Financial leverage impacts the performance of the firm by:
A)increasing the volatility of the firm's EBIT.
B)decreasing the volatility of the firm's EBIT.
C)decreasing the volatility of the firm's net income.
D)increasing the volatility of the firm's net income
E)None of the above.

Question

Quizplus · Accepted Answer

Financial leverage uses debt to increase the potential returns for shareholders. However, it also increases the potential risks because the firm now has fixed interest payments that must be made regardless of the firm's earnings. So, if EBIT increases, then net income will also increase, making shareholders wealthier. However, if EBIT decreases, then fixed interest payments will still need to be made, meaning that net income will fall, and shareholders will lose money. This results in increased volatility of the firm's net income. Therefore, option D is the correct answer.

Financial Leverage Impacts the Performance of the Firm By