In an EPS-EBIT graphical relationship, the debt ray and equity cross. At this point the equity and debt are:
A) equivalent with respect to EPS but above and below this point equity is always superior.
B) at breakeven in EPS but above this point debt increases EPS via leverage and decreases EPS below this point.
C) equal but away from breakeven equity is better as fewer shares are outstanding.
D) at breakeven and MM Proposition II states that debt is the better choice.
E) at breakeven and debt is the better choice below breakeven because small payments can be made.

Question

Quizplus · Accepted Answer

The point where the debt and equity rays cross in an EPS-EBIT analysis represents the breakeven point in terms of EPS. Above this point, the use of debt financing (leverage) increases EPS due to the fixed cost of debt being covered by higher earnings, enhancing returns to equity holders. Below this point, the fixed interest payments on debt decrease EPS more than if the firm were financed only with equity.

In an EPS-EBIT Graphical Relationship, the Debt Ray and Equity