the 35% marginal tax bracket.
A. 14.39%
B. 12.66%
C. 15.21%
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Answer 7
A.
Cost of equity = 5+1.45(14-5) = 18.05%
After tax Cost of debt = 9(1-0.35)=5.85%
WACC = 0.3*0.0585+0.7*0.18= 14.39%
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Question 8
The opportunity cost of capital is 8%. Your firm is evaluating two mutually exclusive
projects with scale differences. Each project requires an initial investment at time zero
and produces one cash inflow at the end of the tenth year. Project A (the smaller
project, requiring an initial investment of $10,000) has an internal rate of return of 9%.
Project B (the larger project, requiring an initial investment of $12,000) has an internal
rate of return of 10%. Which of the two projects has the higher NPV?
A. Project A has the higher NPV.
B. Project B has the higher NPV
C. Both projects have the same NPV.
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Answer 8
B.
Since the IRR of project B is higher than project A , the NPV of project B will also be
higher.
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Question 9
Chempro has planned to purchase a machine to add to the current production
capacities to meet the growing demand of its products in the market. The following
are the additional information provided in addition to the table below:
All sales are on cash basis
Interest on capital is 10%
Corporate income tax is 40%
Machine life is 2 years
What is the net cash flow from the project?
A. $123000
B. $24000
C. $88000
Sr No Description Amount ($)
1 Initial Investment 150,000
2 Estimated Sales 250,000
3 Cost of goods sold 75,000
4 Administration, selling and Distribution expenses
20,000
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Answer 9
A.
Initial investment 150000
Estimated sales (Annual) 250000
Cost of goods sold 75000
Admin, Selling and Distribution expenses 20000
Depreciation (2 years life) 75000
Interest on capital (10% of investment) 15000
PBT 65000
Less : Tax at 40% PBT 16000
Profit After Tax 39000
Add: Depreciation 75000
Net Cash Flow 114000
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Question 10
In a mutually exclusive project, the IRR of project A is 20% while NPV at 10% cost of
capital is $4000. The IRR of project B is 18% while NPV at 10% cost of capital is
$6000, the preferred capital budgeting method to be chosen is
A. IRR
B. NPV
C. Discounted Payback
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Answer 10
B.
NPV is the preferred method in capital budgeting . Only if NPV is the same then IRR is
compared.
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Question 11
In Drag on liquidity pressures from credit management deteriorates because:
A. Payments are made before due dates to vendors, employees and contractors.
B. Banks which trades with the company reduces the line of credit.
C. Uncollected receivables are longer and many may not be collected along with
increasing bad debt expenses.
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Answer 11
C.
Drag on liquidity is delay or reduction in cash inflow.
Hence only option “Uncollected receivables are longer and many may not be collected
along with increasing bad debt expenses” causes drag on liquidity.
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Question 12
Silverton Inc is considering a project in the garment manufacturing industry. It has a
D/E ratio of 1.2 and its debt currently has a after tax return of 6%.Ashley Inc is a
publicly traded company which is only in the garment manufacturing business with a
D/E ratio of 2 and equity beta of 1.1. If the risk free rate is 5% and return on market is
10%, find the appropriate WACC to be used to evaluate Silverton’s project. Assume tax
rate of 40%
A. 8.6%
B. 7.5%
C. 10.3%
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Answer 12
B.
Ashley’s unlevered/asset beta = 1.1*[1/{1+(1-0.4)*2}] = 0.5. Silverton’s project beta =
0.5*[1+(1-0.40)*1.2]= 0.86
Silverton’s cost of equity using CAPM = 0.05+0.86(0.1-0.05) =9.3%
WACC = (1.2/2.2)*0.06+(1/2.2)*0.093 = 0.075
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Question 13
Zeta Technologies is planning to expand into China. The following information is
available:
Chinese US dollar denominated 10 year Govt bond yield= 8.9%
10 Year US treasury bond yield = 4.8%
Annualised standard deviation of Chinese stock Index= 23%
Annualised std dev of Chinese US dollar denominated 10 year govt bond = 14%
Find the country risk premium of China.
A. 8.93%
B. 5.54%
C. 6.73%
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Answer 13
C.
Country risk premium= (8.9-4.8)*(23/14) =6.73%
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Question 14
What happens to a company’s weighted average cost of capital if the firm’s corporate
tax rate increases and if the risk free interest rate decreases, considering the two
events separately?
