Which of the following statements are true regarding the effect of financial leverage and the firm's operating earnings (EBI)?Multiple select question.Financial leverage increases the slope of the EPS line.The rate of return on assets is unaffected by leverage.Below the indifference or break-even point in EBIT, an unlevered capital structure is best.Above the indifference or break-even point in EBIT, the increase in EPS for all equity structures is greater than leveraged structures.
Question
Which of the following statements are true regarding the effect of financial leverage and the firm's operating earnings (EBI)?Multiple select question.Financial leverage increases the slope of the EPS line.The rate of return on assets is unaffected by leverage.Below the indifference or break-even point in EBIT, an unlevered capital structure is best.Above the indifference or break-even point in EBIT, the increase in EPS for all equity structures is greater than leveraged structures.
Solution
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Financial leverage increases the slope of the EPS line: This statement is true. Financial leverage refers to the use of debt to acquire additional assets. When a company uses financial leverage, it increases the potential for higher returns, which in turn increases the slope of the EPS (Earnings Per Share) line.
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The rate of return on assets is unaffected by leverage: This statement is false. The rate of return on assets is affected by leverage because leverage involves the use of borrowed funds, which come with interest costs. These costs reduce the net income, which is used to calculate the return on assets.
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Below the indifference or break-even point in EBIT, an unlevered capital structure is best: This statement is true. Below the break-even point, the interest expense of a leveraged capital structure can cause a company to have negative earnings. Therefore, an unlevered (or equity-financed) capital structure would be best as it does not have this risk.
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Above the indifference or break-even point in EBIT, the increase in EPS for all equity structures is greater than leveraged structures: This statement is false. Above the break-even point, a leveraged capital structure can provide a higher return on equity due to the interest tax shield. Therefore, the increase in EPS for leveraged structures would be greater than for all equity structures.
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