Suppose that a firm has a degree of financial leverage (DFL) that is greater than 1.0; that is, DFL 1. If the firm's sales decrease by 1 percent, its ______ will decrease by more than 1 percent.
A)earnings per share (EPS)
B)net operating income (NOI)
C)interest expense
D)variable costs
E)fixed financing costs

Question

Suppose that a firm has a degree of financial leverage (DFL) that is greater than 1.0; that is, DFL > 1. If the firm's sales decrease by 1 percent, its ______ will decrease by more than 1 percent. 
A)earnings per share (EPS)
B)net operating income (NOI)
C)interest expense
D)variable costs
E)fixed financing costs

Quizplus · Accepted Answer

A degree of financial leverage greater than 1 indicates that the firm has a higher proportion of debt financing than equity financing. This means that the firm is paying fixed financing costs in the form of interest expenses. When sales decrease, the firm's earnings before interest and taxes (EBIT) will also decrease. As the firm has fixed financing costs, the decrease in EBIT will result in a larger decrease in earnings after taxes and, therefore, EPS will decrease by more than 1 percent.

Suppose That a Firm Has a Degree of Financial Leverage