Company D has a 50% debt ratio, whereas Company E has no debt financing. The two companies have the same level of sales and the same degree of operating leverage. Which of the following statements is most CORRECT?
A) If sales increase 10% for both companies, then Company D will have a larger percentage increase in its operating income (EBIT).
B) The two companies have the same degree of total leverage.
C) If sales increase 10% for both companies, then Company D will have a larger percentage increase in its net income.
D) If EBIT increases 10% for both companies, then Company D's net income will rise by more than 10%, while Company E's net income will rise by less than 10%.
E) Company E has a higher degree of financial leverage.

Question

Quizplus · Accepted Answer

Company D, with debt financing, has financial leverage, which amplifies changes in net income relative to changes in EBIT. Therefore, a 10% increase in sales will lead to a larger percentage increase in net income for Company D compared to Company E, which has no debt and thus no financial leverage.

Company D Has a 50% Debt Ratio, Whereas Company E