Tax rate increase / Decrease in risk free rate
A) Decrease / Decrease
B) Increase / Decrease
C) Decrease / Increase
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Answer 14
A.
Increase in the tax rate will reduce the cost of debt and decrease in the risk free rate
will decrease the cost of equity
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Question 15
Under which of the following circumstances would a company be most likely to avail of
a trade discount?
A. Company with a high payable turnover
B. Availability of low cost funds to finance the working capital requirements
C. Company with a low payable turnover
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Answer 15
B.
In such a situation the company would prefer to pay off the payables and use the low
cost funds available to finance its working capital requirements.
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Question 16
Which of the following would most likely to be a sign of independence, prudence of the
auditing committee?
A. 2/3 of the audit committee comprises of independent members and committee is
chaired by managing director
B. Same external auditor is advising company management in M&A activities
C. Committee members are financial experts
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Answer 16
C.
Auditing committee headed by management director is more likely to create a principal
agent problem and would not be effective in protecting shareholders’ interest
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Question 17
The difference between primary and secondary sources of liquidity is
A. Primary source is easily accessible from the market than secondary source of
liquidity.
B. Primary source is likely to affect the normal operations of the company whereas
using the secondary source will not result in company’s financial and operating
position.
C. The normal operations are not affected while using primary source but secondary
source will result in changing the company’s financial and operating position.
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Answer 17
C.
Primary source of liquidity are the sources of cash it uses in its normal day to day
operations.
Secondary source of liquidity include liquidating short term or long lived assets etc.
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Question 18
American Outlook Inc. is issuing bonds to obtain the funding necessary to acquire a
major competitor. Review of the balance sheets indicates that American Outlook has
also issued preferred and common stock in the past. Which component cost(s) should
American Outlook use in evaluating the financial cost of acquiring the new firm?
A. The weighted average component cost of common stock, preferred stock and debt
B. The price the firm paid for its assets divided by their market value
C. The cost of the new debt issue alone
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Answer 18
A.
How a company raises capital and how it invests it are considered independently. In
the short run, a company may highlight the latest capital issued. But in the long run the
firm would look at a targeted capital structure and hence the investment decision
should be made assuming a weighted average cost of capital including each source of
capital.
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Question 19
Which of the following is a case where there is a problem in using the IRR?
A. Mutually exclusive projects
B. Cost of capital not available
C. Cut-off rate is high
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Answer 19
A.
While NPV and IRR are useful metrics for analyzing mutually exclusive projects - that
is, when the decision must be one project or another - these metrics do not always
point you in the same direction. This is a result of the timing of cash flows for each
project. In addition, conflicting results may simply occur because of the project sizes.
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Question 20
Accounting beta is calculated by running a regression using
A. Company's turnover against the operating turnover for market benchmark
B. Company's operating margin against the operating margin for market benchmark
C. Company's return on assets against the return on assets for market benchmark
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Answer 20
C.
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Question 21
A company XYZ Ltd sells 10,000 units of water bottles at a price of $4 per unit. ABC’s
fixed costs are $10,000 and it pays an annual interest of $ 3,000.The variable cost of
production is $ 2 per unit and the operating profit (EBIT) is $ 14,000. Which of the
following statements is true?
A. Degree of Operating leverage = 2.00 , Degree of Financial leverage = 1.27
B. Degree of Operating leverage = 1.27 , Degree of Financial leverage = 2.00
C. Degree of Operating leverage = 1.27 , Degree of Financial leverage = 1.50
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Answer 21
A.
Degree of operating leverage = Q*(P-V)/ (Q*(P-V)-F)
Where Q = number of units sold = 10,000
P = Cost price per unit =$4
V = Variable cost per unit = $2
F = Fixed cost = $10,000
Hence DOL = 10,000*($4-$2)/ (10,000*($4-$2) -$10,000) = 2.00
Degree of Financial leverage = EBIT/ (EBIT – Interest) = $14,000/ ($14,000-$3,000)
= 1.27
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Question 22
25% increase in sales of Irrelevant Corporation causes 50% growth in EPS If operating
earnings of the company is $ 12,000 and financial leverage is 1.5. Calculate operating
earnings of the company if sales increase by 10% next year
A. 15000
B. 14000
C. 13000
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Answer 22
B.
Total leverage = EPS growth/sales growth
Operating leverage (OL) = total leverage/financial leverage
New operating income = old income *(1+ OL * sales growth)