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CFA Level I · CFA Level I Exam · Equity Instrument Features

A company with a thin equity base, funded largely by debt, experiences a sharp fall in operating income. Relative to a similar company funded mostly by equity, the shareholders of the leveraged company are most likely to experience:

The leveraged company's shareholders will most likely suffer a larger decline in returns on equity. Fixed interest payments must be met regardless of operating income, so the fall in operating income is magnified in the residual earnings available to equity holders, increasing equity risk.

  1. Aa smaller decline in earnings per share because interest is tax deductible
  2. Ban identical decline in returns because operating income fell equally
  3. Ca larger decline in returns on equity because fixed interest costs magnify the fallCorrect

Explanation

Interest is a fixed cost, so a fall in operating income reduces the residual profit available to shareholders proportionally more. This financial leverage raises the variability of equity returns. The tax shield does not offset this magnification.

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