If a firm utilizes debt financing, an X% decline in earnings before interest and taxes (EBIT)will result in a decline in earnings per share that is larger than X.

Question

Quizplus · Accepted Answer

This is true because when a firm uses debt financing, it also has fixed interest payments that it must make regardless of its level of EBIT. As a result, a decline in EBIT will cause a larger decline in earnings available to shareholders (i.e. earnings per share). This is because the firm must first use its earnings to pay its interest expenses before any earnings are available to be distributed to shareholders.

If a Firm Utilizes Debt Financing, an X% Decline in Earnings