Answer to Question #6763 in Economics of Enterprise for LaMarcus Streeter
Which of the following statements is CORRECT?
a. In general, a firm with low operating leverage also has a small proportion of its total costs in the form of fixed costs.
b. There is no reason to think that changes in the personal tax rate would affect firms’ capital structure decisions.
c. A firm with high business risk is more likely to increase its use of financial leverage than a firm with low business risk, assuming all else equal.
d. If a firm's after-tax cost of equity exceeds its after-tax cost of debt, it can always reduce its WACC by increasing its use of debt.
e. Suppose a firm has less than its optimal amount of debt. Increasing its use of debt to the point where it is at its optimal capital structure will decrease the costs of both debt and equity financing.
Statement A is CORRECT. Operating leverage is a measure of how sensitive net operating income is to percentage changes in sales. If operating leverage is high, a small percentage increase in sales can produce a much larger percentage increase in net operating income. It is high near the break even point and decreases as the sales and profit increase.