Degree of Operating Leverage and Financial Leverage Explained

What happens when a firm has the lowest possible degree of operating leverage and financial leverage?

A. DOL equals 1, and DFL equals 0.

B. DOL equals 0, and DFL equals 1.

C. DOL equals 1, and DFL equals 1.

D. None of the options.

Answer:

If a firm has the lowest possible degree of operating leverage and the lowest possible degree of financial leverage, then DOL equals 1, and DFL equals 1.

When a firm has the lowest possible degree of operating leverage (DOL) and the lowest possible degree of financial leverage (DFL), it means that the firm is not utilizing any debt or fixed costs in its operations.

Having a DOL of 1 indicates that a change in sales will result in an equal change in operating income. On the other hand, a DFL of 1 means that a change in operating income will result in an equal change in net income.

Therefore, when both DOL and DFL are at their lowest possible levels, the firm would have a DOL of 1 and a DFL of 1. This implies that any changes in sales or operating income will directly impact the corresponding financial metrics, leading to a balance in the firm's leverage.

Overall, having the lowest possible degrees of operating and financial leverage can provide a firm with stability and less exposure to risks associated with leverage. It allows the firm to maintain control over its financial performance without the added complexities introduced by leveraging operations and finances.