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IAI Actuarial Core Principles · Business Finance · Structure and methods of financing a company

A firm with high operating gearing and high financial gearing experiences a fall in sales. Which statement best describes the effect on shareholders' earnings?

Earnings fall proportionately more than sales. Fixed operating costs magnify the change in operating profit, and fixed interest charges magnify it again for shareholders, so combined gearing makes earnings highly sensitive to sales.

  1. AEarnings are unaffected because interest is fixed
  2. BEarnings fall proportionately less than sales
  3. CEarnings fall proportionately more than sales, as fixed costs and fixed interest magnify the changeCorrect
  4. DEarnings rise because fixed costs are spread
  5. Only dividends fall; earnings stay constant

Explanation

Fixed operating costs magnify changes in operating profit relative to sales, and fixed interest magnifies changes in earnings relative to operating profit. A sales fall therefore causes a larger proportionate fall in earnings.

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