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CS Executive · Corporate Accounting and Financial Management · Operational Approach to Financial Decision

Which statement about financial leverage is correct?

Financial leverage is absent only when a firm has no fixed financing charges like interest or preference dividend. It arises from using fixed-cost funds, magnifying the effect of EBIT changes on EPS, whereas fixed operating costs give rise to operating leverage.

  1. AIt arises from the presence of fixed operating costs in the cost structure
  2. BIt is zero only when the firm has no fixed financing charges such as interest or preference dividendCorrect
  3. CIt measures the sensitivity of contribution to changes in sales
  4. DIt is highest when the firm is entirely equity financed

Explanation

Financial leverage arises from fixed financing charges, and with none the DFL is 1, meaning no magnification of EBIT changes on EPS. Fixed operating costs create operating leverage, not financial leverage, so the first option is wrong.

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