Which of the following statements is most correct?
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A. B. C. D. E.E
DOL is the % change in EBIT that results from a given % change in sales, while DFL is the % change in EPS that results from a given % change in EBIT. If no debt were used, the DFL would be 1.0.
Let's analyze each statement and determine which one is most correct:
A. All these statements are false. B. The degree of total leverage (DTL) is equal to the DOL plus the degree of financial leverage (DFL). C. Arithmetically, financial leverage and operating leverage offset one another so as to keep the degree of total leverage constant. Therefore, the formula shows that the greater the degree of financial leverage, the smaller the degree of operating leverage. D. All these statements are true. E. The degree of operating leverage (DOL) depends on a company's fixed costs, variable costs, and sales. The DOL formula assumes (1) that fixed costs are constant and (2) that variable costs are a constant proportion of sales.
Let's start by examining each statement:
A. All these statements are false. This statement implies that none of the statements are correct, which means statement B, C, D, and E cannot be true. However, if any of the statements is true, then statement A itself would be false. Therefore, statement A contradicts itself and cannot be correct.
B. The degree of total leverage (DTL) is equal to the DOL plus the degree of financial leverage (DFL). This statement suggests that the degree of total leverage (DTL) is the sum of the degree of operating leverage (DOL) and the degree of financial leverage (DFL). However, this statement is not accurate. The degree of total leverage (DTL) is actually the product of the degree of operating leverage (DOL) and the degree of financial leverage (DFL). Therefore, statement B is incorrect.
C. Arithmetically, financial leverage and operating leverage offset one another so as to keep the degree of total leverage constant. Therefore, the formula shows that the greater the degree of financial leverage, the smaller the degree of operating leverage. This statement is not correct. Financial leverage and operating leverage do not offset each other to keep the degree of total leverage constant. The formula for the degree of total leverage (DTL) is the product of the degree of operating leverage (DOL) and the degree of financial leverage (DFL). Therefore, as the degree of financial leverage increases, the degree of total leverage increases, rather than decreases. Statement C is incorrect.
D. All these statements are true. If any of the previous statements (A, B, or C) is false, then statement D, which claims that all the statements are true, cannot be correct. Since we have already determined that statements A, B, and C are incorrect, statement D is also false.
E. The degree of operating leverage (DOL) depends on a company's fixed costs, variable costs, and sales. The DOL formula assumes (1) that fixed costs are constant and (2) that variable costs are a constant proportion of sales. This statement is true. The degree of operating leverage (DOL) measures the sensitivity of a company's operating income to changes in sales. It is calculated by dividing the percentage change in operating income by the percentage change in sales. The formula for DOL assumes that fixed costs remain constant and that variable costs are a constant proportion of sales. Therefore, statement E is correct.
In conclusion, the most correct statement among the options provided is statement E: "The degree of operating leverage (DOL) depends on a company's fixed costs, variable costs, and sales. The DOL formula assumes (1) that fixed costs are constant and (2) that variable costs are a constant proportion of sales."