An increase in the financial leverage of a firm will generally increase the variability in EPS for the firm.

Question

Quizplus · Accepted Answer

Financial leverage refers to the use of borrowed funds to finance investments. When a firm uses more debt (or financial leverage), its fixed interest payments increase. This can lead to variability in the earnings per share (EPS) of the firm because when earnings increase, the interest payments stay fixed, so the portion of earnings available to shareholders increases disproportionately. However, if earnings decrease, the interest payments still have to be paid, so the portion of earnings available to shareholders decreases disproportionately, leading to more variability in EPS. Therefore, an increase in financial leverage will generally increase the variability in EPS for the firm.

An Increase in the Financial Leverage of a Firm Will