The Fan Corp. in 2016 had revenues of $24,000, variable costs of $12,000, fixed operating costs of $4,000, interest expenses of $2,000, no taxes, and net income = $6,000. The financial leverage effect for this company is
A) 1.333
B) 2
C) 3
D) 4

Question

Quizplus · Accepted Answer

The financial leverage effect is calculated as the ratio of the percentage change in net income to the percentage change in operating income (EBIT). Here, the operating income (EBIT) is $8,000 ($24,000 revenue - $12,000 variable costs - $4,000 fixed costs). The net income is $6,000 after subtracting the interest expenses of $2,000. The financial leverage effect is calculated as ($8,000 - $6,000) / $6,000 = $2,000 / $6,000 = 1/3. To find the ratio of percentage changes, we compare the change in net income to the change in EBIT, which gives us a leverage effect of 1.333 (since a $1 change in EBIT leads to a $0.75 change in net income, the ratio is 1/0.75 = 1.333).