1. The risk associated with the market demand for a product and the price received for it is best described as:
A. business risk.
B. operating risk.
C. sales risk.
2. Degree of operating leverage is best described as a measure of the sensitivity of:
A. Net earnings to changes in sales.
B. Fixed operating costs to changes in variable costs.
C. Operating earnings to changes in the number of units sold.
3. Asparagus Inc. is highly leveraged relative to its counterpart Supras Inc. If operating income of Asparagus is 0, the most likely effect is that:
A. NI and ROE will be negative for Asparagus Inc.
B. NI and ROE will be negative for Supras. Inc.
C. NI and ROE will be lower but positive for both companies.
1. C is correct.
Sales risk is associated with uncertainty with respect to total revenue, which in turn, depends on price and units sold.
2. C is correct.
The degree of operating leverage is the elasticity of operating earnings with respect to the number of units produced and sold. As elasticity, the degree of operating leverage measures the sensitivity of operating earnings to a change in the number of units produced and sold.
3. A is correct.
For lower levels of EBIT, NI and ROE are negative for the high leverage firm, in this case Asparagus. Inc.