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CA Intermediate · Financial Management and Strategic Management · Financing Decisions - Leverages

Which statement about operating leverage is correct?

Operating leverage is absent when fixed operating costs are zero. Contribution then equals EBIT, so DOL is 1 and EBIT moves exactly in proportion to sales. Debt relates to financial leverage, and DOL rises sharply as the firm nears break-even.

  1. AIt arises from the use of debt in the capital structure
  2. BIt is zero when fixed operating costs are zeroCorrect
  3. CIt measures the effect of EBIT change on EPS
  4. DIt is lowest at the point where EBIT is close to zero

Explanation

If fixed operating costs are zero, contribution equals EBIT, so DOL = 1, meaning EBIT changes in proportion to sales and there is no operating leverage effect. Debt relates to financial leverage, and EBIT-to-EPS effect is financial leverage. DOL is highest, not lowest, near break-even.

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