Question
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Which of the following statements are true regarding the effect of financial leverage and the firm's operating earnings?
Multiple select question.
Above the indifference or break-even point in EBIT, the increase in EPS for all equity structures is greater than leveraged structures.
Financial leverage increases the slope of the EPS line.
The rate of return on assets is unaffected by leverage.
Below the indifference or break-even point in EBIT, an unlevered capital structure is best.
Which of the following statements are true regarding the effect of financial leverage and the firm's operating earnings?
Multiple select question.
Above the indifference or break-even point in EBIT, the increase in EPS for all equity structures is greater than leveraged structures.
Financial leverage increases the slope of the EPS line.
The rate of return on assets is unaffected by leverage.
Below the indifference or break-even point in EBIT, an unlevered capital structure is best.
Answers
Answered by
GPT-4o mini
Let's evaluate each statement regarding the effect of financial leverage and a firm's operating earnings:
1. **Above the indifference or break-even point in EBIT, the increase in EPS for all equity structures is greater than leveraged structures.**
- This statement is **false**. Above the indifference point, financial leverage typically causes the EPS of leveraged structures to increase more significantly than that of unleveraged structures due to the fixed interest expense being covered by higher operating income.
2. **Financial leverage increases the slope of the EPS line.**
- This statement is **true**. Financial leverage amplifies the changes in net income (and hence EPS) in response to changes in EBIT. The slope of the EPS line becomes steeper as leverage increases.
3. **The rate of return on assets is unaffected by leverage.**
- This statement is **true**. The return on assets (ROA) is calculated as net income divided by total assets, which does not change due to leverage. However, leverage affects the return on equity (ROE).
4. **Below the indifference or break-even point in EBIT, an unlevered capital structure is best.**
- This statement is **true**. Below the break-even point, the cost of debt can lead to losses that exacerbate the decline in EPS, making an unlevered structure (with no debt) preferable.
Based on this evaluation, the true statements are:
- Financial leverage increases the slope of the EPS line.
- The rate of return on assets is unaffected by leverage.
- Below the indifference or break-even point in EBIT, an unlevered capital structure is best.
1. **Above the indifference or break-even point in EBIT, the increase in EPS for all equity structures is greater than leveraged structures.**
- This statement is **false**. Above the indifference point, financial leverage typically causes the EPS of leveraged structures to increase more significantly than that of unleveraged structures due to the fixed interest expense being covered by higher operating income.
2. **Financial leverage increases the slope of the EPS line.**
- This statement is **true**. Financial leverage amplifies the changes in net income (and hence EPS) in response to changes in EBIT. The slope of the EPS line becomes steeper as leverage increases.
3. **The rate of return on assets is unaffected by leverage.**
- This statement is **true**. The return on assets (ROA) is calculated as net income divided by total assets, which does not change due to leverage. However, leverage affects the return on equity (ROE).
4. **Below the indifference or break-even point in EBIT, an unlevered capital structure is best.**
- This statement is **true**. Below the break-even point, the cost of debt can lead to losses that exacerbate the decline in EPS, making an unlevered structure (with no debt) preferable.
Based on this evaluation, the true statements are:
- Financial leverage increases the slope of the EPS line.
- The rate of return on assets is unaffected by leverage.
- Below the indifference or break-even point in EBIT, an unlevered capital structure is best.
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