A firm is analyzing two different capital structures for financing a new asset that will cost $100,000.The effects of the two structures on the firm's balance sheet are described below.
Plan A: finance with 50% debt
New asset $100,000 Debt $50,000
Common equity $50,000
Total $100,000
Plan B: finance with 70% debt
New asset $100,000 Debt $70,000
Common equity $30,000
Total $100,000
Based on the information provided,we can conclude that
A)if the firm chooses Plan A,then any changes in the firm's EBIT will lead to larger fluctuations in the firm's EPS than if the firm chooses Plan B.
B)if the firm chooses Plan B,then any changes in the firm's EBIT will lead to larger fluctuations in the firm's EPS than if the firm chooses Plan A.
C)if the firm chooses Plan A,then any changes in the firm's EBIT will lead to the same fluctuations in the firm's EPS as will occur if the firm chooses Plan B.
D)if the firm chooses Plan B,then any changes in the firm's EBIT will lead to smaller fluctuations in the firm's EPS than if the firm chooses Plan A.

Question

Quizplus · Accepted Answer

Plan B has a higher debt ratio, which increases financial leverage. Higher leverage amplifies the effect of changes in EBIT on EPS, leading to larger fluctuations in EPS compared to Plan A.

A Firm Is Analyzing Two Different Capital Structures for Financing