An increase in a firm's financial leverage will:

Question

Quizplus · Accepted Answer

An increase in financial leverage refers to increasing the use of debt financing in a firm's capital structure. This increases the interest expense, which in turn reduces the firm's net income. As a result, the earnings per share (EPS) become more volatile and fluctuate more with changes in operating income. Therefore, choice A is correct as an increase in financial leverage increases the variability in earnings per share. Choice B is incorrect because an increase in financial leverage often leads to higher operating risk as debt must be serviced regardless of the firm's profitability. Choice C is incorrect because, in a non-MM world, an increase in financial leverage may or may not increase the value of the firm, depending on various factors such as taxes, bankruptcy costs, and agency costs. Choice D is also incorrect because an increase in financial leverage generally leads to a higher cost of equity and hence an increase in WACC.

An Increase in a Firm's Financial Leverage Will