The increase in risk to equityholders when financial leverage is introduced is evidenced by:
A) higher EPS as EBIT increases.
B) a higher variability of EPS with debt than all equity.
C) increased use of homemade leverage.
D) equivalence value between levered and unlevered firms in the presence of taxes.
E) None of these.

Question

Quizplus · Accepted Answer

When financial leverage is introduced, the variability of EPS increases because the interest payment on debt does not fluctuate with earnings. This means that a small change in EBIT can cause a large change in EPS, and therefore increases the risk to equity holders. Choice A is incorrect because a higher EPS with increasing EBIT can occur even without financial leverage. Choice C is incorrect because homemade leverage refers to an individual's decision to borrow or lend to adjust personal leverage, not to the impact of financial leverage on a firm's equity. Choice D is incorrect because tax benefits from financial leverage leads to a higher value of the levered firm than the unlevered firm. Choice E is incorrect because option B is a valid explanation.

The Increase in Risk to Equityholders When Financial Leverage Is