The degree of financial leverage for ABC Inc.is 2.5,and the degree of financial leverage for XYZ Corporation is 1.5.According to this information,which firm is considered to have greater financial risk?
A) ABC Inc.
B) XYZ Corporation.
C) The degree of financial leverage is not a measure of financial risk,so it is not possible to tell which firm has the greater financial risk given the above information.
D) To determine which firm has the greater financial risk,we need to know the operating income (NOI or EBIT)of each firm.XYZ Corporation would have less financial risk if its operating income is at least twice that of ABC Inc.
E) None of the above is a correct answer.

Question

Quizplus · Accepted Answer

The degree of financial leverage (DFL) measures the percentage change in earnings per share (EPS) that results from a percentage change in earnings before interest and taxes (EBIT). The higher the DFL, the greater the financial risk because a small change in EBIT can lead to a larger change in EPS. ABC Inc. has a higher DFL compared to XYZ Corporation, which indicates that ABC Inc. has greater financial risk. Therefore, option A is the correct answer. Option B is incorrect because XYZ Corporation has a lower DFL and, therefore, lower financial risk. Option C is incorrect because DFL is a measure of financial risk. Option D is incorrect because the operating income is not necessary to determine which firm has greater financial risk.

The Degree of Financial Leverage for ABC Inc