The increase in risk to shareholders when financial leverage is introduced is best evidenced by:
A)higher EPS as EBIT increases.
B)a higher variability of EPS with debt than with all-equity financing.
C)increased use of homemade leverage.
D)the increase in taxes.
E)decreasing earnings as EBIT increases.

Question

Quizplus · Accepted Answer

Financial leverage, or the use of debt to finance the firm's operations or growth, increases the variability of earnings per share (EPS) due to the fixed interest payments on the debt. When operating profits (EBIT) are high, earnings per share are leveraged upwards, but when operating profits are low, EPS can be negative, leading to increased risk for shareholders. Option A is not true because higher EPS as EBIT increases is a general pattern that holds for both levered and unlevered firms. Option C is not relevant to the increase in risk for shareholders but refers to the notion that individuals can adjust their personal leverage to match their risk preferences. Option D is incorrect because taxes do not directly relate to the introduction of financial leverage. Option E is incorrect, as it implies a negative relationship between EBIT and earnings, which is not necessarily true.

The Increase in Risk to Shareholders When Financial Leverage Is