DOL

CFA Level I
#1

Which of the following statements about leverage is CORRECT? A) A decrease in interest expense will increase the company’s degree of total leverage. B) An increase in interest expense will reduce the company’s degree of financial leverage. C) An increase in fixed costs (holding sales and variable costs constant) will reduce the company’s degree of operating leverage. D) If the company has no debt outstanding, then its degree of total leverage equals its degree of operating leverage. ============================================================= The correct answer according to Schweser is D) Explaination: If the company has no debt outstanding, then its degree of total leverage equals its degree of operating leverage. If debt = 0 then DFL = 1 because DFL = EBIT/(EBIT - I) If debt = 0 then I = 0 and DFL = EBIT/(EBIT - 0) = EBIT/EBIT = 1 DTL = (DOL)(DFL) If DFL = 1 then DTL = (DOL)(1) which complies to DTL = DOL An increase in interest expense will increase DFL, which will increase DTL. A decrease in interest expense will decrease DFL, which will decrease DTL. An increase in fixed costs will increase the company’s DOL. ======================================================= I think C is correct as well because DOL = (S - TVC)/(S-TVC-F) and if we increase F; DOL will decrease. ======================================================== Am I missing anything?

#2

If you increase F, the denominator will decrease, and the DOL will increase. Operating leverage increases when fixed costs increase.

#3

Maybe you’re just having a brainfreeze close to the exam date. Notice that “minus sign” in front of the “F” in the denominator. The higher F is, the smaller the denominator is, and the higher the quotient is, which in this case is DOL.

#4

Thanks guys. Got it. I guess I am tired…

#5

vishalarora Wrote: ------------------------------------------------------- > Thanks guys. > Got it. I guess I am tired… Happens to everyone. All the more reason to ensure you get enough rest in the days leading up to the exam. Good luck!

#6

Thanks man. but I guess no rest for me. Just started preparing 3 weeks ago.

#7

sorry to bring back an already answered question, but you can also solve these questions intuitively: Which of the following statements about leverage is CORRECT? A) A decrease in interest expense will increase the company’s degree of total leverage. B) An increase in interest expense will reduce the company’s degree of financial leverage. C) An increase in fixed costs (holding sales and variable costs constant) will reduce the company’s degree of operating leverage. D) If the company has no debt outstanding, then its degree of total leverage equals its degree of operating leverage. just remember taht fixed operating costs lead to more DOL… fixed interest costs lead to more DFL… so, A leads to LESS leverage financial (and thus total) B leads to more financial leverage C leads to more DTL (doesnt say whether the fixed cost is financial cost or operating cost, but either way it will NOT reduce DOL) therefore the answer is D. If company has no debt, therefore no fixed finance costs, therefore DFL equals 1… which means the total leverage (DTL) must be made up entirely of DOL