Question

1. Which of the following statements is least likely to be correct?

A. The amount of capital at which the weighted average cost of capital would change is termed as a break point.

B. The marginal cost of capital schedule is the weighted average cost of capital for different risk levels, hence it is upward sloping.

C. Country risk premium can be incorporated into the cost of equity from CAPM by adding the country risk premium to the market risk premium.

2. Which of the following statements is most likely to be correct if a firm has an operating leverage of 1.5 and a financial leverage of 1.6 at 80,000 units?

A. At 72,000 units of sales, net income would fall by 24%

B. A 10% increase in sales would result in a 16% increase in net income.

C. A 16% increase in operating income would result in a 15% increase in net income.

Answer 1

(1)

B is incorrect - The marginal cost of capital schedule is the weighted average cost of capital for different levels of total capital, not for different levels of risk.

A is correct. Break point is the level at which WACC changes.

C is correct. Adding country risk premium to CAPM cost of equity is a method to incorporate country risk premium.

(2)

degree of operating leverage = % change in EBIT / % change in sales.

degree of financial leverage = % change in net income / % change in EBIT.

degree of total leverage =  degree of operating leverage * degree of financial leverage.

(A) is correct.  degree of total leverage = 1.5 * 1.6 = 2.4. If the sales fall to 72,000 (fall of 8,000 units, which is 10% of sales), decrease in net income = 10% * 2.4 = 24%.

(B) is incorrect. If sales increase by 10%, increase in net income = 10% * 2.4 = 24%.

(C) is incorrect. If operating income increased by 16%, increase in net income = 16% * 1.6 = 25.6%.