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CMA Intermediate · Financial Management and Business Data Analytics · Leverage Analyses and EBIT - EPS Analysis

Which statement about financial leverage is correct for a firm whose return on investment exceeds the cost of debt?

More debt raises EPS while also raising financial risk. When the return earned on funds exceeds the interest cost, the surplus accrues to equity holders, which is trading on equity. However, higher fixed interest widens the gap between EBIT and EBT, so DFL increases.

  1. ARaising more debt increases EPS, and financial risk also risesCorrect
  2. BRaising more debt lowers EPS but reduces financial risk
  3. CRaising more debt leaves EPS unchanged because interest is fixed
  4. DRaising more debt lowers DFL since EBT falls

Explanation

When return on investment exceeds the cost of debt, leverage is favourable and extra debt raises EPS (trading on equity). But fixed interest increases EBIT-to-EBT gap, so DFL rises and so does financial risk. DFL does not fall with more debt, because EBT becomes smaller relative to EBIT.

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